Chapter 1Introduction One of the popular definitions of strategic financial management as per the official terminology of the CIMA is, “the identification of the possible strategies capable of maximizing an organization’s net present value, the allocation of scarce capital resources among the competing opportunities and the implementation and monitoring of the chosen strategy, so as to achieve stated objectives”. So it can be said that, strategy depends on the stated objectives or targets. So, let us start with identifying and formulating these objectives. Financial Objectives It is needless to say that one of the most important objectives of a company is maximizing the wealth of its shareholders. It is to be kept in mind that a company is financed by its ordinary shareholders, preference shareholders, loan stock holders and other long-term and short-term creditors. The entire fund that is surplus, belongs to the legal owners of the company, and its ordinary shareholders. Any retained profits are the undistributed wealth of these equity shareholders. The non-financial objectives do not ignore financial objectives altogether, but they point towards the fact that the simple theory of company finance which postulates that the primary objective of a firm is to maximize the wealth of ordinary shareholders, is too simplistic. In essence, the financial objectives may have to be compromised in order to satisfy non-financial objective. Value Enhancement in the Business Parlance When the prices of the shares of a company that are traded on a stock market rises, the wealth of the shareholders tends to get increased. The price of a company’s share goes up when the company is expected to make attractive profits, which it plans to pay as dividends to its shareholders or re-invest in the business to achieve future profit growth and dividend growth. However, it is also to be kept in mind that in order to increase the price of the share, the company should achieve its profits without taking business risks and financial risks which might worry its shareholders. Non-financial Objectives of a Firm Having discussed the financial objectives of the firm at length, let us now look into some of the non-financial objectives. The non-financial objectives of a firm can be as follows: a. General welfare of the employees, which includes providing the employees with good wage, salaries, comfortable and safe working conditions, good training and career developments and good pensions. b. Welfare of the management which includes providing them with the better salaries and perquisites though it will be at the cost of the company’s expenditure. c. Welfare of the society as a whole. For example, the oil companies confront with the problem of protecting the environment and preserving the earth’s dwindling energy resources. d. Fulfillment of responsibilities towards customers and suppliers. e. Leadership in research and development. Agency Theory Agency theory is often described in terms of the relationships between the various interested parties in the firm. The theory examines the duties and conflicts that occur between parties who have an agency relationship. Agency relationships occur when one party, the principal, employs another party, called the agent, to perform a task on their behalf. Agency theory is helpful in explaining the actions of the various interest groups in the corporate governance debate. For example, managers can be seen as the agents of shareholders, employees as the agents of managers, managers and shareholders as the agents of long and short-term creditors, etc. In most of these principal-agent relationships conflicts of interest is seen to exist. It has been widely observed that the conflicts between shareholders and managers and in a similar way the objectives of employees and managers may be in conflict. Although the actions of all the parties are united by one mutual objective of wishing the firm to survive, the various principals involved might make various arrangements to ensure their agents work closer to their own interests. For example, shareholders might insist that part of management remuneration is in the form of a profit related bonus. The agency relationship arising from the separation of ownership from management is sometimes characterized as the agency problem. For example, if managers hold none or very little of the equity shares of the company they work for, what is to stop them from: Working inefficiently? Not bothering to look for profitable new investment opportunities? Giving themselves high salaries and perks? 1 One power that shareholders possess is the right to remove the directors from office. But shareholders have to take the initiative to do this, and in many companies, the shareholders lack the energy and organization to take such a step. Even so, directors will want the company’s report and accounts, and the proposed final dividend, to meet with shareholders’ approval at the AGM. Another reason why managers might do their best to improve the financial performance of their company is that managers’ pay is often related to the size or profitability of the company. Managers in very big companies, or in very profitable companies, will normally expect to earn higher salaries than managers in smaller or less successful companies. Perhaps the most effective method is one of long-term share option schemes to ensure that shareholder and manager objectives coincide. Management audits can also be employed to monitor the actions of managers. Creditors commonly write restrictive covenants into loan agreements to protect the safety of their funds. These arrangements involve time and money both in initial set-up, and subsequent monitoring, these being referred to as agency costs. Stakeholder Groups and Strategy The actions of stakeholder groups in pursuit of their various goals can exert influence on strategy. The greater the power of the stakeholder, the greater the influence will be. Each stakeholder group possesses different expectations about what it wants, and the expectations of the various groups’ conflicts with each other. Each group, however, tends to influence strategic decision-making. The relationship between management and shareholders is sometimes referred to as an agency relationship, in which the managers act as agents for the shareholders, using delegated powers to run the affairs of the company in the shareholders’ best interests. Primary Reasons for Conflicts of Interest Maximization of Shareholder Wealth Although most of the financial management theory is developed keeping in mind the assumed objective of maximizing shareholder wealth, it is, at the same time, important to note that in reality, companies may be working toward other objectives. The other parties that share interests in the organization (e.g., employees, the community at large, creditors, customers, etc.) have objectives that differ to those of the shareholders. As the objectives of these other parties might conflict with those of the shareholders, it will be impossible to maximize shareholder wealth and satisfy the objectives of other parties at the same time. In such situations, the firm faces multiple, conflicting objectives, and satisfying of the interested parties’ objectives becomes the only practical approach for management. If this strategy is adopted, then the firm seeks to earn a satisfactory return for its shareholders while at the same time (for example) is able to pay reasonable wages to its workforce. Goal Congruence Goal congruence is the term which describes the situation when the goals of different interest groups coincide. A way of helping to achieve goal congruence between shareholders and managers is by the introduction of carefully designed remuneration packages for managers which would motivate managers to take decisions which were consistent with the objectives of the shareholders. Agency theory sees employees of businesses, including managers, as individuals, each with his or her own objectives. Within a department of a business, there are departmental objectives. If achieving these various objectives also leads to the achievement of the objectives of the organization as a whole, there is said to be goal congruence. Achieving Goal Congruence Goal congruence can be achieved, and at the same time, the ‘agency problem’ can be dealt with, providing managers with incentives which are related to profits or share price, or other factors such as: a. Pay or bonuses related to the size of profits termed as profit-related pay. b. Rewarding managers with shares, e.g.: when a private company ‘goes public’ and managers are invited to subscribe for shares in the company at an attractive offer price. c. Rewarding managers with share options. In a share option scheme, selected employees are given a number of share options, each of which gives the right (after a certain date) to subscribe for shares in the company at a fixed price. The value of an option will increase if the company is successful and its share price goes up. For example, an employee might be given 10,000 options to subscribe for shares in the company at a price of Rs.30,000 (by buying Rs.50,000 worth shares for Rs.20,000). Such measures might encourage management in the adoption of “creative accounting” methods which will distort the reported performance of the company in the service of the managers’ own ends. However, creative accounting methods such as off-balance sheet finance present a temptation to management at all times given that they allow a more favorable picture of the state of the company to be presented than otherwise, to shareholders, potential investors, potential lenders and others. An alternative approach is to attempt to monitor 2 managers’ behavior, for example, by establishing ‘Management audit’ procedures, to introduce additional reporting requirements, or to seek assurance from managers that shareholders’ interests will be foremost in their priorities. External Constraints and Financial Strategy Economic Influences Aggregate Demand and Inflation A growth in aggregate demand can have either or both of the following consequences. a. An increased production by the firms. b. Inability on the part of the firms to produce more to meet the demand, due to limitations, resulting in the increase in the price. The impact of the rate of price inflation in the economy has the following affects: a. Costs of production and selling prices b. Interest rates c. Foreign exchange rates d. Demand in the economy (high rates of inflation seem to put a brake on real economic growth). Let us now try to understand each of the above factors in detail. Interest Rates Interest rates exert the following economic influences. a. Interest rates in a country influence the foreign exchange value of the country’s currency. b. Interest rates act as a guide to the return that a company’s shareholders might want, and changes in market interest rates will affect share prices. A positive real rate of interest enhances an investor’s real wealth to the income he earns from his investments. However, when interest rates go up or down, perhaps due to a rise or fall in the rate of inflation, there will also be a potential capital loss or gain for the investor. In other words, the market value of interest-bearing securities will alter. Market values will fall when interest rates go up and vice versa. Interest Rates and Share Prices When interest rates change, the return expected by investors from shares also tends to change. For example, if interest rates fall from 14 percent to 12 percent on government securities, and from 15 percent to 13 percent on company debentures, the return expected from shares (dividends and capital growth) would also fall. This is because shares and debt are alternative ways of investing money. If interest rates fall, shares become more attractive to buy. As demand for shares increases, their prices too rise, and so the dividend return gained from them falls in percentage terms. Interest Rates are Important for Financial Decisions by Companies Interest rate is important for financial decisions by companies. The incidence of the interest rates can have the following effects. a. When interest rates are low, it might be beneficial: i. To borrow more, preferably at a fixed rate of interest, and so increase the company’s gearing, ii. To borrow for long periods rather than for short periods, iii. To pay back loans which incur a high interest rate, if it is within the company’s power to do so, and take out new loans at a lower interest rate. b. When interest rates are higher: i. A company might decide to reduce the amount of its debt finance, and to substitute equity finance, such as retained earnings, ii. A company which has a large surplus of cash and liquid funds to invest might switch some of its short-term investments out of equities and into interest bearing securities, iii. A company might opt to raise new finance by borrowing short-term funds and debt at a variable interest rate (for example on overdraft) rather than long-term funds at fixed rates of interest, in the hope that interest rates will soon come down again. 3 Interest Rates and New Capital Investments When interest rates go up, consequently the cost of finance to a company also goes up; the minimum return that a company will require on its own new capital investments also goes up. A company’s management is supposed to give close consideration, when interest rates are high, keeping investments in assets, particularly unwanted or inefficient fixed assets, stocks and debtors, down to a minimum. This activity of the company is done in order to reduce the company’s need to borrow. At the same time, the management also needs to bear in mind the deflationary effect of high interest rates that deters spending by raising the cost of borrowing. Financial Planning and Strategic Planning Financial Planning The management function of planning requires the development, definition and evaluation of the following: a. The organization’s objectives, b. Alternative strategies for achievement of these objectives. The objectives of business activity are invariably concerned with money, as the universal measure of the ability to command resources. Thus, financial awareness probes into all business activities. Nevertheless, finance cannot be managed in isolation from other functions of the business and, therefore, financial planning will be undertaken within the framework of a plan for the whole organization, i.e., a corporate plan. The Relationship between Short-term and Long-term Financial Planning The process of financial planning must begin at the strategic level, where the corporate strengths and weaknesses are reviewed and long-term objectives are identified. It is to be kept in mind that business review should enable a forecast to be made of future changes in sales, profitability and capital employed. When this forecast is compared with the results desired by the corporate objectives, a gap may be identified which must be made good by developing new strategies. Senior management must negotiate with middle management, until a single strategic plan for the whole company is agreed. From this strategic plan, tactical plans must be drawn up (e.g., pricing policies, personnel requirements, and production methods) and a medium-term plan established. This medium-term plan can be broken down into a series of short-term financial plans at a later point of time. Potential Conflicts between Short-term and Long-term Objectives Companies are often accused of favoring short-term profitability at the expense of long-term prosperity. For example, an investment in the latest technology in production machinery might be postponed because of fear of increasing the depreciation charge, although longer-term profitability will be improved by the investment. Types of Long-term Strategy The different types of long-term strategies can be better understood with the help of the following flow chart. Long-term strategies Survival Growth By acquisition Internal 4 Survival Strategies Non-growth Strategies A non-growth strategy refers to that strategy where there is no growth in earnings. This does not necessarily mean no turnover. A company might pursue a non-growth strategy if it saw its non-economic objectives as more important than its economic objectives. The primary reasons for adopting a non-growth strategy may include, • Pressure from public opinion; • Maintain an acceptable quality of life; • Lack of enough additional staff with sufficient expertize and loyalty; • Enable the owner-manager to retain personal control over operations; and • Diseconomies of scale of the particular production set-up. In certain cases, there could even be negative growth, by paying out dividends larger than current earnings, so that shareholders are effectively receiving a refund of their capital investment, and there is a net fall in assets employed. A negative growth strategy can be adopted in pursuit of an objective to increase the percentage return to the shareholders – if the company pulls out of the least profitable areas of its operations first, it will increase its overall return on investment, although the total investment will be less. The negative growth strategy consists of an orderly, planned withdrawal from less profitable areas, and while the shareholder’s dividend may eventually decline, his return can rise since the capital invested also falls. If the company simply runs down, his return will also fall. Corrective Strategies A non-growth strategy certainly does not mean that the company can afford to be complacent. A considerable amount of management time should be devoted to consider the actions needed to correct its overall strategic structure to achieve the optimum. This involves seeking a balance between its overall strategic structures to achieve the optimum. This involves seeking a balance between different areas of operations and also seeking the optimum organization structure for efficient operation. Thus although there is no overall growth (or negative growth occurs) the company will shift its product market position, employ its resources in different fields and continue to search for new opportunities. In particular, the company will aim to correct any weaknesses which it has discovered during its appraisal. For this reason the term corrective strategy is also used. A non-growth strategy is bound to be a corrective strategy, but a corrective strategy can also be used in conjunction with, or as one component of, a growth strategy. Risk-reducing Contingency Strategies A company faces risk because of its lack of knowledge of the future. The extent of the risk it faces can be revealed by the use of performance-risk gap analysis, where forecasts of the outcome in n years’ time takes into account not only the likely return but also the risk involved. While on the subject of risk, it should be remembered that although it is desirable to reduce risk, risk is inevitably involved in any business. In fact there are different ways of looking at risk. • Risk which is inevitable in the nature of the business; this risk should be minimized as above. • Risk which an organization can afford to take. In general, high return involves higher risk and a company which is in a strong position might be prepared to take a higher risk in the hope of achieving a high return. • Risk which an organization cannot afford to take. A company cannot afford to commit penny (and perhaps an overdraft as well) to a risky project. In the event of failure it would be left in an extremely vulnerable position and could even face winding up. • Risk which an organization cannot afford not to take. Sometimes a company is forced to take a risk because it knows that its competitors are going to act and if it does not follow it could be seriously left behind. 5 Chapter 2 Conceptual Framework The capital structure is the basic concept that should be designed with the aim of maximizing the market valuation of the firm in the long run. The important determinants in designing capital structure are: 1. Type of Asset Financed: Ideally short-term liabilities should be used to create short-term assets and long-term liabilities for long-term assets. Otherwise a mismatch develops between the time to extinguish the liability and the asset generation of returns. This mismatch may introduce elements of risks like interest rate movements and market receptivity at the time of refinancing. 2. Nature of the Industry: A firm generally relies more on long-term debt and equity if its capital intensity is high. All short-term assets need not be financed by short-term debt. In a non-seasonal and non- cyclical business, investments in current assets assume the characteristics of fixed assets and hence need to be financed by long-term liabilities. If the business is seasonal in nature, the funding needs at seasonal peaks may be financed by short-term debt. The risk of financial leverage increases for businesses subject to large cyclical variations. These businesses need capital structures that can buffer the risks associated with such swings. 3. Degree of Competition: A business characterized by intense competition and low entry barriers faces greater risk of earnings fluctuations. The risks of fluctuating earnings can be partially hedged by placing more weightage for equity financing. Reductions in the levels of competition and higher entry barriers decrease the volatility of the earnings stream and present an opportunity to safely and profitably increase the financial leverage. 4. Obsolescence: The key factors that lead to technological obsolescence should be identified and properly assessed. Obsolescence can occur in products, manufacturing processes, material components and even marketing. Financial maneuverability is at a premium during times of crisis triggered by ' obsolescence. Excessive leverage can limit the firm's ability to respond to such crisis. If the chances of obsolescence are high, the capital structure should be built conservatively. 5. Product Life Cycle: At the venture stage, the risks are high. Therefore equity, being risk capital per se, is usually the primary source of finance. The venture cannot assume additional risks associated with financial leverage. During the growth stage, the risk of failure decreases and the emphasis shifts to financing growth. Rapid growth generally signals significant investment needs and requires huge sums of capital to fuel growth. This may entail large doses of debt and periodic induction of additional equity capital. As growth slows, seasonality and cyclicality become more apparent, As the business reaches maturity stage, leverage is likely to decline as cash flows accelerate. 6. Financial Policy: Designing an optimum capital structure should be done in response to overall financial policy of the firm. The management may have evolved certain financial policies like maximum debt-equity ratio, predetermined dividend pay-out, minimum debt service coverage level, etc, Designing of capital structure will become subservient to such constraints and the solution provided may be suboptimal. 7. Past and Current Capital Structure: The proposed capital structure is often determined by past events. Prior financing decisions, acquisitions, investment decisions, etc. create conditions which may be difficult to change in the short run. However, in the medium- to long-term, capital structure can be changed by issuing or retiring debt, issuing equity, equity buy-backs (when permitted), securitization, altering dividend policies, changing asset turnover, etc. 8. Corporate Control: Firms which are vulnerable to takeover are averse to further issuance of equity as it can result in the dilution of the ownership stake. Such firms place an excessive reliance on debt and retained earnings. Firms with 'strong' management (having controlling stake) are unlikely to have reservations over further issue of equity. 9. Credit Rating: The market assigns a great deal of weightage to the credit rating of a firm. Hence obtaining and maintaining a target rating has become imperative for most firms. Rating agencies maintain constant watch to identify any signs of deterioration in the creditworthiness of the company. The market reacts negatively to any downgrading of the rating of a firm. This may result in a denial of access to capital either due to the provision of any law/regulations (companies below a certain rating cannot issue CPs) or by the market forces (investors may not subscribe to debt with low ratings). The possibility of downgrading of rating due to the increase in leverage should be factored in while making capital structure decisions. ROI-ROE Analysis The relationship between the Return on Investment (total capital employed) and the return on equity (net worth) at different levels of financial leverage needs to be analyzed. 6 The relation between ROI and ROE is as follows: ROE = {ROI + (ROI - kd) D/E) (I -1). Where, ROE is the return on equity ROI is the return on investment kd is the cost of debt (pre-tax) D is the debt component in the total capital E is the equity component in the total capital t is the tax rate The ROE of an unlevered firm (or a firm with a lower leverage) is higher than the ROE of a levered firm (or a firm with a higher leverage) when the ROI is lower than the cost of debt. Conversely, the ROE of a levered firm is higher than the ROE of an unlevered firm (or a firm with lower leverage) when the ROI is higher than the cost of debt. The ROE will remain constant irrespective of the levels of leverage if the ROI is equal to the cost of debt. Beta and Theta are identical firms except for their capital structure. Particulars Beta Theta Debt - 500 Equity 1000 500 Total Investment 1000 1000 Tax Rate 40% 40% Cost of Debt - 10% We shall examine the impact on ROE of both the firms if the ROI is 5%, 10% and 20%. Particulars Beta Theta ROI 5% 10% 20% 5% 10% 20% EBIT 50 100 200 50 100 200 Interest 0 0 0 50 50 50 PBT 50 100 200 0 50 150 Tax 20 40 80 0 20 60 PAT 30 60 120 0 30 90 ROE 3% 6% 12% 0% 6% 18% It can be observed that firm Beta is better off (generates a higher ROE) when the ROI at 5% is less than the cost of debt at 10%. On the other hand, firm Theta is better off when the ROI at 20% is higher than the cost of debt at 10%. When the ROI is equal to the cost of capital, both the firms generate an identical ROE of 6%. DU PONT ANALYSIS It is important to examine a firm's rate of return on assets (ROA) in terms of profit margin and asset turnover. The profit margin measures the profit earned per Rupee of gross revenue but does not consider the amount of assets used to generate the revenue margin ratio. Return on assets = es assets/sal Average fit/sales pro Net 7 = Net profit margin x Average asset turnover When analyzing a change in return on assets, the analyst could look into the above equation to see changes in its components: net profit margin and total assets turnover. Figure 2.1 Du point Analysis A firm's rate of return on firm equity (ROE) is related to ROA through the interest-expense to-average-asset ratio and a leverage ratio - the asset-to-equity ratio, often termed the equity multiplier. Thus, the impact of ROE of changes in leverage as well as changes can be determined in firm operations and efficiency. Du point analysis is an excellent method to determine the strengths and weaknesses of a firm. A low or declining ROE is a signal that there may be a weakness. However, using Du pont analysis, source of the weakness can be determined. Asset, management, expense control, production efficiency or marketing could be the potential weaknesses within the firm. Expressing the individual components rather than interpreting ROE itself, may identify these weaknesses more readily. ECONOMIC VALUE ADDED (EVA) Economic Value Added or EVA is the economic profit generated after the cost of invested capital. EVA incorporates the opportunity cost of invested capital that is not realized by traditional accounting measures. Numerous studies have shown EVA to have a higher correlation to stock valuation than accounting based measures. EVA = Net Operating Profit after Tax - (Invested Capital x Cost of Capital) There are two steps required to convert GAAP net income to EVA. First, calculate net operating profit after tax (NOPAT) by adjusting net income. Common adjustments include extraordinary gains and losses, securities gains and losses, provision expenses and preferred stock dividends. Second, calculate invested capital and apply cost of capital. Invested capital includes book value of common and preferred equity, after-tax allowance for loan losses, and certain adjustments for cumulative non-operating gains and losses. Cost of capital equals the minimum required rate of return for investors (e.g. 15%). Whenever EVA is positive, shareholders have received a total economic return on their investment in excess of their required rate of return. . CASH FLOW RETURNS ON INVESTMENT (CFROI) CFROI is defined as the return on investment expected over the average life of the firm's existing assets. CFROI is nothing but another form of IRR measure. The key difference between the IRR and CFROI is that cash flows and investment are stated in constant monetary units in CFROI which overcome deficiencies of the traditional return on investment methods. Model for Maximizing Shareholder Value The following section discusses a few models for maximizing shareholders' wealth. Management focused on maximizing shareholders' wealth is referred to as value-based management. The models being discussed are • Marakon model • Alcar model • McKinsey model. 8 MARAKON MODEL The Marakon model was developed by Marakon Associates, a management consulting firm known for its work in the field of value-based management. According to this model, a firm's value is measured by the ratio of its market value to the book value. An increase in this ratio depicts an increase in the value of the firm, and a reduction reflects a reduction in the firm's value. The model further states that a firm can maximize its value by following these four steps: • Understand the financial factors that determine the firm's value • Understand the strategic forces that affect the value of the firm • Formulate strategies that lead to a higher value for the firm • Create internal structures to counter the divergence between the shareholders 1 goals and the management's goals. Financial Factors The first step in this model is to identify the financial factors that affect the value of the firm. The model states that a firm's market value to book value ratio, and hence, its value depends on three factors - return on equity, cost of equity, and growth rate. This conclusion is drawn indirectly from the constant growth dividend discount model. Let P0 M be the current market price of the firm's share D1 be the dividend per share after one year k be the cost of equity g be the growth rate in earnings and dividends r be the return on equity B be the current book value per share b be the dividend pay-out ratio. The constant growth dividend discount model says that g k D P − · 1 0 Further, D0 – B x r x b Substituting the value of Dj in the dividend discount model, we get Bxrxb g k b x r x B P − · 0 Dividing both sides of the equation by B, we get g k xb r B P − · 0 Further, we know that g = r (1- b) 9 or, r x b = r - g Replacing the value of r x b in the equation, we get g k b x r B M B P − · · 0 Thus, a firm's market value to book value ratio can be derived from its return on equity, its cost of equity and its growth rate. It can be observed from the formula that 1. A firm's market value will be higher than its book value only if its return on equity is higher than its cost of equity. This is supported by the other theories of valuation of equity. 2. When the return on equity is higher than the cost of equity, the higher a firm's growth rate, the higher its market value to book value ratio. Hence, a firm should have a positive spread between the return on equity and the cost of equity, and a high growth rate in order to create value tor its shareholders. Strategic Forces The financial factors that affect a firm's value are in turn affected by some strategic forces. The two important strategic factors that affect a firm's value are market economics and competitive position. The market economics determines the trend of the growth rate and the spread between the return on equity and cost of equity for (he industry as a whole. The firm's competitive position in the industry determines its relative rate of growth and its relative spread. The following figure illustrates the effect of the strategic factors on the firm's value. Figure 2.2 Strategic Determinants of Value Creation Market economics refers to the forces that affect the prospects of the industry as a whole. These include • Level of entry barriers • Level of exit barriers • Degree of direct competition • Degree of indirect competition • Number of suppliers • Kinds of regulations • Customers' influence. 10 Competitive Position refers to a firm's relative position within the industry, A firm's relative position is affected by its ability to produce differentiated products and its economic cost position. A product can be referred to as a differentiated product when the consumers perceive its quality to be better than the competitive products and are ready to pay a premium for the same. The firm can benefit from a differentiated product in two ways. It may either increase its market share by pricing it competitively, or can command a higher price for its product than its competitors, and forego the higher market share. Thus, the ability to produce differentiated products improves a firm's relative position vis-a-vis its competitors. The other factor that helps a firm enjoy a strategic advantage over its competitors is a low per unit economic cost. Economic costs include operating costs and the cost of capital employed. A low economic cost may result from a number of factors like • Access to cheaper sources of finance • Access to cheaper raw material • State-of-the-art technology resulting in better quality control • Better management • Strong dealer network • Exceptional labor relations. Strategies Once a company has identified its potential growth prospects and analyzed its strengths and weaknesses, it needs to develop strategies that would help it utilize its strengths and underplay its weaknesses, thus achieving the maximum possible growth and creating value. For achieving this objective two kinds of strategies are required - participation strategy and competitive strategy. A company, to create value for its shareholders, has to either operate in an area where the market economies are favorable, or has to produce those products in which it can enjoy a highly competitive position. The strategy that specifies the broad product areas or businesses in which a firm is to be involved is referred to as its participation strategy. At the level of a business unit, this strategy outlines the market areas (in terms of the geographical areas, the high-end market or the low-end market, the level of quality and differentiation to be offered) to be entered. The strategy on the preferred markets is followed by the competitive strategy, which specifies the plan of action required for achieving and maintaining a competitive advantage in those markets. It includes deciding the way of achieving product differentiation, the method for utilizing the differentiation so created (i.e. by increasing the price of the product or the market share) and the means of creating an economic cost advantage. Internal Structures The separation of ownership and management in the traditional manner results in the management bearing all the risks associated with value-adding decisions, without their enjoying any of the benefits. This often results in the management taking sub-optimal decisions. A firm needs internal structures which can control this tendency of the management. These may include • The management's compensation being linked to the company's performance • Corporate governance mechanisms that specify responsibilities and holds managers accountable for their decisions • Resource allocation among projects guided by the specific requirements of the projects rather than the past allocations and capital rationing • A mechanism for making sure that the various projects undertaken form part of a strategy, rather than being disjointed, discrete projects Plans being made in accordance with the long-term goals and target performance being fixed in accordance with these plans, rather than the level of achievable targets determining the plans. Performance targets should 11 be a function of the plans, rather than being the base for the plans. Target performance, when achieved, should be rewarded with promised incentives. Non-fulfillment of such promises affects the future performance. ALCAR MODEL The Alcar model, developed by the Alcar Group Inc., a company into management education and software development, uses the discounted cash flow analysis to identify value adding strategies. According to this model, there are seven 'value drivers' that affect a firm's value. These are • The growth rate of sales • Operating profit margin • Income tax rate • Incremental investment in working capital • Incremental investment in fixed assets • Value growth duration • Cost of capital. Value growth duration refers to the time period for which a strategy is expected to result in a higher than normal growth rate for the firm. The first six factors affect the value of the strategy for the firm by determining the cash flows generated by a strategy. The last term, i.e. the cost of capital, affects the value of the strategy by determining the present value of these cash flows. The following figure represents the Alcar approach. According to the model, a strategy should be implemented if it generates additional value for a firm. For ascertaining the value generating capability of a strategy, the value of the firm's equity without the strategy is compared to the value of the firm's equity if the strategy is implemented. The strategy is implemented if the latter is higher than the former. The following steps are undertaken for making the comparison. Figure 2.3 Calculate the value of the firm's equity without the strategy The present value of the expected cash flows of the firm is calculated using the cost of capital. The cash flows should take the firm's normal growth rate and its effect on operating flows and additional investment in fixed assets and working capital into consideration. The cost of capital would be the weighted average cost of the various sources of finance, with their market values as the weights. The value of the equity is arrived at by deducting the market value of the firm's debt from its present value. Calculate the value of the firm if the strategy is implemented The firm's cash flows are calculated over the value growth duration, taking into consideration the growth rate 12 generated by the strategy and the required additional investments in fixed assets and current assets. These cash flows are discounted using the post-strategy cost of capital. The post-strategy cost of capital may be different from the pre-strategy cost of capital due to the financing pattern of the additional funds requirement, or due to a higher cost of raising finance. The PV of the residual value of the strategy is added to the present value of these cash flows to arrive at the value of the firm. The residual value is the value of the steady perpetual cash flows generated by the strategy, as at the end of the value growth duration. The post-strategy market value of debt is then deducted from the value of the firm to arrive at the post-strategy value of equity. The value of the strategy is given by the difference between the post-strategy value and the pre-strategy value of the firm's equity. A strategy should be accepted if it generates a positive value. MCKINSEY MODEL The McKinsey model, developed by leading management consultants McKinsey & Company, is a comprehensive approach to value-based management. It focuses on the identification of key value drivers at various levels of the organization, and places emphasis on these value drivers in all the areas, i.e. in setting up of targets, in the various management processes, in performance measurement, etc. According to Copeland, Roller and Murrin, value-based management is "an approach to management whereby the company's overall aspirations, analytical techniques, and management processes are all aligned to help the company maximize its value by focusing management decision-making on the key drivers of value". According to this model, the key steps in maximizing the value of a firm are as follows: • Identification of value maximization as the supreme goal • Identification of the value drivers • Development of strategy • Setting of targets • Deciding upon the action plans • Setting up the performance measurement system • Implementation. Value Maximization - The Supreme Goal A firm may have many conflicting goals like maximization of PAT, maximization of market share, achieving consumer satisfaction, etc. The first step in maximizing the value of a firm is to make it the most important goal for the organization. It is generally reflected in maximized discounted cash flows. The other goals that a firm may have are generally consistent with the goal of value maximization, but in case of a conflict, it should prevail over all other objectives. Identification of the Value Drivers The important factors that affect the value of a business are referred to as key value drivers. It is necessary to identify these variables for value-based management. The value drivers need to be identified at various levels of an organization, so that the personnel at all levels can ensure that their performance is in accordance with the overall objective. The other objectives of a firm mentioned above may act as value drivers at some level of the organization. For example, degree of innovation in products may be identified as the value driver for the design department. The three main levels at which the key value drivers need to be identified are • The generic level: At this level, the variables that reflect the achievement or non-achievement of the value maximization objective most directly are identified. These may be the return on capital employed or operating margin or the net profit margin, etc. • The department level: At this level, the variables that guide the department towards achieving the overall objective are identified. For example, for the sales department, the key value drivers may be achieving the optimum product mix, maximizing market share, etc. • The grass roots level: At the grass roots level, the variables that reflect the performance at the operational level are identified. These may be the level of capacity utilization, cost of managing inventory, etc. Development of Strategy The next step is to develop strategies at all levels of the organization, which are consistent with the goal of value maximization, and lead to the achievement of the same. The strategies should be aimed at and give 13 directions for the achievement of the desired level of the key value drivers. Setting of Targets Development of strategies is followed by setting up of specific short-term and long-term targets. These should be specified in terms of the desirable level of key value drivers. The short-term targets should be in tune with the long-term targets. Similarly, the targets for the various levels of the organization should be in tune. They should be set both for financial as well as non-financial variables. Deciding upon the Action Plans Once the strategy is in place and the targets have been determined, there is a need to specify the particular actions that are required to be undertaken to achieve the targets in a manner that is consistent with the strategy. At this stage, the detailed action plans are laid out. Setting up the Performance Measurement System The future performance of personnel is affected by the way their performance is measured, to a large extent. Hence, it is essential to set up a precise and unambiguous performance measurement system. A performance measurement system should be linked to the achievement of targets and should reflect the characteristics of each individual department. 14 Chapter 3 Strategic Wage Management Preparation and Payment of Wages and Accounting PREPARATION AND PAYMENT OF WAGES When wages are paid on the basis of time, Clock Cards form the basis of preparation of Payroll On the other hand, when payments are made on the basis of results, Piece Work Cards form the basis of preparation of the Payroll or Wages Sheet. It is desirable that separate Payroll or Wages Sheet is prepared for each cost centre or department. This will serve three purposes, viz., (a) The volume of work can be spread over; (b) The departmental labour rate can be calculated for each department, and (c) The actual wages of a department can be compared with the budgeted wages so as to pin down responsibility. From the gross wages certain deductions are made to ascertain the net amount payable to the workers. For instance, under the Payment of Wages Act, 1963, some of the authorized heads of deductions are: 1. House Rent and supply of other amenities and services. 2. Advance taken by workers. 3. Income-tax. 4. Provident Fund. 5. Employees' Slate Insurance. 6. Co-operative Society dues, etc. When the Wages Sheets are completed, they are passed to the cashier for payment. The cashier then makes arrangement for paying out wages. Prevention of fraud in wage payment: One of the problems associated with wage payment is the possibility of fraud perpetuated by workers. The following types of frauds are more commonly seen: 1. Inclusion of ghost or dummy workers in the payroll. 2. Inclusion of wrong hours when payment is done on the basis of time or overstatement of work done when payment is made on the basis of results. 3. Use of wrong rate of pay in the payroll. 4. Inclusion of overtime, bonus, etc. not entitled or due, or overstatement of the amount due, 5. Deliberate absenteeism on the date of wage payment to claim fraudulent payment later. 6. Omission to make authorized deductions (partially or fully), etc. To prevent fraud in payment of wages, a number of steps should be taken. These are: 1. Payment of wages in a factory is to be made preferably at the same time and in all the departments/sections in the presence of the departmental/sectional heads. All payments should be made only on proper identification. 2. Attendance time should be reconciled with time booked and lost time. This will help in detecting attendance of a dummy worker fraudulently marked in the time card. 15 3. The rate of wages (time or piece basis) should be verified from relevant schedule of wage rates. Any change in the rate should be incorporated in the schedule only when it is approved by a responsible officer. 4. There should be proper authorization in advance for overtime work. Actual hours worked should not exceed that authorized, Similarly, payment for idle time, scrap and defective production should be made only on proper authorization. Payment for incentives should be made only on the basis of a certificate issued and initialled by the inspector. 5. Certain necessary safeguards within the wages section are to be taken. For instance, those who check the Clock Cards should not be concerned with the preparation of the payroll and those who do that work should not be concerned with making up the pay, or in paying out the wages. Further, all calculations of payroll should be verified by another clerk. The payroll should be signed by the individuals on preparation and verification. 6. Unclaimed wages should be paid on particular dates under strict supervision. All payments in this respect should be made after proper scrutiny of the reason for not drawing wages on the payment day. 7. The exact amount of wages should be drawn from the bank and each individual should be paid his exact amount. Before handing over the pay packet, it should be recounted by another individual. 8. Outstation workers should be paid by the staff from Head or Main Cash office. ACCOUNTING FOR WAGES An analysis of the wages to the main control accounts is essential for accounting purposes. For this purpose, it is necessary to make use of a Wages Analysis Book. Wages Analysis Book Dept Total Work-in- Progress Fy. O.H. Control A/c Admn. O.K. Control A/c Selling and Distribution O.H. Control A/c Net Amount Deduction Accounts Income Tax P.F. E.S.I. Others Wages Analysis Book The above analysis is necessary for accounting. The deduction accounts relate to credit side for use in an integral system of accounts. From Figure 3.9 it will be seen that provision is made for entering the wages by departments, and. extending them to Work-in-Progress Control Account, Factory Overhead Control Account, Administration Overhead Control Account, and Selling and Distribution Overhead Control Account. The documents necessary for compiling these extensions are: (1) Payroll (2) Job Cards (3) Idle time Cards (4) Wages Analysis Sheet Treatment of Idle Facilities, Idle Time, etc. Idle Facilities It is the availability of facilities of plant and machinery and others which are not being utilized. It is not possible to work a machine all the available time. Idle facilities may be unavoidable and avoidable. Unavoidable idle facilities is the difference between maximum capacity and budgeted or standard capacity expected. Avoidable idle facilities is the difference between budgeted or standard capacity expected and the aggregate of actual time booked and the idle time. 16 No ................... Week Ending. Wages Analysis Sheet Job No. 10 Job No. 1 1 Job No. 13 Job No. 15 Job No, 16 Summary C l o c k N o . H r s . A m o u n t C l o c k N o . H r s . A m o u n t C l o c k N o . H r s . A m o u n t C l o c k N o . H r s . A m o u n t C l o c k N o . H r s . A m o u n t J o b N o . H r s . A m o u n t C o s t L e d g e r F o l i o 10 11 13 15 16 Total Wages Analysis Sheet. This type of analysts is done with the help of Job Card and Idle time Cards. The total shown in the summary column must agree with the direct wages on the Payroll- The total will be posted to Work-in -Progress Account and Factory Overhead Control Account via Wages Analysis Book. Figure 3.1 Accounting of Labour Cost in a diagram. While accounting for wages in the Cost Ledger, it is important to segregate the cost into direct and indirect—the direct labour cost being charged to prime cost while indirect labour being included in product cost as overhead (production, administration, selling and distribution, as the case may be) on some equitable basis. (For details of accounting procedure see Chapter 7 on Cost Control Accounts.) Illustration 3.1 Machine capacity: 48 hours per week No. of working weeks in a year 50 Anticipated working hours: 80% of maximum possible hours Actual hours worked: 1,800 Idle time (hours): Waiting for instructions 40 Waiting for materials 20 Machine breakdown 30 17 90 Idle facilities may be calculated as follows: Maximum possible capacity in the year (48 X 50) = 2,400 hours Budgeted or standard capacity expected for the period (2,400 x 80%) = 1,920 hours (i) Unavoidable idle facilities (2,400 - 1,920) 480 hours (ii) Avoidable idle facilities: Standard capacity expected 1,920 hrs. Less: Actual hours recorded 1,800 Add: Idle time 90 1,890 hrs. 30 hours The main point of distinction between idle facilities and idle time is that the former is related with idleness of plant, machinery and other facilities while the latter with idleness of labour. Treatment in cost: The cost of idle facilities will include part of standing or fixed charges relating to the machine, and share of general overhead. The labour cost of operator may be excluded on the assumption that the operator has worked with another machine during the hours the machine was available for work. The cost of idle facilities for reasons such as trade depression, shortage of demand, etc. should be written off to Costing Profit and Loss Account. The remaining portion of the cost of idle facilities should be included in the works overhead. Idle Time Idle lime may be defined as the time during which no production is obtained although wages are paid for that period. In other words, it denotes payment made to a worker for a period during which he remains 'idle' and does no work. This is represented by the difference between the time as per the attendance records and the time booked to the various jobs or work orders. The various causes that lead workers to sit idle may be grouped under three broad heads: I. Productive Causes which may be further classified as follows: (i) Waiting for work (ii) Waiting for tools and/or raw materials (iii) Waiting for instructions (iv) Power failure (v) Machine breakdown, etc. II. Administrative Causes which arise out of administrative decisions, e.g., when there is a surplus capacity of plant and machinery which the management decide not to work, there may be some idle time. This is represented by idle facilities. III. Economic Causes, e.g., stoppage of production due to non-availability of raw materials, fall in demand, etc. Some of the causes mentioned are controllable internally while others are beyond the control of management. Therefore, from the standpoint of controllability, idle time may be of two types: (i) controllable, i.e., idle time due to many of the productive causes is subject to control internally. (ii) uncontrollable, e.g., idle time arising out of economic and administrative causes. Treatment in costs: The cost of idle time includes wages of operators for 'lost hours', proportion of machine standing charges and general overheads. The unproductive labour element is charged to a special standing order number, or to a series of them, in order to analyze the cost by causes. The treatment of idle time in costs is as follows: (a) Cost for normal and controllable idle time: The costs should be segregated under separate standing order numbers and charged to Factory Overhead. When responsibilities can be identified with a department, they should be included in the departmental overhead. (b) Cost for normal but uncontrollable idle time: Such a cost may be merged with wages of the 18 workers. As a result of merger of idle time cost, the wage rate of the workers gets inflated. (c) Cost of abnormal and uncontrollable idle time: This represents the cost of idle time for such reasons as strike, lockouts, fire, shortage of demand, etc. This should be charged directly to Costing Profit and Loss Account. The object behind this is to keep the cost structure more or less comparable at different times and not to allow this to be disturbed by any unforeseen contingencies. Control of idle time: For effective control, each type of idle time should be allotted a separate Standing Order Number 1 and booking should be made against each of them. For example, the standing orders may be for: SO 1 Waiting for material SO 2 Waiting for instructions SO 3 Waiting for tools SO 4 Waiting for machine repairs SO 5 Waiting for change-over time SO 6 Waiting for machine setting, etc. Idle time due to productive causes are more or less subject to internal control. The procedure in this respect may be outlined below: (a) Waiting for work: All the jobs in hand should be properly planned so that machines can always take up the jobs in sequence and workers do not have to wait for them. (b) Waiting for tools, etc.: Considerable amount is being spent for idle time due to waiting for tools and/or materials. This can be prevented by ensuring proper stores control and tool scheduling system. (c) Waiting for instructions: Idle time due to waiting for instructions can be prevented if the production control department issues clear instructions to the workers as to how to handle the job in sequence. The instructions and drawings should be clearly laid down for all jobs taken in hand. (d) Power failure: It may be due to internal causes, such as improper inspection and maintenance of power plant, breakdown of the transmission wires or due to external reasons like failure from the main power supply station. Idle time due to internal power failure may be reduced by keeping a proper inspection and maintenance of the power plant, transmission wires, etc. But power failure due to external reason, e.g., load shedding, is generally uncontrollable. (e) Machine breakdown: Machine breakdown can be prevented by keeping proper maintenance system. In other words, a routine check of all the machines at periodical intervals is normally a cure for any major breakdown. Although the above items can be controlled by proper planning, some amount of idle time is bound to occur due to the time taken in changing from one job to another, setting up the tools for a different job when the previous one is complete. Therefore, it is advisable to prepare a report showing the analysis of lost time so that action may be taken to control idle time where necessary. The report will enable the management to locate the persons or departments responsible for any controllable lost time and to take effective remedial actions. A suggested specimen of such a report of an engineering firm is given in Figure 3.12. Overtime Generally, overtime is paid at a higher rate than the normal time. The additional amount expended on overtime work is known as overtime premium. The normal wages paid form part of direct labour cost while there is considerable controversy as regards treatment of overtime premium. Before dealing with the treatment of overtime premium, it is, therefore, necessary to give consideration to the circumstances under which overtime work is generally required. They are: (i) To complete a work or job within a specific date as requested by the customer. (ii) To make up time lost due to breakdown of machinery, power failure or for any other unavoidable reason, (iii) To work as a matter of policy due to labour shortage or for any other reason. In case of (i), the overtime premium should be directly charged to the job concerned and treated as direct wages. But in case of (ii), the premium paid should be treated as an excess cost and, therefore, should be kept out of prime cost. In other words, they should be treated as overhead which would be allocated and recovered 19 from jobs completed during the period. In case of (iii), the premium paid may be treated as part of labour cost by spreading the overtime premium over various jobs completed. This may be done with the help of an average rate calculated by dividing the total wages payable by the total clock hours worked. The logic behind it is that jobs will not show disproportionate labour only because they are produced at different times, e.g., usual working hours, evening overtime, holiday overtime, etc. When overtime is worked on account of abnormal conditions, such as strike, flood, etc., the premium payable should be charged to Costing Profit and Loss Account. For overtime on capital works, e.g., installation of machinery, the entire cost of overtime should be charged to the Capital Order. Work on Holiday and/or Weekly Closed Day Usually, holiday work is paid at a higher rate than normal day's wages. Such additional payment is allocated to overhead like overtime premium. However, if there is a special circumstance as visualized in case of overtime (i.e., to meet the. requirements of the customer), the additional amount is charged directly to the job concerned. Employer's Contribution to ESI The contribution made by the employer to Employees' State Insurance Corporation may be treated as follows: 1. Wage rate is inflated to include it in direct wages; 2. Recovered as overhead by means of a separate overhead percentage on direct wages; 3. Included in general overhead for recovery. For instance, in contract or process costing, it is possible to treat it as direct charge while in the case of a general engineering works which is engaged on jobbing work, the amount contributed by the employer may be treated as general overhead. Learner's Wages Generally, a worker takes more time to do a job during his training period than a trained worker. Therefore, in order to avoid loading the job with excess labour cost, half of his wages may be charged to the job direct while the other half allocated to overhead. However, when the wages cannot be identified with a job, they should be treated as overhead. In many organizations, learners' wages are, as a matter of policy, treated as training cost which forms part of overhead. Dearness Allowance, House Rent Allowance, etc. Dearness allowance is paid to the worker in addition to basic wages to cover increased cost of living. When a worker cannot be provided with factory quarters, house rent allowance is also paid for the purpose. Sometimes, compensatory allowance is paid to the workers for natural hardship in a locality. All these payments are made with an idea to keep the basic pay structure of the workers unaltered. Payments made on account of dearness allowance, etc. are treated in accounts as follows: 1. Charge directly to the work on which a worker is engaged. In other words, if payment made to each worker and the work done by him is identifiable, the job or work order (in case of direct workers) or standing order number (in case of indirect workers) is to be charged directly. 2. Charge to general overhead. (Separate standing order numbers are to be used for booking each type of allowance.) Alternatively, it may be recovered as overhead by means of a separate percentage on basic wages. Fringe Benefits These are payments for which direct efforts of the workers are not necessary. Fringe benefits, therefore, include: (i) Leave and sick pay; (ii) Holiday pay; (iii) State insurance and medical benefits; (iv) Attendance bonus and shift allowance; (v) Pension provision, retirement allowance, employer's contribution to provident fund; and (vi) other cost representing a present or future return to an employee which is neither deducted on a payroll nor paid for by the employee. 20 The cost of fringe benefits is included in the departmental overheads when department-wise identification is possible. If not, it should form part of general overheads. Separate standing order numbers should be used for each type of fringe benefits. Problems and solutions Problem 1 (Normal and Overtime Wages) Calculate the normal and overtime wages payable to a workman from the following data: Days Hours worked Monday 8 hrs. Tuesday 10 hrs. Wednesday 9 hrs. Thursday 11 hrs. Friday 9 hrs. Saturday 4 hrs. 51 hrs. Normal working hours 8 hours per day Normal rate Re. 1 per hour Overtime rate up to 9 hours in a day at single rate and over 9 hours in a day at double rate; or up to 48 hours in a week at single rate and over 48 hours at double rate, whichever is more beneficial to the workmen. Solution Total hours Normal working Overtime hours Days worked hours At Single Rate At Double Rate Monday 8 8 — — Tuesday to 8 1 1 Wednesday 9 8 1 — Thursday 11 8 1 2 Friday 9 8 1 — Saturday 4 4 _ — Total 51 44 4 3 Normal wages : 44 hours @ Re. 1 = Rs. 44 Overtime wages : At single rate : 4 hours @ Re. 1 = Rs. 4 At double rate : 3 hours @ Rs. 2 = Rs. 6 54 Rs. 10 Rs. Total wages or Normal wages : 48 hours @ Re. 1 = Rs. 48 Overtime wages : 3 hours @ Rs. 2 = Rs.54 6 Rs. Total wages Thus, whatever method is followed, wages payable to the workman is Rs. 54. Problem 2 (Overtime Impact on Labour Cost) 21 A company's basic wages rate is £ 0.45 per hour and its overtime rates are: Evenings—time and one-third; Weekends—double time. During the previous year, the following hours we; re worked Normal time 4,40,000 Clock hours Time plus one-third 40,000 Clock hours Double time 20,000 Clock hours The following times have been worked on the stated jobs: Job X Job Y Job Z Clock hours Clock hours Clock hours Normal time 6,000 10,000 8,000 Evening overtime 600 1,200 2,100 Weekend overtime 200 100 600 You are required to calculate the labour cost chargeable to each job in each of the following circumstances: (a) Where overtime is worked regularly throughout the year as company policy due to labour shortage. (b) Where overtime is worked irregularly to meet spasmodic production requirement. (c) Where overtime is worked specifically at the customer's request to expedite delivery. State briefly the reason for each method chosen. Solution Basic rate Per hour £ 0.45 Evening rate , ` . | + 45 . 0 3 1 45 . 0 x 0.60 Weekend rate (2 x 0.45) 0.90 Average wage rate during the previous year = worked hours Total paid wages Total Particulars Hours worked Rate per hour (£) Wages paid (£) Normal time 4,40,000 0.45 1,98,000 Evening overtime 40,000 0.60 24,000 Weekend overtime 20,000 0.90 18,000 Total 5,00,000 £ 2,40,000 Thus, average wage rate = 500000 £240000 = £ 0.48. (a) Since overtime is worked regularly throughout the year as a matter of company policy due to labour shortage, jobs completed during overtime (evening or holiday) should not be overloaded by charging more while those completed during normal time should not be under-loaded. This necessitates the application of the average wage rate as follows. Job Job Job X Y Z Total Clock hours 6,800 11,300 10,700 Rate per hour (£) 0.48 0.48 0.48 Labour cost chargeable (£) 3,264 5,424 5,136 (b) In this case, overtime is an abnormal and irregular feature and, therefore, overtime premium should be treated as production overhead while the jobs should be charged at basic rate only. Job Job Job X Y Z 22 Total Clock hours 6,800 11,300 10,700 Rate per hour (£) 0.48 0.45 0.45 Labour cost chargeable (£) 3,060 5,085 4,815 Since overtime is worked specifically at the request of the customer to expedite delivery, the customer would be ready to bear the excess labour cost. Therefore, the overtime premium should be charged to the jobs as follows Methods of Remuneration Labour is one of the four factors of production. Remuneration for labour is wages as remuneration for capital is interest, for land is rent and for organization is profit. Both direct and indirect labour employed in an organization will have to be paid remuneration for the services rendered by them. Selection of a right person for the right job, as we have seen in the previous Section, is crucial to labour cost management. The amount of remuneration or wages payable to each of the employees depends on a number of factors. The terms of employment generally specify the rate or scale of pay and other allowances payable to workers. In the modern industrial enterprise of mass production, a worker's wages are Dased upon job evaluation, negotiated labour contracts, profit-sharing, incentive and wages plans, etc. In this Section, we discuss methods of remuneration by grouping them under two main headings, viz. (1) Time basis, e.g., by hour, day or week, (2) Results basis, e.g., straight piecework, differential piecework. Besides all these, there are monetary and non-monetary incentive schemes which are also discussed. NEED FOR INCENTIVE SCHEMES Low wages do not necessarily mean a low cost of production. On the other hand, high wages may ultimately result in low cost of production. This is achieved in two ways: 1. High wages induce workers to produce more. Increase in productivity will result in lower labour cost per unit. 2. Because of the greater number of units produced, the unit fixed cost will also tend to come down. Further, in underdeveloped countries, one of the main needs of modern days is to raise the standard of living. This again requires the larger output of a number of consumer goods, which by chain action needs increased output all round. Sufficiency in production will also help to check inflation. FACTORS TO BE CONSIDERED The following factors must be given due consideration before selecting a system of payment. (a) Simplicity: Unless the wage system is understood by the workers, the fullest advantage cannot be obtained out of it. Therefore, the wage system should be simple and capable of being understood by workers of average intelligence. Simplicity from the point of view of analysis and recording in the Cost Accounts may also be considered. (b) Quantity and quality of output: If quantity is more important than quality, the method of remuneration should be such that it encourages increased production. On the other hand, when quality is 23 more important, wage payments should be preferably based upon time rather than on production quantities. (c) Incidence of overhead: In large manufacturing enterprises, heavy expenses of indirect nature (overhead) are incurred. A major portion of overhead is again fixed, that is to say, they remain constant even when volume of production fluctuates with a range. It should be emphasized that an increased volume of production results in lower unit fixed cost whereas a decrease in production results in increased cost of production per unit of output. Consequently, the factor 'incidence of overhead' is of outstanding significance and lies at the basis of all schemes of remuneration. In this connection, two things should be considered: (i) expected volume of output, and (ii) expected savings in time in producing it. (a) Effect upon workers: High wages will attract efficient workers from outside, and retain those who are already in employment; so the cost of labour turnover is less. The role of workers' union should also be assessed and it should be taken into consideration in selecting the wage system. (b) Statutory provisions: There may be legislative measures to protect the right of wage earners and to emphasize managerial obligations in this regard. However, the government legislation, if any, generally sets the floor, i.e., the minimum wages payable under a given situation. This aspect should not also be lost sight of. ESSENTIAL FEATURES OF AN EFFECTIVE WAGE PLAN These may be enumerated as follows: 1. It should be based upon scientific time and motion study to ensure a fair output and a fair remuneration. 2. There should be guaranteed minimum wages at a satisfactory level. 3. The wages should be related to the effort put in by the employee. It should be fair to both the employees and employer. 4. The scheme should be flexible to permit any necessary variations which may arise. 5. There must be continuous flow of work. After completing one piece, the workmen should be able to go over to the next without waiting. 6. After a certain stage, the increase in production must yield decreasing rate so as to discourage very high production which may involve heavy rejections. 7. The scheme should aim at increasing the morale of the workers and reducing labour turnover. 8. The scheme should not be in violation of any local or national trade agreements. 9. The operating and administrative cost of the scheme should be kept at a minimum. METHODS OF REMUNERATION For convenience, the various methods of remuneration may be broken down into the following main heads: 1. Time Rates 2. Piece Rates 3. Combination of Time and Piece Rates 4. Premium Bonus Schemes 5. Group Bonuses 6. Others 24 The different methods included in each of the above groups can be diagrammatically shown. Various systems may now be considered in greater detail. Figure 3.2 Wage System and Incentive Schemes Time Rate Systems The general characteristic of all the time rate systems is that the workers do not get anything beyond their time wages, i.e., Time x Rate. It is the employer who may gain arising out of extra efficiency of his workers or lose due to their inefficiency. We discuss below the features of three time rate systems. (a) Time rate at ordinary levels: Under this method, payment is made on the basis of time which may be hour, day, week or a month. The rate of pay should not be less than that prescribed by a tribunal, wage board award or by the Government through Payment of Minimum Wages Act. When payment is made on the basis of hours worked by the employees, wages are to be calculated as follows: Wages - Hours worked x Rate per hour For overtime work, an extra premium will be usually paid. (b) Time rate at high wage levels: This system is similar to the previous one except that the day rates are made high enough, so that in return a much higher standard of performance from the workers is ensured. Henry Ford was of the opinion that time rates at high wage levels are equally effective like other incentive plans. The features of a high-wages plan may be summarized below: 1. The hourly rate is higher than normal wage for the industry. 2. Standards of performance are set and there is stricter supervision to ensure the attainment of the standards. The standards set should be capable of being accomplished by an efficient worker. 3. Overtime work is not permitted. (c) Graduated time rates: Under this method, wages are paid at time rates which vary with changes in local 25 cost of living index. In India, the basic wage rates normally remain fixed and it is the dearness allowance that varies with the cost of living. Sometimes, wage rates are adjusted with changes in the selling price of the product. Application of Time Rate Systems There are many circumstances in which lime rate systems are suitable. They are: 1. Where the work demands a high degree of skill and quantity of production is less important, e.g., tool-making, machine manufacturing, watch-making, etc. 2. Where it is difficult to measure the work done by workers. This is applicable in case of indirect workers such as supervisors, cleaners and sweepers, night watchmen, etc. 3. Where machine performs the job and the workers have no control over the work, e.g., in process industries the flow of work is regulated by the speed of the conveyor belt. 4. Where work is not repetitive, e.g., in jobbing type industries. 5. Where work is of such a nature that efficiency can be ensured by close supervision. 6. Where worker does a work in his own interest, e.g., construction of accommodation. Advantages and Disadvantages of Time Rate Systems Advantages 1. It is simple to understand and operate. 2. The workers are more or less certain about the amount they will earn so long as they remain in employment. This leads to contented body of workers which in turn improve the employer-employee relationship. 3. For precision work (e.g., tool-making and pattern-making) where care is more important than speed, the time rate systems will help in maintaining quality of products. Disadvantages 1. Since the workers are certain about their wages, they may not care to improve their efficiency to increase production. In other words, the workers tend to adopt 'go-slow' tactics. This leads to higher cost of production inasmuch as more time means more labour cost and consequently more overheads. 2. Efficient workers' efforts are not rewarded. This will lead to frustration of efficient workers and consequently more labour turnover. Piece Rate Systems, i.e., Payments by Results Systems based on work are otherwise known as piece rate systems. According to these systems, the extent or volume of work done forms the basis for determination of the wages payable to the workers. It is paid at a certain rate per unit produced or job performed or operation completed irrespective of the duration of time taken by the workers. Generally, workers stand to gain or lose as a result of a standard efficiency which they attain. The slogan may be "produce more and earn more". The advantages and disadvantages of the piece rate systems in general may be summarized as follows: Advantages 1. Workers are paid only for the work they have done. Thus, the employer does not stand to lose anything because of variation in the efficiency of the workers. 2. In their bid to earn more, workers will try to adopt better and more efficient methods in order to increase production. As a result, the general dexterity and skill of the workers are enhanced. 26 3. Because of (2), a larger output will generally result. This will, in turn, lead to reduction in cost and a greater margin of profit. 4. Change-over time, wasted time, etc. are not paid for, as the payment is made only for the turnover of work and consequently idle time will be reduced to minimum. 5. Cost ascertainment becomes simplified to some extent because exact cost of labour for each unit is available. 6. The operation of piece rate wage system provides a sound basis for standard costing and production control, e.g., for ascertaining rates, a very careful time-study is necessary. Disadvantages 1. The workers will always try to produce more to earn more. Where quality of the product is no less important than the quantity, the increase in production may be achieved at the cost of quality. 2. Increased production does not necessarily mean reduced cost. For instance, if increase in production is effected through more wastage of material, high tool cost, high cost of inspection and quality control, the ultimate cost of production will be higher. Therefore, payment on the basis of piece rate system may induce the workers to increase production disregarding all this which will affect costs adversely. 3. Over-strain on the part of workers will cause frequent absenteeism and bad health. 4. The fixation of piece rates on the basis of standard time required a considerable amount of work at the outset and also during the operation of the scheme. 5. If day wages are net guaranteed, the workers will have to lose when there will be no work. Thus, if flow of work cannot be maintained, opposition from the workers is bound to come. (a) Straight Piece Rate: Under this method, payment is made on the basis of a fixed amount per unit or per fixed number of units produced without regard to time taken. Thus, Earnings = Number of units x Rate per unit The fixation of piece rate generally depends upon: (i) comparable time rate for the same class of workers, and (ii) expected output, in a given time. The piece rate is usually fixed with the help of work study Standard time for each job is ascertained first. Piece rate is then ascertained with reference to hourly or daily rate of pay. Illustration 3.3 Hourly rate of pay Standard lime per unit (ascertained by time and motion study) Rs. 2 90 minutes .'. Piece rate = 60 2 Rs x 90 = Rs. 3 (b) Piece Rates with graduated time rates: Under this system, workers are paid minimum wages on the basis of time rates. A piece rate system with graduated time rate may include any one of the following: (i) If earning on the basis of piece rate is less than the guaranteed minimum wages, the workers will be paid on the basis of time rate. On the other hand, if earning according to piece rate is more, the workers will get more. (ii) Guaranteed wages according to time rate plus a piece rate payment for units above a required minimum, (iii) Piece rate with a fixed dearness allowance or cost of living bonus. 27 (c) Differential Piece Rates: Under this system, there is more than one piece rate to reward efficient workers and to encourage the less efficient workers or a trainee to improve. In other words, earnings vary at different stages in the range of output. This scheme was first introduced in the U.S.A. by F.W, Taylor, the father of scientific management, and was subsequently modified by Merrick. These are now discussed below. (i) Taylor Differential Piece Rate System: In the original Taylor differential system, piece rates were determined by time and motion study. Day wages were not guaranteed. There were two rates: below the standard, a very low piece rate and above the standard, a high piece rate was fixed. Thus, the system was designed to: 1. discourage below-average workers by providing no guaranteed wages and setting low piece rate for low level production, and 2. reward the efficient workers by setting a high piece rate for high level production. Illustration 3.4 A factory works 8 hours a day. The standard output is 100 units per hour and normal wage rate is Rs. 5 per hour. The factory has introduced the following differentials in the matter of wage payment: 80% of piece rate when below standard 120% of piece rate when at or above standard. Thus, two piece rates will be fixed as follows: Normal piece rate = units 100 5 Rs = Re. 0.05. (a) When below standard, the piece rate will be Re. 0.04, i.e., 80% of Re. 0.05; (b) When at or above standard, the piece rate will be: Re. 0.06, i.e., 120% of Re. 0.05. The Taylor differential system is often criticized as "unfair" due to the fact that minimum wages of the worker are not guaranteed. However, Taylor's system is suitable to those industries where products including the processes and operations can be standardized. (ii) Multiple Piece Rates or Merrick Differential System: Merrick afterwards modified the Taylor's Differential Piece Rate. Under this plan, the punitive lower rate is not imposed for performance below standard. On the other hand, performance above a certain level is rewarded by more than one higher differential rates. The rates which are applied are: Efficiency Piece-rate applicable Up to 83 1% Normal rate Above 83}% but up to 100% 10% above normal rate Above 100% 30% above normal rate. Thus, this plan rewards the efficient workers and encourages the less efficient workers to increase their output by not penalizing them for performance below 834%. This method also does not guarantee day wages. Combination of Time and Piece Rates (i) Emerson's Efficiency Plan: The main features of the plan are: (a) Day wages are guaranteed. (b) A standard time is set for each job or operation, or a volume of output is taken as standard. (c) Below 66 -|% efficiency, the worker is paid his hourly rate. (d) From 66y% up to 100% efficiency, payments are made on the basis of step bonus rates. 28 (e) Above 100% efficiency, an additional bonus of 1% of the hourly rate is paid for each 1% increase in efficiency. Efficiency for this purpose is calculated as follows: (1) On time basis: Percentage Efficiency - taken Time allowed time Standard x 100 (2) On production basis: Percentage Efficiency = Production Standard Production Actual x 100 Emerson's Efficiency Plan is suitable to: (1) encourage slow workers to better their performance; (2) facilitate an easy transfer from time wages to payment by results scheme. But this scheme is not meant for skilled and competent workers. Illustration 4.5 Time Rate: Rs. 8 per hour. Standard production per week of 40 hours: 600 units. Step bonus rates are: Efficiency (%) Bonus (%) 67-75 1 76-85 4 86-95 10 96-100 20 With the foregoing basic data., Emerson's Plan may be illustrated below: Clock Card No. Production per week Percentage Efficiency Bonus Total wages Labour cost per unit Percentage Amount Rs. Rs. Re. 10 390 65 — — 320.00 0.82 11 400 67 1 3.20 323.20 0.81 12 480 80 4 12.80 332.80 0.69 17 530 88 10 32.00 352.00 0.66 19 550 92 10 32.00 352.00 0.64 20 570 95 10 32.00 352.00 0.62 26 580 97 20 64.00 384.00 0.66 28 600 100 20 64.00 384.00 0.64 30 620 103 23 73.60 393.60 0.63 (ii) Gantt Task and Bonus Scheme: This system combines time rales, high piece rates and bonus. Its main features are: 1. Day wages are guaranteed. 2. Standards are set and bonus is paid if a work is completed within the standard time allowed. 3. Performance below standard is paid on the basis of time rates (guaranteed). 29 4. Performance above standard (i.e., when time taken is less than standard time allowed) is paid at high piece rate. The foreman may also receive bonus if the workers under him qualify for it. The time and bonus rates are fixed for each job, and when a job is completed the worker goes on with the next. The pay thus earned consists of (i) day wages plus (ii) the sum of all bonuses (i.e., quantity x high piece rate). Thus, this plan provides an incentive for efficient worker to reach a high level of performance and also protects and encourages the less efficient workers by ensuring the payment of their minimum wages in case their performance is below the standard level. The Gantt Task scheme may be introduced in: 1. Heavy engineering and structural workshop. 2. Machine tool manufacturing industry. 3. Contract costing where work is to be completed within a specified date. (iii) Bedaux Scheme or 'Points' Scheme: This system requires a very accurate time study and work study. Under this scheme, each minute of standard time is called the Bedaux point or "B". Thus, each operation to be performed can be expressed as being so many "Bs" and payment is made on the basis of the number of "Bs" standing to the credit of a worker. Time wages are paid until 100% efficiency rate is reached. Under the original plan, the worker received only 75% of the bonus while the 25% was received by supervisors. But, according to modified scheme, the workers nowadays receive 100% of the bonus. The advantages of the scheme are; 1. A competitive element is introduced and this acts as an additional spur to production. 2. It is a means of strong managerial control and accordingly receives managerial support. The limitations of the scheme are: high cost due to additional clerical work and inspection, lack of attempt to control material costs, etc. Premium Bonus Schemes The various schemes under this method combine time wages with piece rates. As a result, the gains on labour efficiency and losses on inefficiency are shared by employer and employee. There are three chief schemes under this heading, viz. (a) The Halsey scheme, (b) The Halsey-Weir scheme, and (c) The Rowan scheme. (a) The Halsey Scheme: The main features of this scheme are: 1. Standard time is fixed for each job or operation. 2. Time rate is guaranteed and the worker receives the guaranteed wages irrespective of whether he or she completes the work within the time allowed or takes more time to do it. 3. If the job is completed in less than standard time, a worker is paid a bonus of 50% of the time saved at time rate in addition to his normal time wages. Thus, Earnings under this scheme will be: Guaranteed wages + Bonus (50% of time saved), if any - (Hours worked x Hourly Rate) -t- — (Time allowed - Time taken) x Hourly Rate. Illustration 3.6 30 Normal hourly rate Rs. 2 Time allowed for a job 10 hours Time taken 8 hours Therefore, total earnings will be: 1 (8 x Rs. 2) + ~ (10 - 8) x 2 = Rs. 16 -t- 2 - Rs. 18 The advantages and disadvantages of this scheme are mentioned below: Advantages 1. Simple to understand and operate. 2. The more efficient workers will be able to increase hourly rate of earnings more rapidly with the increase in hours saved. 3. Inefficient workers are not penalised as they get day wages for the hours worked. 4. The employer will share 50% of the bonus due to time saved by the workers. This may induce him to introduce better equipments and methods. Disadvantages 1. The earning per unit will come down with the increase in efficiency. This may make the workers feel that it is the employer who gains more by their efficiency. The workers may, therefore, object to share their bonus with the employer. 2. The incentive, as compared with other high incentive schemes, is not strong enough to induce the more efficient workers to work harder. (b) The Halsey-Weir Scheme: Under this scheme, a worker will get a bonus of 30% of time saved as against 50% in the case of previous scheme. In other respects, both Halsey and Halsey-Weir Schemes are similar. Illustration 3.7 Continuing the previous illustration, the earnings under this scheme will be: 8 X Rs. 2 + 100 30 (10 - 8) X Rs. 2 = Rs. 16+ 1.20 = Rs. 17.20 (c) Rowan Scheme: This scheme was introduced by David Rowan in Glasgow in 1901. As before, the bonus is paid on the basis of time saved. But unlike a fixed percentage in the case of Halsey Scheme, it takes into account a proportion as follows: Time saved Time allowed The bonus may be calculated in two ways: (i) adding it to the normal time wages, or (ii) adjusting the hourly rate. But whatever method may be followed, the final result will be the same. Formulae: (i) Time wages + (Time wages X Bonus ratio) (ii) Time taken x (Hourly rate + Hourly rate x Bonus ratio) 31 Bonus Ratio = allowed Time saved Time Time saved = Time allowed - Time taken Illustration 3.8 Time taken 8 hours Time allowed 10 hours Rate per hour Rs. 2 Therefore, bonus ratio is = 5 1 10 2 10 8 10 · · − Earnings : Method (i) 8 hrs. x Rs. 2 + Rs. 16 x 5 1 = Rs. 16 + 3.20 = Rs. 19.20 Method (ii) 8 hrs. x , ` . | + 5 1 2 2 . x Rs = 8 hrs. X Rs. 2.40 = Rs. 19.20 The advantages and disadvantages of this method are mentioned below. Advantages 1. The workers share the benefit with the employer, 2. It is suitable for learners and beginners. 3. It provides a safeguard against loose fixation of standard. For example, even if the rale setting department being newly established in a factory sets erroneously the time allowed, the workers cannot take undue advantage as only a proportion of the savings is passed on to them. Disadvantages 1. Efficiency beyond certain point is not rewarded. 2. A beginner and a more efficient worker may get the same amount of bonus. This will adversely affect the morale of the efficient workers. 3. It is more complicated than the Halsey System. Comparison of Halsey and Rowan Schemes The following table may be of interest in making the comparison between these two premium bonus schemes: Rate per hour (1) Time allowed (2) Time taken (3) Time saved (4) Time wages (5) = (1 x3) Bonus Total earnings Earnings per hour Halsey (6) Rowan (7) Halsey (8) (5 +6) Rowan (9) (5 + 7) Halsey (10) (8-3) Rowan (11) (9 + 3) Rs. Rs. Rs. Rs. Rs. Rs. Rs. Rs. 2 10 10 Nil 20 — --- 20.00 20.00 2.00 2.00 2 10 8 2 16 2.00 3.20 18.00 19.20 2.25 2.40 2 10 6 4 12 4.00 4.80 16.00 16.80 2.67 2,80 2 10 5 5 10 5.00 5.00 15.00 15.00 3.00 3.00 32 2 10 4 6 8 6.00 4.80 14.00 12.80 3.50 3.20 2 10 2 8 4 8.00 3.20 12.00 7.20 6.00 3.60 (1) Bonus earned: A comparative position of bonus at different efficiency levels under both the schemes is shown in Figure 3.3. The main points may be summarized below: (i) In the Halsey scheme, the bonus increases steadily with increase in efficiency. But in the Rowan scheme, the bonus increases up to a certain stage and then starts decreasing, (ii) Rowan scheme provides better bonus than the Halsey scheme until the work is completed in half the standard lime. Again, under Rowan scheme a less efficient worker may get the same bonus as a more efficient one will get. As for instance, when the work is done in 6 hours, the bonus payable is Rs. 4.80 while the same amount is payable to another worker who takes only 4 hours to do it. Although this is unfair, Rowan scheme may provide a safeguard against loose fixation of standard. Figure 3.3 Bonus under Halsey and Rowan Schemes (iii) When the work is completed in half the standard lime, the bonus is the same under both the schemes. 50% efficiency is the cut-off or break-even point for both the schemes. This can be proved as follows: Bonus under Halsey plan = Standard wage rate x 100 50 x Time saved (i) Bonus under Rowan plan - Standard wage rate x allowed Time saved Time x Time taken (ii) Bonus under Halsey Plan will be equal to the Bonus under Rowan Plan when the following condition holds good: Standard wage rate x 100 50 x Time saved = Standard wage rate x allowed Time taken Time x Time taken or 2 1 = allowed Time taken Time or Time taken = 2 1 of Time allowed Hence, when the time taken is 50% of the time allowed, the bonus under Halsey and Rowan plans is equal. 33 (iv) When the work is completed in less than half the standard time, bonus under Halsey scheme is greater. (2) Total earnings: Time wages under both the schemes remaining constant at a particular level of efficiency, total earnings will vary depending upon the amount of bonus. Therefore, the following points will emerge: (i) Below 50% efficiency, earnings under Rowan method will be greater than that under Halsey. (ii) At 50% efficiency level, earnings under both the schemes will be equal. (iii) Beyond 50% efficiency level, earnings under Rowan scheme will be lower than that of Halsey. (iv) In the Halsey scheme, total earnings or labour costs steadily decrease with increase in efficiency. The decrease, in the Rowan scheme, is at an accelerating pace up to saving of 50% on the time allowed; beyond that the labour costs are less than that under the Halsey scheme. (3) Earnings per hour: In the Halsey scheme, the earnings per hour increase at an accelerating rale. Under the Rowan scheme, it increases steadily. A diagrammatic representation of the comparison between Halsey and Rowan schemes is shown in Fig. 4.6. (d) Bank Scheme: Under this plan day wages are not guaranteed. Wages payable are arrived at by multiplying the hourly rate by square root of the product of the time allowed and time taken. In other [words, Wages - Hourly rate -Time allowed X Time taken Illustration 3.9 Hourly rate Time allowed for a job Rs 2 5 hours Find wages payable when time taken is given to be 5 hours, 6 hours and 4 hours respectively by three different workers. Time allowed Time taken Wages payable Wages per Worker (hours) (hours) Hourly rate x x AT ST hour Rs. X 5 6 Rs. 2 6 x 5 - Rs. 11 (approx.) 1.83 Y 5 5 Rs. 2 5 x 5 = Rs. 10 2.00 Z 5 4 Rs. 2 4 x 5 = Rs. 9 (approx.) 2.50 It appears that when efficiency increases, the rate of increase in the total earnings falls. Another disadvantage of this scheme is that because of complication involved in calculating wages, an average worker cannot himself determine his own wages. But this plan is most useful for beginners and trainees and unskilled workers. (e) Accelerating Premium Bonus: Under this scheme, bonus increases at a faster rate. For example, one may get 175% of basic wages for 175% efficiency. This scheme is not suitable for machine operators, in that owing to the high incentives the workers may rush through work to earn more, disregarding quality of production. But it is suitable for foremen and supervisors, so that they may obtain the maximum possible production from workers under them. There is no simple formula for this scheme. Therefore, each firm has to devise its own formula. However, by way of illustration, a graph of y = 0.8x 2 may be given as a general picture of the scheme (where x is percentage efficiency ÷ 100 and y = wages). Thus, Percentage efficiency 100 110 130 150 X 1 1.1 1.3 1.5 x 2 1 1.21 1.69 2.25 y = 0.8x 2 0.8 0.97 1.35 1.80 Multiplying the values of x and y by 100, one gets percentage earnings against percentage efficiency. Group Bonus Schemes 34 In all the schemes discussed so far, the bonus payable has been ascertained on an individual basis. But bonus scheme for a group of workers working together may also be introduced where: (a) it is thought necessary to create a collective interest in the work; (b) it is difficult to measure the output of individual workers; (c) the output depends upon the combined effort of a team. Under these circumstances, a group bonus based on the results of the team effort may be introduced. Illustration 3.10 Standard production 40 units per week Number of men working in the group 10 Bonus—for every 25% increase in production, a bonus of Rs. 100 will be shared pro rata among the 10 members of the group. Actual Production during a week 55 units Calculate bonus payable to each member of the group. Actual production 55 units Standard production 40 units Increase in production 15 units or 37.5% Bonus: Rs. 100 + (12.5/25 x Rs. 100) = Rs. 150 Each member of the group, therefore, receives: Rs. 150 H- 10 = Rs. 15. Illustration 3.11 In a factory, Group Bonus system is in use which is calculated on the basis of earnings under time rate. The following particulars are available for a group of 4 workers P, Q, R and S: (i) Output of the group 16,000 units (ii) Piece rate per 100 units Rs. 2.50 (iii) No. of hours worked by: P 90 Q 72 R 80 S 100 (iv) Time rate per hour for: P Re. 0.80 Q Re. 1.00 R Rs. 1.20 S Re. 0.80 Calculate the total of bonus and wages earned by each worker. Total Piece Earnings for the group = 100 50 . 2 . Rs x 16,000 = Rs. 400 Time wages of the workers: Rs. P 90 hrs. @ Re. 0.80 = 72 0 72 hrs. @ Re. 1.00 = 72 35 R 80 hrs. @ Rs. 1.20 = 96 S 100 hrs. @ Re. 0.80 = 80 320 The advantages of group bonus scheme are: 1. It creates a team spirit. 2. Harmonious working in a group leads to increased output and hence lower cost of production. 3. It eliminates excessive waste of time, materials, etc. The alleged disadvantages are: 1. The effort of more efficient workers are not properly rewarded. Put in another way, the share of inefficient workers may be the same as that received by more efficient members of the group. 2. It is difficult to fix the amount of incentive and its principle of distribution among the members. Principal Group Bonus Schemes Sometimes the idea of group bonus may be extended to the whole factory. The various schemes which may be introduced for this purpose may include the following: (a) Priestman's Production Bonus, (b) Rucker, or "Share of Production" Plan, (c) Scanlon Plan, and (d) Towne Gain Sharing Plan. (a) Priestman's Production Bonus: Under this system, a standard is fixed in terms of units or points. If actual output, measured similarly, exceeds standard, the workers will receive a bonus in proportion to the increase. Therefore, this system can operate in a factory where there is mass production of a standard product with little or no bottlenecks. Illustration 3.12 In a mass production factory, 1,000 workers are employed. Standard output for a week is set at 5,00,000 points. During a week actual output is valued at 6,50,000 points. In addition to the basic wages, the employees will, therefore, receive a bonus calculated as follows: Standard output 5,00,000 points Actual output 6.50,000 points Increase 1,50,000 36 or 30% All employees will be entitled to a bonus of 30% of their wages. (b) Rucker, or "Share of Production" Plan: According to this plan, employees receive a constant proportion of the 'added value' or 'value added 1 . The term value added is defined in the Terminology as follows: The increase in realizable value result ing from an alteration inform, location or availability of a product or service, excluding the cost of purchased materials and services. Note: Unlike conversion cost, value added includes profit. The value added concept has become increasingly important in recent years. Many firms are using it both as a measure of performance and as a labour incentive scheme. Value added measures the value added by an enterprise to its product or the provision of a service. In other words, VA = Sales less cost of bought-in materials and services or VA = Profit before tax + Conversion costs + Other costs where conversion costs include manufacturing labour and manufacturing overheads, and other costs include administration, selling and distribution costs (including interest, depreciation, etc.) In introducing an incentive scheme based on value-added, a ratio of labour cost to value added is set based on normal relationships. Any reduction in the ratio entitles appropriate bonus payment. According to Rucker, labour will receive a constant proportion of 'added-value'. Illustration 3.13 A Ltd shows the following average pattern over the past five years: Rs. Labour cost 2,20,000 Production, Admn. and Selling & Dist. Overheads 1,40,000 Profit before tax 60,000 Value added Rs . 4,00,000 The ratio of labour cost to VA is: 400000 200000 x100 = 50% Assume that bonus is payable for reduction in the ratio at 1% of the added value. In the following year, sales and added value increased. Their results were as follows: Rs. Labour cost 2,00,000 Production, Admn. and Selling & Distribution Overheads 1,50,000 Profit before tax 80,000 Value added Rs. 4,50,000 Labour cost to VA is: 450000 220000 x 100 = 48.5% Since the ratio was reduced, the bonus payable was: 1% of Rs. 4,50,000 = Rs. 4,500 The value-added scheme appears to be a more satisfactory method than the normal profit-sharing scheme for many reasons. But profit-sharing schemes are still relatively widely used in industry. However, this system presupposes a great deal of consultation between management and workers so as to make the effort more effective. 37 (c) Scanlon Plan: This plan is similar to the Rucker plan except that it adopts the ratio between wages and sales value of production. (d) Towne Gain Sharing Plan: According to this plan, 50% of "gain" (savings in cost) is paid to individual workers pro rata in addition to their basic wages. Here bonus is calculated on the basis of reduction in labour cost vis-a-vis the standard set. The supervisory staff may also receive a share of the bonus. Incentive Schemes tor Indirect Workers One of the main conditions of the incentive systems is that actual output and/or time taken in relation to standard set is determinable. In case of direct workers the measurement of performance does not involve any problem. But in case of indirect workers, whose performance cannot be directly measured (e.g., supervisors, machine maintenance staff, staff of stores, internal transport, packing, dispensing, canteen, etc.), introduction of an incentive system may appear to be difficult. Still it is essential to provide for incentives to the indirect workers for the following reasons: 1. If direct workers are rewarded for their efficiency, there is no reason why the indirect workers should not be brought under some incentive schemes. 2. When only direct workers enjoy incentive schemes, indirect workers who work side by side with them are dissatisfied with such discrimination. This, therefore, affects morale and hence efficiency of the indirect workers. On the other hand, an incentive scheme for indirect workers will increase their efficiency and promote team spirit. 3. When the work of the direct workers is related to or dependent upon that of the indirect workers, any deficiency on the part of the latter due to lack of incentive schemes will also affect adversely the efficiency of direct workers. As for example, if the plant and machinery is not properly and regularly maintained by the staff concerned, the efficiency of machine operator is bound to decrease. Therefore, to attain all round efficiency it is necessary to have incentive schemes both for direct and indirect workers. For the purpose of incentive schemes, indirect workers may be grouped as under: (a) Indirect workers working with direct workers, e.g., supervisors, inspectors, checkers, transport workers, etc. In this case, bonus may be based on the output of direct workers whom the indirect workers serve. (b) Indirect workers rendering general service, e.g., sweepers, canteen workers, dispensing staff, maintenance staff, etc. Bonus to be paid will be determined on a wider basis, e.g., output of a department or of the whole factory, a percentage of bonus payable to the direct workers, job evaluation, merit rating, etc. In designing an incentive scheme for the indirect workers, the following points must be considered: 1. It should be guaranteed for a specific period, e.g., weekly, monthly, half-yearly, yearly, etc. 2. It should be so organized as to achieve all round efficiency. 3. It should be paid at regular intervals. 4. Rewards should be related to results. A few examples of incentive schemes to indirect workers are stated below. (i) Bonus to foremen and supervisors: Supervisors and foremen may be paid a weekly or monthly bonus based upon the following: (a) output of the section or department concerned; (b) savings in time or expenditure effected over the standards set; (c) overall improvement in efficiency; (d) improvement in the quality of product; (e) reduction of scrap and waste; and (f) reduction of labour turnover. Incentive for supervisors and foremen would assist in: (a) reducing idle lime, scrap, waste, etc. (b) increasing production and productivity, and (c) reducing costs (this is possible if production and productivity are increased). (ii) Banus to repairs and maintenance staff; For routine and repetitive maintenance, a group bonus system can 38 be established on the basis of reduction on the number of complaints or reduction in breakdown. Alternatively, efficiency percentage can be evaluated for the purpose of payment of bonus. (iii) Bonus to stores staff: It may be based on value of materials handled or number of requisitions. When standards are set, efficiency percentage may be calculated for the purpose. Other Incentive Schemes (a) Indirect Monetary Incentives Of late, employees frequently receive additional remuneration based on the prosperity of the concern. The principal schemes under this heading include: (i) Profit-sharing, and (ii) Co-partnership. These schemes are becoming more and more widespread and are growing in importance. (i) Profit-sharing: Under this scheme, the employees are entitled, by virtue of an agreement, to a share of profits at an agreed percentage in addition to their wages. Sometimes, a minimum period of service is a condition of participation in the scheme. This type of scheme recognizes the principle that every worker contributes something towards profits and hence he should be paid a percentage thereof. In India, profit-sharing schemes take the form of an annual or other periodical bonus. In other words, the "available surplus" is generally distributed amongst three parties: 1. The shareholders, 2. The industry, and 3. The employees. There were considerable disputes as regards the quantum of bonus to be paid to the employees. The Govt. of India set up a Bonus Commission and on the basis of its report the Payment of Bonus Act had been adopted in 1965. Under this Act, the minimum and maximum bonus payable is respectively 8^% and 20% of salary. (ii) Co-partnership: Under this scheme, employees are allowed to have a share in the capital of the business and thereby to have a share of the profit. The shares held by the employees may or may not carry voting rights. When co-partnership operates in conjunction with profit-sharing, the employees are allowed to leave their bonus with the company as shares or as a loan carrying lucrative interest. Advantages 1. Schemes like Profit-sharing, Co-partnership, etc. will recognize the principle that every employee, directly or indirectly, contributes something towards profit. This will increase employee morale and thereby reduce labour turnover. 2. More profits may lead to more bonus to the employees. This induces them to increase their efficiency to work hard. As a result, there will be increased productivity. 3. The employees feel a greater "sense of belonging" to the enterprise and this leads to careful handling of costly materials and plants and machinery. However, certain objections are often raised. They are: 1. Employees are not paid bonus on the basis of output and hence efforts of more efficient employees are not properly rewarded. 2. The employees do not have any access to the accounts of the enterprise and, therefore, they cannot ascertain the propriety of the amount paid to them as bonus. This may, and very often does, lead to disputes which may turn to strike, lockout, etc. (b) Non-monetary Incentives These types of incentives relate more to the conditions of employment rather than to job functions. The objectives behind these schemes are two-fold: 1. Making the conditions of employment more and more attractive, and 2. Promoting better health amongst the employees so as to build up a happy and contented staff. Non-monetary incentives may be entirely free or subsidized by the company. They are wide in number and may include: 1. Canteen—free or subsidized 39 2. Health and safety 3. Recreational facilities 4. Housing facilities 5. Educational and training 4. Pension, Provident Fund schemes, etc. 40 Chapter 4 Financial aspect of supply chain management A supply chain is a network of manufacturers, suppliers, distributors, transporters, storage facilities and retailers that perform functions like procurement and acquisition of material, processing and transformation of the material into intermediate and finished tangible goods, and finally, the physical distribution of the finished goods to intermediate or final customers. Components A supply chain may consist of variety of components depending on the business model selected by a firm. A typical supply chain consists of the following components: • Customers • Distributors • Manufacturers • Suppliers Customers The customer forms the focus of any supply chain. A customer activates the processes in a supply chain by placing an order with the retailer. The customer order is filled by the retailer, either form the existing inventories, or by placing a fresh order with the wholesaler/manufacturer. In some cases a customer bypasses all these supply chain components by getting in touch with the manufacturers directly. For example in the case of an online purchase of a computer from Dell Computers, the customer places an order directly with the manufacturer. Figure 4.1: Supply Chain Network S u p p l i e r s M a n u f a c t u r e r s D i s t r i b u t i o n C e n t e r s M a r k e t s / C u s t o m e r s Retailers/Distributors The retailer acts as a link between the customer and the distributor/manufacturer. He caters to the needs of the customer by making the products available at his store. As part of this process, the retailer places orders with the inanufacturer to replenish the stocks. In a typical supply chain, purchase orders originate at the retailer's end, but in some cases where there is arrangement to share, the POS information with manufacturers the manufacturer monitors the stock levels' and replenishes it automatically, Wal-Mart has such an arrangement with P&G, 41 Manufacturers The manufacturer plays a key role in deciding the structure of supply chain. Depending on the market situation, the manufacturer either uses the pull or the push strategy to generate demand required for the movement of products in the supply chain. The manufacturer then plans for a production schedule depending on the resultant demand. Suppliers Suppliers facilitate the manufacturers', production process by ensuring continuous supply of raw materials. Manufacturers 1 place orders with suppliers on the basis of 'forecasted customer demand. Since it is very difficult to forecast demand accurately, manufacturers try to integrate their processes with those of the suppliers to be in a better position to respond to fluctuations in customer demands. Suppliers help manufacturers to decrease their inventory levels by arranging for Just-in-time supplies. Supply chain management involves the use of a set of approaches to integrate efficiently the activities of suppliers, manufacturers, warehousing providers and retailers, so that goods are produced and distributed in right quantities, to the right locations, and at the right time, in order to minimize system-wide costs while meeting customer service expectations. SUPPLY CHAIN MANAGEMENT PROCESSES Although there are many views of supply chain management, at present, many practitioners look upon supply chain management as the management of key business processes across the network of organizations that form the supply chain. According to the definition given by the Global Supply Chain Forum, supply chain management is the integration of key business processes from end-user,to original suppliers that provides products, services, and information that-.add value for customers and other stakeholders. There are eight business processes that are carried out across the supply chain. They are: • Customer Relationship Management • Customer Service Management • Demand Management • Order Fulfillment • Manufacturing Flow Management • Procurement • Product Development and Commercialization • Returns Each of the above processes consists of a set of activities from within various functions of the organizations comprising the supply chain. These functions include marketing, production, finance, research and development, logistics etc. Figure 4.1 shows the various business processes that are performed across the supply drain. Customer Relationship Management Customer relationship management involves establishing a framework for building and maintaining relationships with customers. This involves identifying the customer-groups who form the target for achieving the firm's business objectives. Then the customer service teams design the product or service agreements specifying the level of service that is to be offered to each of these customer groups. These teams work in close coordination with the key account customers to reduce demand variability. Performance reports are designed in order to measure levels of service made available to the customer and the profits resulting from serving each of the customer groups. Customer Service Management Customer service management is concerned with providing the customer -with up-to-date information relating to shipping dates, product availability, product application, etc. The customer service management teams act as an interface between the customers and the functional departments like production and logistics in administering product and service agreements. Various aspects of customer service management are discussed at length in Chapter 12. Demand Management Demand management is the key to effective supply chain management. It plays a major role in balancing the customer's requirements with the firm's supply capabilities. Demand management involves determining 42 forecasting methods to gauge customer demand, synchronizing demand with the supply capabilities of the firm, and developing contingency management systems to handle variations in demand. Steps involved in planning demand and supply in a supply chain are discussed in Chapter 4. Customer Order Fulfillment The effectiveness of a supply chain is determined by its ability to fill customer orders on time. A high order fulfillment rate with low costs requires coordination between various organizations across -the supply chain and their internal functions like manufacturing, distribution and transportation. The order fulfillment process includes activities like, receiving orders, defining the for order fulfillment, evaluating the logistics network developing plans for order fulfillment etc This topic is discussed in detail in Chapter 13. Manufacturing Flow Management Manufacturing flow management is concerned with ensuring the smooth production of goods and developing flexible production processes that can respond to the demands of the target markets. This supply chain process includes activities like determining the degree of manufacturing flexibility required, manufacturing and material planning, determining manufacturing capabilities, synchronizing production and demand, etc. Procurement Supplier relationship management guides the interactions of the firm with its suppliers. This process aims at developing long with suppliers to ensure uninterrupted flow of supplies for the firm's manufacturing processes. Such relationships are essential for effective supply chain management. Product Development and Commercialization Reducing the time to market is one of the objectives of supply chain management. The product development and commercialization process involves establishing cross-functional product development teams, designing and building prototypes, developing product rollout plans, etc. This requires the integration of customers and suppliers into the product development process to ensure speedy rollout of new products. Returns Management Many companies are forced to recall products to rectify defects upgrade the products or recycle them. Thus the returns management capability of a firm also plays a major role in providing a competitive edge to the firm. There may be many environmental issues associated with, the way a firm handles its returns. Hence, managing the products returned is also a major part of supply chain management. The returns management process is discussed at length in Chapter 11. OBJECTIVES OF SCM One of the major objectives of supply chain management is to reduce the total amount of resources necessary to provide the required level of customer service to a particular customer group. Some of the other objectives of supply chain management are to: i. Reduce inventory levels ii. Improve customer service iii. Make more efficient use of human resources iv. Ensure better delivery through reduced cycle times v. Increase the sharing of information and technology among the participants in the supply chain. vi. Decrease the time required to market new products vii. Enable firms to focus on core competencies viii. Enhance the public image of companies ix. Induce greater trust and interdependence between supply chain partners x. Increase shareholder value xi. Gain competitive advantage over others. Financial flow is an important flow in any supply chain [apart from material and information "flows]. Firms in the past, focused mainly on improving the material flow in their supply chains. But with opportunities for saving cost and making profits arising from improving the financial flow, firms have begun to streamline the financial flow as well. Technological advances that facilitate automation, have enabled firms to improve the financial flow. Traditionally, backward flow of cash from customers to the product manufacturer or service provider is considered as the financial flow. This includes payments for goods and services to the suppliers and collection 43 of payments from the customers for providing goods and services. An efficient financial flow can help the firm in reducing inventory, increasing cash flow, improving collaboration between the supply chain partners, and enhancing customer satisfaction. In this chapter, we first discuss the components of a financial flow and how they can be improved. Then, we examine the various options available for automating the financial flow in a supply chain. Finally, we discuss the ways by which an integration of material and financial flows can be achieved. COMPONENTS OF FINANCIAL FLOW IN A SUPPLY CHAIN There are two key components that constitute the financial flow in a supply chain, viz., purchase-to-pay process and order-to-cash process. Purchase-to-pay process consists of financial transactions with the suppliers and order-to-cash process consists of financial transactions with the customers. Efficient management of cash flow in these two processes can improve the profitability of the supply chain. This involves faster collection of the accounts receivables and efficient management of accounts payable. In this section, we discuss both the processes in detail and the ways to speed them up in order to achieve cost savings and profitability. Purchase-to-Pay Process (PTP) Purchase-to-pay process starts with the buyer making the requisition and ends with the payment to the supplier. The buyer makes a purchase requisition and it is passed on to the purchasing department for approval. After getting the approval of the purchasing manager, a purchase order is sent to the supplier. On receiving the purchase order the supplier dispatches the shipment along with the invoice. On receiving the goods, the firm checks the shipment and the invoice to confirm whether the shipment matches the purchase order arid the product quality and quantity is as desired. Upon confirmation, the accounts department pays the supplier. Figure 4.2 describes the purchase-to-pay process. Figure 4.2: Purchase-To-Pay-Process R e q u i s i t i o n A p p r o v a l S e n d P u r c h a s e O r d e r R e c e i v e G o o d s I n v o i c e P r o c e s s i n g P a y m e n t S u p p l i e r Some of the measures to improve efficiency of purchasing transactions are discussed below. Focus on reducing processing time and costs There are various ways of reducing processing time and costs in order to expedite the purchasing process. Firms should allow the buyers (an employee who is involved in purchase activities) to order goods, up to a certain permissible limit, without approval. This reduces the time and costs involved in routing and approving the purchase orders. In cases where the purchase requisitions are approved before the order is placed with the supplier, the approval again at the time of payment to the supplier should be eliminated to reduce the delay in the purchasing process. Use of Evaluated Receipt Settlement (ERS). In ERS, the buyer makes the payment as and when he receives the goods, thus eliminating the need for an invoice. On receipt of the goods, the buyer compares the packing slip and the goods with the purchase order, and the amount is calculated based on the price quoted in the purchase order. Then, the payment is made to the supplier. Thus, the firm pays the supplier for what it receives, and this reduces the time and costs in matching the invoices and the errors that occur due to repeated data entry. Use of electronic invoicing. Electronic invoicing (EDI, Electronic Invoice Presentment and Payment etc.) can reduce paperwork and processing costs. This can reduce the errors and disputes that arise due to manual processing. 44 Performance management A proper performance management process needs to be established to effectively measure the FTP process. This can provide some inputs to make the PTP process more efficient. There are two types of performance metrics in the PTP process: top down performance metrics, which measure the overall performance of the PTP process, and bottom up performance metrics, which measure individual or team performance. Top down metrics include percentage of payments made using checks and electronic payments, processing costs incurred, purchase order error rates etc. Bottom up metrics include time taken for processing each payment voucher, processing cost per invoice etc. The metrics need to be aligned with the goals set by the firm. The metrics are measured against the goals set to analyze the extent to which goals have been achieved. The goals need to be based on industry benchmarks. Automation of PTP process A firm can enhance the efficiency of the PTP process by automating it. Firms can implement an E-procurement system and streamline the purchasing process. But an E-procurement application can only improve the physical process of purchasing and not the financial processes. Many ERP systems contain various modules of PTP process that may help in the automation of financial components. Another application that aid the automation of financial processes is Electronic Invoice Presentment and Payment (EIPP) systems. EIPP systems enable the suppliers and buyers to exchange invoices, resolve disputes, and make payments electronically. Thus, these systems enable collaboration between supply chain partners. EIPP systems need to be integrated with the internal systems like procurement, ERP and accounts payable for effective functioning. Outsourcing Outsourcing some of the components of the PTP process to a third party is an option that a firm can consider, to enhance the effectiveness of the PTP process. A firm has to identify the functions that can be outsourced so that cost savings or faster processing can be achieved. Many financial institutions offer cash management services like receiving invoices, check printing, dispute handling, reporting & analysis, managing international payments, electronic funds transfer, supplier management etc. In some cases the entire FTP process is outsourced. The benefits from outsourcing include reduction in processing costs. Outsourcing provides the firm flexibility and the ability to scale up the operations as and when needed. By outsourcing time consuming and routine activities, a firm can focus more on strategic functions and the personnel can be used for productive purposes. The risks involved in FTP operations can be reduced by sharing the operations with a third party. Order-to-Cash Process Order-to-cash process starts with the customer placing the order and ends with receiving the payment from the customer. The steps involved in the order-to-cash process are explained below. The order is placed by the customer directly through phone, fax, or the Internet. Then, the inventory is checked for the availability of the product in the quantity required by the customer. The firm then checks the customer credit status to decide whether or not to extend credit to the customer. For this, the customer's credit limit and the status of receivables from the customer are checked. If the customer has placed the order within the credit limits and has nil or permissible receivables, then the product can be delivered to the customer. If not, the firm has to evaluate whether to fulfill the order or to reject it or put it on hold. If it is a new customer, the firm has to establish a new credit line for the customer. If the customer is an existing one and has high credit risk, then the order may be rejected. If the order is placed by an existing customer having low credit risk, then the order may be put on hold for farther analysis. After delivering the goods, the customer is billed and the invoice is sent to the customer. The disputes that are raised by the customer are then examined and resolved. Finally, the collection of the payment is done either at the convenience of the customer or as per rules and norms set by the firm. Figure 4.2 describes the order-to-cash process. By expediting the order-to-cash process, cash flows can be improved. Some of the steps that can be carried out to expedite the order-to -cash process are as follows: • Review of processes and procedures • Identifying the processes fit for automation • Developing appropriate performance metrics • Designing an effective reporting system 45 Review of processes and procedures B2B firms generally provide goods on credit to the customers. In most of the cases, credit is interest free and the firm has to bear the credit costs. Firms, therefore, have to carefully evaluate and set guidelines for providing credit to the customers. Firms may have to provide credit on liberal terms. Yet, at the same time, they have to make sure that the bad debts generated on account of those liberal policies are kept under control. While developing the credit policy and procedures, several factors have to be considered. Credit policy needs to take into account the industry within which the firm is operating and its size. Big retailers wield more power, thus forcing the suppliers to make their policies towards such firms liberal. The firm should also consider customer preferences and requirements. It has to evaluate its competitive environment and develop a credit policy that differentiates it from its competitors. It also needs to develop credit risk analysis guidelines, which enable it to evaluate a customer while providing the credit. There are four key types of credit policies which a firm can adopt. The first type of credit policy puts high credit risk limits and stringent measures of collection. In such a policy, the firm only accepts those customers who have a good credit history and high credit ratings. At the same time, the firm may also have strict collection policies such as imposing penalties and fines, for late payments. Such a policy enables the firm to obtain payments faster and reduces the risk of high bad debt. But such a policy is not customer friendly. The second type of policy is to be liberal in providing credit but strict in collecting dues. In such a policy, the firm accepts customers with even low credit ratings but the collection will be strict and no kind of lenience towards the customers is allowed in the collection policy. Such a policy is customer friendly but it increases the collection costs and the risk of bad debts. The third kind of credit policy allows only customers with high credit ratings, but has liberal collection policies. In such a policy, only customers who have high credit ratings and 'good track record are allowed. But the collections are made liberally. The idea behind such a policy is that a customer with a good track record will pay the dues promptly; therefore, making the collection process liberal will not have any impact on the receivables. But such a policy is not advisable for firms which handle large orders. The fourth kind of credit policy allows customers with low credit ratings and a liberal collection policy. Such a policy may increase the risk of bad debts and the collection process may take a long time and become tedious. Such a policy is advisable when the firm wants to increase its market share. The firm has to choose an optimal credit policy, which while being customer friendly, should not impact the collection and quality of the receivables. Automating receivables management Another important step in enhancing the efficiency of receivables management is the automation of a part, or whole of the process. By automating receivables management a firm can track and monitor the receivables and evaluate as to how the receivables process can be improved. Automation helps in faster and more accurate risk assessment of customers. Firms can easily distinguish between the customers with low credit profiles and customers with high credit profiles. This enables the firm to decide upon the customers to whom credit can safely be extended. Activities like payments and credit analysis can be automated, to reduce time and costs and to improve the receivables collection and management. Developing relevant performance metrics Developing relevant performance metrics helps the firm assess the effectiveness of the receivables management process. It can also help the firm identify opportunities to improve the process. Performance measures are needed for all the elements of order-to-cash process, and should be developed in line with organizational objectives. They should also be based on industry standards. By matching the measures to the industry standards, a firm can analyze its position in relation to its competitors, and take necessary action to improve upon those measures. Days Sales Outstanding (DSO) is the key measure that is generally used to evaluate the order-to-cash process. But there are other metrics, related to each step in the order-to-cash process, that can be measured for better performance analysis. They are; • Percentage of invoice errors • Percentage of bad debts • Average time taken for credit approval • Percentage of orders executed perfectly • Percentage of cash collected within the stipulated credit terms • Percentage of invoices issued manually • Percentage of invoices issued electronically 46 Developing an effective reporting system Information needs to be shared between different departments for efficient receivables management. Proper information sharing enables the departments to have accurate and up to date information, which in turn helps them to take timely action. For example, suppose a customer holds back payment due to quality or quantity issues. This information is first received by the accounts receivables department. If this information is communicated to the manufacturing department then it can take timely action to improve the quality of the products. This would help the firm collect receivables and also resolve customer grievances faster. This information needs to be shared with the other supply chain partners like logistics service providers and financial institutions as well. As customers expect timely and accurate order delivery, any deviations can delay the payment process. Supply chain partners help in providing the right product to the right customer at the right time. An effective reporting system would help provide accurate information to the supply chain partners, so that the right order can be delivered to the customer, on time. AUTOMATING FINANCIAL FLOW IN A SUPPLY CHAIN One of the key elements which helps in efficient financial flow in a supply chain is the use of IT solutions in the purchase-to-pay and order-to-cash processes. By automating these processes firms can minimize inefficiencies and improve the effectiveness of the supply chain. Some of the prominent IT solutions that are used in automating the financial flow are: • Electronic Invoice Presentment and Payment (EIPP) solutions • Electronic trade financing systems • Credit information and management systems. Assigning ratings to the customers. By providing the required credit rules to these systems, a firm can obtain the ratings of its customers as per the predefined credit rules. This would help the firm to distinguish between the customers who need to be focused upon and the customers who need to be ignored. Helps sales representatives during the sales process. By entering the customer data into these systems, these systems provide instant credit analysis information about the customers, such as credit limit and credit terms. This helps the sales representatives in taking faster decisions at the point of sale, to sell higher range products to the customers to provide liberal credit terms to the customers with high credit limits and good credit history. Sales representatives can also decide upon the pricing of the product based on the credit risk. A firm can charge a higher price to the customers with high credit risk and a lower price to customers with low credit risk. This helps the firm to improve its revenue as well as to reduce its credit risks. Improved customer satisfaction. Faster credit processing enables the firm to process orders without much delay thus increasing customer satisfaction. This may help in developing a long term relationship with the customers. Three prominent firms Dun & Bradstreet, Coface and Equifax provide such applications. With the emergence of the Internet, these firms have begun to provide these services on the worldwide web. INTEGRATING MATERIAL AND FINANCIAL FLOWS IN A SUPPLY CHAIN Firms in the past have mainly focused on improving the material flow in a supply chain using various innovative methods like cross docking, Vendor Managed Inventory (VMI), Collaborative Planning, Forecasting and Replenishment (CPFR) etc. Firms have also used IT solutions to automate the material flow. Today, they have also begun to focus on improving the financial flow in the supply chain. Many firms have adopted best practices of cash flow management to improve the financial flow. Many firms have automated the same or all of the elements of the financial flow in a supply chain through implementing ERP systems and cash flow management solutions. However, most firms have not focused much on integrating the material and the financial flow in a supply chain. By integrating material and financial flows, firms can remove the inefficiencies in the supply chain. Integration of these two flows can be done in three different ways. Linking of functional systems with financial systems. For example, by linking the procurement system with the accounts payable system or the ERP system, the physical order information can be matched with the financial information, thus reducing the errors arising due to improper information flow between the two systems. This linking can also be extended to the supply chain partners thus enabling the physical order information flow to closely match with the payment information flow. This enables increased collaboration between supply chain partners. 47 Linking supply chain partner's or customer's preferences and behavior with the financial elements. Firms can track and analyze the behavior of supply chain partners and customers. Based upon the needs and requirements, firms can provide financial options to the customers and supply chain partners. Suppose, a firm orders a large consignment from a supplier. Then, the firm can provide the option of paying the amount through traditional means like checks or through electronic means. The supplier can decide upon the payment option. If the supplier wants a faster payment, he may opt for the electronic payment means. Linking financial and physical flows based on business intelligence. Firms can set the pricing of the product and payment options based on the customer's requirements and the existing market conditions. This may help the firm in maximizing its revenue. This policy is well utilized by airline companies where flight ticket prices are changed depending on supply and demand conditions. In order to align financial and physical supply chains, firms need to reengineer the physical flow processes so as to integrate them with the financial processes. Automation of financial processes is an area in which firms have to focus. Integrating the financial flow with the material flow provides many benefits to the members of the supply chain. Members can obtain the products as per their requirement and pay the supplier using a suitable payment mode. With such integration, members share a common and full view of all their transactions, increasing efficiency in the supply chain. Specific benefits for the members of the supply chain are: • Suppliers can make accurate forecasts about working capital requirements and also product demand. Thus inventory levels and working capital can be reduced as they have a better view about the situation. They can resolve disputes easily as both the supplier and the customer share the same information about the transaction Payment processing can become faster. The processing costs due to personnel and paperwork are reduced. Errors are minimized, thus helping the supplier to obtain correct payment. • Buyers can benefit from perfect order delivery. This helps the buyer to forecast and plan effectively. Thus the buyer can reduce working capital requirements to deal with the payables. With the automation of the processes, buyers can reduce the time and costs in processing the invoices like routing for approval, matching the invoices and payments. Trade terms can be negotiated more effectively between the buyer and the supplier because of the availability of precise information about a transaction. Buyers and suppliers have an accurate view about the risk involved. Hence, the buyer and the seller can negotiate financing options like insurance, supplier credit etc., more optimally. COST CENTRE, COST UNIT, PROFIT CENTRE AND INVESTMENT CENTRE Cost Centre It is a location, person or item of equipment in respect of which costs may be ascertained and related to cost units for control purpose. Broadly speaking, a cost centre may be of two types: Personal cost centre which consists of a person or group of persons; and Impersonal cost centre which consists of a location or item of equipment (or group of these). From the standpoint of functions, a cost centre may be of two types: Production cost centre, i.e., a cost centre in which production is carried on (this may embrace one specific operation, e.g., machining, or a continuous process, e.g., distillation), and Service cost centre, i.e., a cost centre which renders services to the production cost centres. When the output of an organization is a service rather than goods, it is usual to use some alternative term such as support cost centre or utility cost centre for supporting services, 1 If machine and/or persons carrying out similar operations are brought together, a cost centre is known as operation cost centre. Again, when machines and/or persons are grouped according to a specific process or a continuous sequence of operations, a cost centre is termed as process cost centre. Division of production, administration, selling and distribution and other functions into cost centres is necessary for two purposes; (i) cost ascertainment, and (ii) cost control. Costs are ascertained by cost centres or cost units or by both. For example, direct costs can be identified with the cost centres or cost units easily. Indirect costs are allocated to the cost centres based on volume (e.g., direct labour hours, machine hours, etc.) or activity (e.g., number of set-ups, inspections, material movements, etc.). Similarly, cost control is facilitated by pinpointing responsibility through cost centres. In other words, different persons are allotted different cost centres and a person is held responsible for the control of cost of the cost centre or centres running under him only. It is in this sense that cost centres are also termed as responsibility centres. 48 The type, size and number of cost centres in an undertaking will depend upon the nature and size of the business, attitude of the management towards cost ascertainment and cost control, and so on. However, it should be noted that too many cost centres tend to be expensive while too few cost centres tend to defeat the very purpose of accurate cost ascertainment and cost control. Cost Unit It is a quantitative unit of product or service in relation to which costs are ascertained. For ascertainment of costs, it is necessary to express them in terms of physical measurement like number, weight, volume, area, length or any other convenient unit. When single type unit does not serve the desired purpose, composite units may be used for the purpose of cost measurement. For example, in transport costing, ton-miles or passenger- miles are better measures than only tons or passengers as the latter do not take into account distance carried or distance travelled. A few examples of cost units applicable to different industries are given below. Name of industry Cost units used Furniture, ship building, automobile, etc. Number Printing Job Mines and quarries Ton Chemicals Litres, gallons, kg, etc. Steel and cement Ton Motor transport Ton-miles, passenger-miles Canteen Meals, persons served Boiler-house Thousand kg of steam Electricity kW h Soap kg, litres Bricks Thousand Coal mining Tonne Gas Cubic foot Confectionery kg Paper Ream Timber 100 ft. Illustration 4.1 Specify the methods of costing and cost units applicable to the following industries: (i) Toy-making (ii) Cement (iii) Radio (iv) Bicycle (v) Ship-building (vi) Hospital Industry Method of costing Cost units (i) Toy-making Batch Per batch (ii) Cement Unit Per tonne or per bag (iii) Radio Multiple Per radio or per batch (iv) Bicycle Multiple Per bicycle (v) Ship-building Contract Per ship (vi) Hospital Service Per bed per day or per patient per day. Profit Centre Profit is the difference between revenues and costs. Therefore, a profit centre represents segment of a business that is responsible for both revenues and costs. This may also be called a business centre, business unit, or strategic business unit, depending upon the concept of management responsibility prevailing in the entity concerned. 49 Investment Centre An investment centre is a responsibility centre that is accountable for revenues, costs and investments. It is defined as "a profit centre in which inputs are measured in terms of expenses and outputs are measured in terms of revenues, and in which assets employed are also measured, the excess of revenue over expenditure then being related to assets employed." Thus, the relationship between cost, profit and investment centres may be stated as follows: Cost Centre—formal reporting of costs only; Profit Centre—formal reporting of revenues and costs; and Investment Centre—formal reporting of revenues, costs, and investment MATERIAL CONTROL Material constitutes a substantial portion of the production cost in many industries. Sometimes, it may be the major item of all the items constituting total cost. Therefore, it is natural that large amounts will be invested in it. But there should be optimum level of investment for any asset, whether it is a plant, cash or inventories. Inadequate inventories will disrupt production and result in loss of safes. All this calls for an effective material control programme. The main objectives of material control will, therefore, be: 1. To ensure that material is available: (a) for use in production and production services, as and when required; (b) for delivery to customers to fulfil orders for supplies from purchasers, if any. 2. To minimize investment in inventories. ORGANIZATION In order to exercise effective control on material, there should be proper co-operation and co-ordination in the following departments: 1. Purchase 2. Receiving and Inspection 3. Stores 4. Production 5. Stock Control 6. Sales 7. Accounts For instance, the Sales Manager will intimate as to the number or quantity of finished goods to be kept in hand so that no customer is ever turned away or forced to wait because of lack of stock. Similarly, the Accountant or the financial manager should ensure that only optimum stock of materials is kept in stock so that additional funds may be channelled into more profitable investment. INSTALLATION OF THE SYSTEM The various steps involved in introducing a material control system can be broadly grouped under two heads mentioned below: • Primary steps, and • Operational steps. Primary Steps These will include the following: 1. Classification and codification of material and fixation of stock levels in respect of each item of stock. Materials may be classified into: (a) Raw materials 50 (b) Work-in-progress (c) Component parts (i) Manufactured (ii) Purchased (d) Consumable stores, etc. Again, the above materials may be further classified into: (a) fast-moving items, and (b) slow-moving items. After making the classification in the above line, the following stock levels in terms of quantities are to be fixed in respect of each type of material: (a) Maximum stock level, (b) Minimum stock level, (c) Re-order stock level, and Order size. We have discussed these aspects earlier in detail. 2. Consulting and advising engineer about current and proposed product design, programmes of production, schedules of materials, tools and jigs, packaging, etc. to achieve desired quality specifications. Standardization and simplification of material are to be done after giving due importance to substitution, if necessary. 3. Establishing material budget to accomplish the objectives. 4. Training of workmen and staff responsible for material control. Operational Steps After the primary steps are taken, it is necessary to ensure: 1. Control over: (a) Purchasing (b) Receiving and Inspection (c) Storing and Issues We have discussed earlier the role of EOQ and various stock levels under conditions of certainty and uncertainty in controlling costs of inventory. We now discuss the other aspects of purchasing. Control over purchasing means that the Purchase Requisition and the Purchase Order should be in writing in prescribed forms and shall be duly authorized by the executive concerned. Further, the quality of materials should be according to specification or design and price should relate to quality and market condition. In short, it should ensure materials of right quality and quantity at the right price from the right source and at the right time. Control over receiving and inspection means that: (a) Materials received are checked with the Delivery Note and copy of Purchase Order. (b) Quantity as revealed by physical verification agrees with that shown in the Delivery Note, and (c) Quality is as per specification mentioned in the Purchase Order. On the other hand, control on storing and issues will include the following: (a) To ensure that the goods received are in accordance with the instruction detailed in the Purchase Order and Goods Received Note. (b) To ensure that the material received are placed in appropriate bins, racks, etc. and quantities are entered in the respective Bin Cards to facilitate easy location and perpetual record of stores received. (c) Material to be issued only against properly authorized requisitions and appropriate Bin Card should be credited with the quantity issued. (d) Material returned from shops should be checked with properly authorized Shop Credit Note and appropriate Bin Card to be debited with the quantity received. 51 (e) Checking the Bin Card balance with that shown by Stores Ledger and physical verification. 2. Proper implementation of the Perpetual Inventory System. The perpetual inventory system is an aid to material control. It represents a system of records which reflects the physical movement of stocks and their current balance. 3. Selective control through ABC Analysis. 4. Establishment of standards for materials and analysis of material variance according to their originating causes. Standards for materials should be fixed after considering factors like specification, size, quality of materials, effect on labour cost, tools, machines, etc. A standard for scrap, waste, spoilage, etc. should also be laid down for all major materials used in production. Detailed analysis in respect of minor materials may not be feasible and in such a case a monetary limit on consumption may be laid down. Material consumed should be properly recorded and compared with standards fixed in order to develop material variances, viz., (a) Price Variance (b) Usage Variance (c) Yield Variance (d) Mix Variance (e) Scrap, Spoilage and Wastage Variance The analysis of variance will pin down responsibilities so that proper action can be taken where necessary. 5. Comparison of material costs of different periods with the help of different ratios. The selection of proper ratios will depend upon their suitability to the requirements for control purposes. However, as a general guide, the following may be mentioned: (i) Cost of materials to Production Cost; (ii) Value of materials scrapped to Production Cost; (iii) Cost of materials to Average Stock of Materials; (iv) Stock of materials to Working Capital; (v) Stock of materials to Current Assets; (vi) Raw Materials and Stores to total Inventories; (vii) Profit to material cost, elc. JUST-IN-TIME (JIT) PURCHASING JIT purchasing is considered to be one of the modern techniques used for management of costs associated with inventories. JIT purchasing is the purchase of materials or goods such that delivery immediately precedes use or demand. In an extreme case, no inventories (raw materials, work-in-progress or finished goods in case of a manufacturing firm; goods for resale for a retailer) are held. Very often it is difficult to estimate the relevant inventory carrying costs probably because the accounting system does not routinely collect such costs. It is easy to overlook some spoilage, obsolescence, warehousing, tax, insurance, and opportunity cost of capital. When management estimates these costs correctly, carrying costs of inventories become higher than expected and consequently, EOQ declines and JIT becomes more attractive. The success of JIT purchasing depends on costs of quality and timely deliveries. Defective materials and late deliveries may disrupt the operation. So companies adopting JIT purchasing must select their suppliers very carefully and pay attention to developing long-run relationship with them. It should be emphasized that in the evaluation of suppliers, price is only one of the components. The advantages of JIT purchasing are as follows: 1. JIT reduces the inventory carrying costs, e.g., costs of spoilage and obsolescence, materials handling and breakage, warehousing, tax, insurance and opportunity cost of capital. 2. Due to frequent purchase of materials or goods, the issue price is likely to be closer to the replacement price. This facilitates pricing decision. 52 3. It helps to develop a long-run relationship with the suppliers. This will reduce the cost of quality and stock-out costs. 4. In retail business using JIT purchasing, purchasing is now attempted to extend daily deliveries to as many items as possible, so that the goods are stored in the warehouse or on store shelves for a minimum period before they are sold to the customers. As for example, milk and breads are supplied daily to the retailers. As a result, customers get better quality products. JIT purchasing, however, may result in stock-out costs, i.e., cost of not having materials or goods. Examples of such costs are loss of contribution, loss of goodwill, loss of customers, etc. STOCK TURNOVER It has been stated earlier that to minimize the amount of investment, raw materials stocks may be classified (a) fast-moving items, and (b) slow-moving items. The Stock Turnover Ratio will facilitate such a classification and it will act as a tool for exercising control on raw material inventories. period the during materials of stock Average period the during consumed materials of Cost The turnover ratio 8 should normally be 2. A low ratio indicates bad buying, accumulation of obsolete stock, carrying of loo much stock, etc. On the other hand, a high ratio is an indicator of fast-moving stock and, therefore, speaks of better inventory management. Illustration 4.2 The following information is available from the books of a company for 2005: Material Material A B Rs. Rs. Opening Stock 1,400 2,000 Purchases 23,000 3,600 Closing Stock 1,000 2,400 Calculate the material turnover ratio of the above types of materials and determine which of the two materials is more fast-moving. Material A Rs. Material B Rs. Materials Consumed: Opening Stock 1,400 2,000 Add: Purchases 23,000 3,600 24,400 5,600 Less: Closing Stock 1,000 2,400 23,400 3,200 Average Stock: Opening Stock 1,400 2,000 Closing Stock 1,000 2,400 2,400 ÷ 2 4,400 ÷ 2 = 1,200 = 2,200 Materials Turnover Ratio: , ` . | Stock Average consumed Materials of Cost 1200 23400 2200 3200 = 19.5 times p. a. = 1.5 times p.a. Average stock holding period 5 . 19 12 = 0.6 onth 5 12 = 8 months Or 5 . 19 365 in 19 Or 5 . 1 365 = 243 53 days days A stock turnover of 19.5 times p.a. shows that an average stock is being held for less than one month (i.e., 19 days). On the other hand, a stock turnover of 1.5 times p.a. shows that an average stock is being held for 8 months (or for 243 days). Therefore, material B is very slow-moving material while material A is very fast- moving. An alternative method of measuring stock turnover is one involving the use of maximum and minimum stock levels. This is measured as follows: ( ) level stock Minimum level stock Maximum 2 1 period the during consumed materials of Cost + However, the formula that uses re-order or economic order quantity is considered a more refined method of measuring stock turnover. The formula is: EOQ 2 1 level stock Minimum consumed Material + Illustration 4.3 The bin card for Material M 27 shows the following position: Maximum stock level 1,400 units Minimum stock level 750 units Re-order quantity (EOQ) 300 units Issues during the year 5,400 units Stock turnover 5,400 750 + (300) times per annum. In examination, the method to be used depends on the availability of information. Information permitting, the students may use the last-mentioned formula which uses the economic order quantity. On the other hand, if stock control system involving stock levels is not in operation, one has to depend on the first-mentioned formula. PERPETUAL INVENTORY It represents a system of records maintained by the controlling department, which reflects the physical movement of stocks and their current balance. Under this method, stores balances are recorded after every receipt and issue. A perpetual inventory is usually checked by a programme of continuous stock-taking. But the two terms 'perpetual inventory' and 'continuous stock-taking' should not be considered synonymous. Perpetual inventory means the system of records, whereas continuous stock-taking means the physical checking of those records with actual stocks. The perpetual inventory system is intended as an aid to material control. In other words, when the records are maintained up-to-date, the balance shown by the Bin Card or Stores Ledger should agree with ground or physical balance. When there are discrepancies, proper investigation will have to be made and a report will have to be submitted (see Fig. 3.27). If the physical balance is greater than the balance shown by the Bin Card or Stores Ledger, a Debit Note is to be prepared and stock records adjusted accordingly. Similarly, in case of shortage of stock, a Credit Note is to be prepared. (The treatment of surplus or deficiency of stock in accounts has already been explained elsewhere in accordance with originating causes.) The operation of the perpetual inventory system is outlined below: 1. The stock-taking programme is divided into a number of functions such as counting, weighing, measuring, listing, etc., and work is distributed to different members of the team. 2. Different sections of the Store are taken up by rotation. For this purpose, a list showing priority of sections 54 or stock items or both are prepared. Advance notice is given to storekeeping staff concerned whenever a particular stock item is verified each day. 3. Stores received but awaiting inspection is not mixed up with regular stores at the time of verification. 4. The physical stock, after counting, weighing or measuring, as the case may be, is properly recorded. Any one of the following documents may be used for this purpose: (i) Bin Card: The balance as per physical verification together with date of verification is entered usually in different ink (preferably red) in the line below the last entry in the balance column. (ii) Inventory Tag (see Fig. 3.26): It consists of two portions. The top portion is fastened to bins to indicate that the item has been verified. Any bin not having an inventory tag would indicate that the item is yet to be verified. The lower portions of inventory tags are torn off and collected together to constitute inventory records. The lower portions are detached at the end of counting and checking of inventory. Inventory Tag (iii) Stock Verification Sheets : Separate sheets may be maintained to record the results of stock verification. When this method of recording is followed, the sheets are maintained date-wise so as to indicate a chronological list of items verified. The balance as per bin card is also entered in it by the stock verifier for comparison. The advantages of the Perpetual Inventory system may be summarized as follows: 1. A detailed and more reliable check on the stores is possible. 2. Like periodic inventory, it does not hamper production. 3. Since stock figures are available quickly, it facilitates preparation of interim Profit and Loss Accounts and Balance Sheets. 4. It obviates the need for the physical stock-taking at the end of the period. 5. Discrepancies, malpractices, etc. will be quickly discovered, so that appropriate steps are taken to prevent their recurrence in future. 6. It ensures that adequate stocks are maintained within the prescribed limits. This is possible by comparing actual stock with the authorized maximum, minimum and re-order levels. The physical balance and issues and receipts during stock verification are recorded in it. 7. As a result of (6) above, the investment in stock cannot exceed the amount arranged for. Thus, it avoids the disadvantage of carrying excessive stocks. 55 Figure Stores Audit Note The usual reasons for discrepancy are breakage, pilferage, evaporation, breaking bulk, absorption of moisture, short or overissue, etc. Sometimes, discrepancy may arise due to clerical errors, viz. wrong posting or non- posting of entries. In case of clerical errors, corrections are made without any difficulty. PERIODIC INVENTORY This refers to a system where stock-taking is usually done periodically, say once or twice in a year. In case of materials of small value, the periodic inventory system is adopted for determining the physical movement of stock and its closing balance as on a particular date. Thus, companies even adopting ABC Analysis and Perpetual Inventory System for some of stock items, may follow periodic inventory system for others. Again, when the Perpetual Inventory System becomes very costly (say, for slow-moving items of low value), periodic inventory is the only alternative. But the oft-quoted disadvantages of the system are; 1. In the absence of a continuous check, there is possibility of greater fraud, discrepancy, etc. 2. The discrepancy, fraud, if any, are revealed only after stock-counting at the end of a certain period and, therefore, there is little scope for taking preventive action. 3. Stock-taking will take a considerable time and this may affect production and other important work. Interim Profit and Loss Accounts and Balance Sheets cannot also be prepared for want of stock figures. INTRODUCTION Inventory Management involves the control of assets being produced for the purposes of sale in the normal course of the company's operations. Inventories include raw material inventory, work-in process inventory and finished goods inventory. The goal of effective inventory management is to minimize the total costs - direct and indirect - that are associated with holding inventories. However, the importance of inventory management to the company depends upon the extent of investment in inventory. It is industry-specific. Role of Inventory In Working Capital Inventories are a component of the firm's working capital and, as such, represent a current asset. Some characteristics that are important in the broad context of working capital management, include: 1. Current Asset: It is assumed that inventories will be converted to cash in the current accounting cycle, which is normally, one year. In some cases, this is not entirely true, for example, a vintner may require that the wine be aged in casks or bottles for many years. Or, a manufacturer of fine pianos may have a production process that exceeds one year. In spite of these and similar problems, we will view all inventories as being convertible into cash in a single year. 2. Level of Liquidity: Inventories are viewed as a source of near cash. For most products, this description is accurate. At the same time, most firms hold some slow-moving items that may not be sold for a long time. With economic slowdowns or changes in the market for goods, the prospects for sale of entire product lines may be diminished. In these cases, the liquidity aspects of inventories become highly important to the manager of working capital. At a minimum, the analyst must recognize that inventories are the least liquid of current assets. For firms with highly uncertain operating environments, the analyst must discount the 56 liquidity value of inventories significantly. 3. Liquidity Lags: Inventories are tied to the firm's pool of working capital in a process that involves three specific lags, namely: a. Creation Lag: In most cases, inventories are purchased on credit, creating an account payable. When the raw materials are processed in the factory, the cash to pay production expenses is transferred at future times, perhaps a week, month, or more. Labor is paid on payday. The utility that provided the electricity for manufacturing is paid after it submits its bill. Or for goods purchased for resale, the firm may have 30 or more days to hold the goods before payment is due. Whether manufactured or purchased, the firm will hold inventories for a certain time period before payment is made. This liquidity lag offers a benefit to the firm b. Storage Lag: Once goods are available for resale, they will not be immediately converted into cash. First, the item must be sold. Even when sales are moving briskly, a firm will hold inventory as a back- up. Thus, the firm will usually pay suppliers, workers, and overhead expenses before the goods are actually sold. This lag represents a cost to the firm. c. Sale Lag: Once goods have been sold, they normally do not create cash immediately. Most sales occur on credit and become accounts receivable. The firm must wait to collect its receivables. This lag also represents a cost to the firm. 4. Circulating Activity: Inventories are in a rotating pattern with other current assets. They get converted into receivables which generate cash and invested again in inventory to continue the operating cycle. PURPOSE OF INVENTORIES The purpose of holding inventories is to allow the firm to separate the processes of purchasing, manufacturing, and marketing of its primary products. The goal is to achieve efficiencies in areas where costs are involved and to achieve sales at competitive prices in the market place. Within this broad statement of purpose, we can identify specific benefits that accrue from holding inventories. 1. Avoiding Lost Sales: Without goods on hand which are ready to be sold, most firms would lose business. Some customers are willing to wait, particularly when an item must be made to order or is not widely available from competitors. In most cases, however, a firm must be prepared to deliver goods on demand. Shelf stock refers to items that are stored by the firm and sold with little or no modification to customers. An automobile is an item of shelf stock. Even though customers may specify minor variations, the basic item leaves a factory and is sold as a standard item. The same situation exists for many items of heavy machinery, consumer products, and light industrial goods. 2. Gaining Quantity Discounts: In return for making bulk purchases, many suppliers will reduce the price of supplies and component parts. The willingness to place large orders may allow the firm to achieve discounts on regular prices. These discounts will reduce the cost of goods sold and increase the profits earned on a sale. 3. Reducing Order Costs: Each time a firm places an order, it incurs certain expenses. Forms have to be completed, approvals have to be obtained, and goods that arrive must be accepted, inspected, and counted. Later, an invoice must be processed and payment made, Each of these costs will vary with the number of orders placed. By placing fewer orders, the firm will pay less to process each order. 4. Achieving Efficient Production Runs: Each time a firm sets up workers and machines to produce an item, startup costs are incurred. These are then absorbed as production begins. The longer the run, the smaller the costs to begin production of the goods. As an example, suppose it costs Rs. 12,000 to move machinery and begin an assembly line to produce electronic printers. If 1,200 printers are produced in a 57 single three-day run, the cost of absorbing the startup expenses is Rs.10 per unit (12,000/1,200). If the run could be doubled to 2,400 units, the absorption cost would drop to Rs.5 per unit (12,000/2,400). Frequent setups produce high startup costs; longer runs involve lower costs. These benefits arise because inventories provide a "buffer" between purchasing, producing, and marketing goods. Raw materials and other inventory items can be purchased at appropriate times and in proper amounts to take advantage of economic conditions and price incentives. The manufacturing process can occur in sufficiently long production runs and with pre-planned schedules to achieve efficiency and economies. The sales force can respond to customer needs and demands based on existing finished products. To allow each area to function effectively, inventory separates the three functional areas and facilitates the interaction among them. This role of inventory is diagrammed in Figure Figure 4.3 A V O I D L O S S E S O F S A L E S P U R C H A S E G A I N Q U A N T I T Y D I S C O U N T S W H I C H H E L P S R E D U C E O R D E R C O S T S A C H I E V E E F F I C I E N T P R O D U C T I O N S E P A R A T E F I R M S H O L D I N G I N V E N T O R I E S T O P R O D U C E S E L L 5. Reducing Risk of Production Shortages: Manufacturing firms frequently produce goods with hundreds or even thousands of components. If any of these are missing, the entire production operation can be halted, with consequent heavy expenses. To avoid starting a production run and then discovering the shortage of a vital raw material or other component, the firm can maintain larger than needed inventories. TYPES OF INVENTORY Four kinds of inventories maybe identified: 1. Raw Materials Inventory: This consists of basic materials that have not yet been committed to production in a manufacturing firm. Raw materials that are purchased from firms to be used in the firm's production operations range from iron ore awaiting processing into steel to electronic components to be incorporated into stereo amplifiers. The purpose of maintaining raw material inventory is to uncouple the production function from the purchasing function so that delays in shipment of raw materials do not cause production delays. 2. Stores and Spares: This category includes those products which are accessories to the main products produced for the purpose of sale. Examples of stores and spares items are bolts, nuts, clamps, screws, etc. 58 These spare parts are usually bought from outside or sometimes they are manufactured in the company also. 3. Work-in-Process Inventory: This category includes those materials that have been committed to the production process but have not been completed. The more complex and lengthy the production process, the larger will be the investment in work-in-process inventory. Its purpose is to uncouple the various operations in the production process so •that machine failures and work stoppages in one operation will not affect the other operations. 4. Finished Goods Inventory: These are completed products awaiting sale. The purpose of a finished goods inventory is to uncouple the productions and sales functions so that it no longer is necessary to produce the goods before a sale can occur. Table 4.1 provides the details of the investment in inventories in confectionery industry. Table 4.1 Investment in Inventories Types of Inventories Cadbury India Ltd. Value in Rs. lakh % m total Inventory Raw Materials 715.01 27.50 Packing Materials Work-in- Process 387.70 551.17 14.90 21.17 Finished Goods 937.38 36.00 Stores and Spare Parts 11.32 0.43 Total 2,602.58 100.00 COSTS ASSOCIATED WITH INVENTORIES The effective management of inventory involves a trade off between having too little and too much inventory. In achieving this trade off, the Finance Manager should realize that costs may be closely related. To examine inventory from the cost side, five categories of costs can be identified of which three are direct costs that are immediately connected to buying and holding goods and the last two are indirect costs which are losses of revenues that vary with differing inventory management decisions. The five categories costs of holding inventories are; Material Costs: These are the costs of purchasing the goods including transportation and handling costs. Ordering Costs: Any manufacturing organization has to purchase materials. In that event, the ordering costs refer to the costs associated with the preparation of purchase requisition by the user department, preparation of purchase order and follow-up measures taken by the purchase department, transportation of materials ordered for, inspection and handling at the warehouse for storing. At times even demurrage charges for not lifting the goods in time are included as part of ordering costs. Sometimes, some of the components and/or material required for production may have facilities for manufacture internally. If it is found to be more economical to manufacture such items internally, then ordering costs refer to the costs associated with the preparation of requisition forms by the user department, set-up costs to be incurred by the manufacturing department and transport, inspection and handling at the warehouse of the user department. By and large, ordering costs remain more or less constant irrespective of the size of the order although transportation and inspection costs may vary to a certain extent depending upon order size. But this is not going to significantly affect the behavior of ordering costs. As ordering costs are considered invariant to the order size, the total ordering costs can be reduced by increasing the size of the orders, Suppose, the cost per order is Rs.100 and the company uses 1200 units of a material during the year. The size of the order and the total ordering costs to be incurred by the company are given below. Size of order (units) 100 150 200 Number of orders in a year 12 8 6 Total ordering costs @ Rs. 100 per order Rs. 1,200 Rs.800 Rs.600 From the above example, it can be easily seen that a company can reduce its total ordering costs by increasing 59 the order size which in turn will reduce the number of orders. However, reduction in ordering costs is usually followed by an increase in carrying costs to be discussed now. Carrying Costs: These are the expenses of storing goods. Once the goods have been accepted, they become part of the firm's inventories. These costs include insurance, rent/depreciation of warehouse, salaries of storekeeper, his assistants and security personnel, financing cost of money locked-up in inventories, obsolescence, spoilage and taxes. By and large, carrying costs are considered to be a given percentage of the value of inventory held in the warehouse, despite some fixed elements of costs which comprise only a small portion of total carrying costs. Approximately, carrying costs are considered to be around 25 percent of the value of inventory held in storage. The greater the investment in inventory, greater is the carrying costs. In the example considered in the case of ordering costs, let us assume that (he price per unit of material is Rs.40 and that on an average about half-of the inventory will be held in storage. Then, the average values of inventory for sizes of order 100, 150 and 200 along with carrying cost @ 25 percent of the inventory held in storage are given below. Size of order (units): 100 150 200 Average value of inventory: Rs.2,000 Rs,3,000 Rs.4,000 Carrying cost @ 25 percent of above: Rs.500 . Rs.750 Rs. 1,000 From the above calculations, it can be easily seen that as the order size increases, the carrying cost also increasing in a directly proportionate manner. Cost of Funds Tied up with Inventory: Whenever a firm commits its resources to inventory, it is using funds that otherwise might have been available for other purposes. The firm has lost the use of funds for other profit making purposes. This is its opportunity cost. Whatever the source of funds, inventory has a cost in terms of financial resources. Excess inventory represents unnecessary cost. Cost of Running out of Goods: These are costs associated with the inability to provide materials to the production department and/or inability to provide finished goods to the marketing department as the requisite inventories are not available. In other words, the requisite items have run out of stock for want of timely replenishment. These costs have both quantitative and qualitative dimensions. These are, in the case of raw materials, the loss of production due to stoppage of work, the uneconomical prices associated with 'cash' purchases and the set-up costs which can be quantified in monetary terms with a reasonable degree of precision, As a consequence of this, the production department may not be able to reach its target in providing finished goods for sale. Its cost has qualitative dimensions as discussed below. When marketing personnel are unable to honour their commitment to the customers in making finished goods available for sale, the sale may be lost. This can be quantified to a certain extent. However, the erosion of the good customer relations and the consequent damage done to the image and goodwill of the company fall into the qualitative dimension and elude quantification. Even if the stock-out cost cannot be fully quantified, a reasonable measure based on the loss of sales for want of finished goods inventory can be used with the understanding that the amount so measured cannot capture the qualitative aspects. INVENTORY MANAGEMENT ECHNIQUES As explained above, while the total ordering costs can be decreased by increasing the size of order, the carrying costs increase with the increase in order size indicating the need for a proper balancing of these two types of costs behaving in opposite directions with changes in order size. Again, if a company wants to avert stock-out costs it may have to maintain larger inventories of materials and finished goods which will result in higher carrying costs. Here also proper balancing of the costs becomes important. Thus, the importance of effective inventory management is directly related to the size of the investment in inventory. To manage its inventories effectively, a firm should use a systems approach to inventory management. A systems approach considers in a single model all the factors that affect the inventory, A system for effective inventory management involves three subsystems namely economic order quantity, reorder point and stock level. Economic Order Quantity 60 The economic order quantity (EOQ) refers to the optimal order size that will result in the lowest total of order and carrying costs for an item of inventory given its expected usage, carrying costs and ordering cost. By calculating an economic order quantity, the firm attempts to determine the order size that will minimize the total inventory costs. As the lead time (i.e., time required for procurement of material) is assumed to the zero an order for replenishment is made when the inventory level reduces to zero. The level of inventory over time follows the pattern shown in figure 4.4 As the lead time (i.e., time required for procurement of material) is assumed to be zero an order for replenishment is made when the inventory level reduces to zero. The level of inventory over time follows the pattern shown in figure 4.4; Figure 4.4: Inventory Level and Order Point for Replenishment From figure 4.4 it can be noticed that the level of inventory will be equal to the order quantity (Q units) to start with. It progressively declines (though in a discrete manner) to level O by the end of period 1. At that point an order for replenishment will be made for Q units. In view of zero lead time, the inventory level jumps to Q and a similar procedure occurs in the subsequent periods. As a result of this the average level of inventory will remain 61 at (Q/2) units, the simple average of the two end points Q and Zero. From the above discussion the average level of inventory is known to be (Q/2) units. From the previous discussion, we know that as order quantity (Q) increases, the total ordering costs will decrease while the total carrying costs will increase. The economic order quantity, denoted by Q*, is that value at which the total cost of both ordering and carrying will be minimized, It should be noted that total costs associated with inventory where the first expression of the equation represents the total ordering costs and the second expression the total carrying costs. The behavior of ordering costs, carrying costs and total costs for different levels of order Quantity (Q) is depicted in figure 4.5. Behavior of costs associated with inventory for changes in order quantity Figure 4.5 From figure, it can be seen that the total cost curve reaches its minimum at the point of intersection between the ordering costs curve and the carrying costs line. The value of Q corresponding to it will be the economic order quantity Q*. We can calculate the EOQ formula. The order quantity Q becomes EOQ when the total ordering costs at Q is equal to the total carrying costs. Using the notation, it amounts to stating: To distinguish EOQ from other order quantities, we can say In the above formula, when 'U' is considered as the annual usage of material, the value of Q* indicates the size of the order to be placed for the material which minimizes the total inventory-related costs. When 'U' is considered as the annual demand Q* denotes the size of production run. Suppose a firm expects a total demand for its product over the planning period to be 10,000 units, while the ordering cost per order is Rs.100 and the carrying cost per unit is Rs.2. Substituting these values, 62 Thus if the firm orders in 1,000 unit lot sizes, it will minimize its total inventory costs. Examination of EOQ Assumptions The major weaknesses of the EOQ model are associated with several of its assumptions, in spite of which the model tends to yield quite good results. Where its assumptions have been dramatically violated, the EOQ model can generally be easily modified to accommodate the situation. The model's assumptions are as follows: 1. Constant or uniform demand: Although the EOQ model assumes constant demand, demand may vary from day-to-day. If demand is stochastic that is, not known in advance - the model must be modified through the inclusion of a safety stock. 2. Constant unit price: The EOQ formula derived is based on the assumption that the purchase price Rs.P per unit of material will remain unaltered irrespective of the order size. Quite often, bulk purchase discounts or quantity discounts are offered by suppliers to induce customers for buying in larger quantities. The inclusion of variable prices resulting from quantity discounts can be handled quite easily through a modification of the original EOQ model, redefining total costs and solving for the optimum order quantity. 3. Constant carrying costs: Unit carrying costs may vary substantially as the size of the inventory rises, perhaps decreasing because of economies of scale or storage efficiency or increasing as storage space runs out and new warehouses have to be rented. This situation can be handled through a modification in the original model similar to the one used for variable unit price. 4. Constant ordering costs: While this assumption is generally valid, its violation can be accommodated by modifying the original EOQ model in a manner similar to the one used for variable unit price. 5. Instantaneous delivery: If delivery is not instantaneous, which is generally the case, the original EOQ model must be modified by including of a safety stock. 6. Independent orders: If multiple orders result in cost savings by reducing paperwork and transportation cost, the original EOQ model must be further modified. While this modification is somewhat complicated, special EOQ models have been developed to deal with this. These assumptions have been pointed out to illustrate the limitations of the basic EOQ model and the ways in which it can be easily modified to compensate for them. Moreover, an understanding of the limitations and assumptions of the EOQ model will provide the Finance Manager with a strong base for making inventory decisions. Inflation and EOQ Inflation affects the EOQ model in two major ways. First, while the EOQ model can be modified to assume constant price increases, many times major price increases occur only once or twice a year and are announced ahead of time. If this is the case, the EOQ model may lose its applicability and may be replaced with anticipatory buying - that is buying in anticipation of a price increase in order to secure the goods at a lower cost. Of course, as with most decisions, there are trade offs associated with anticipatory buying. The costs are the added carrying costs associated with the inventory that you would not normally be holding. The benefits of course, come from buying the inventory at a lower price. The second way inflation affects the EOQ model is through increased carrying costs. As inflation pushes interest rates up, the cost of carrying inventory increases. In the EOQ model this means that C increases, which results in a decline in the optimal economic order quantity. Determination of Optimum Production Quantity: The EOQ Model can be extended to production runs to determine the optimum production quantity. The two costs involved in this process are: (i) set up cost and (ii) inventory carrying cost. The set-up cost is of the nature of fixed cost and is to be incurred at the time of commencement of each production run. The larger the size of the production run, the lower will be the set-up cost per unit. However, the carrying cost will increase with an increase in the size of the production run. Thus, there is an inverse relationship between the set-up cost and inventory carrying cost. The optimum production size is at that level where the total of the set-up cost and the inventory carrying cost is the minimum. In other words, at this level the two costs will be equal. The formula for EOQ can also be used for determining the optimum production quantity as given below: 63 Illustration 4.4 Arvee Industries desires an annual output of 25,000 units. The set-up cost for each production run is Rs.80. The cost of carrying inventory per unit per annum is Rs.4. The optimum production quantity per production run (E) is Modified EOQ to include Varying Unit Prices: Bulk purchase discount is offered when the size of the order is at least equal to some minimum quantity specified by the supplier. The question may arise whether Q*, EOQ calculated on the basis of a price without discount will still remain valid even after reckoning with the discount. While no general answer can be given to such a question we can certainly say that a general approach using the EOQ framework will prove useful in decision-making - whether to avail oneself of the discount offered and if so what should be the optimal size of the order. The procedure for such an approach is outlined below: The first step under the general approach is to calculate Q*, EOQ without considering the discount. Let us suppose Q' is the minimum order-size stipulated by the supplier for utilizing discount. After calculating Q* the same will be compared to Q'. Only three possibilities can arise out of the comparison. In case Q* is greater than or equal to Q', then Q* will remain valid even in the changed situation caused by the quantity discount offered. This is so because the company can avail itself of the benefit of quantity discount with an order-size of Q* as it is at least equal to Q', the minimum stipulated order size for utilizing discount. Only in the case of Q* being less than Q' the need for the calculation of an optimal order size arises as the company cannot avail itself of the discount with the order size of Q*. An incremental analysis can be carried out to consider the financial consequences of availing oneself of discount by increasing the order-size to Q'. A decision to increase the order-size is warranted only when the incremental benefits exceed the incremental costs arising out of the increased order-size. The incremental benefits will have two components: First, the total amount of discount available on the amount of material is to be used. If we assume Rs. D of discount per unit of material, then the total discount on the annual usage of material of U units amounts to: Annual usage of materials in units x Discount per unit of material = Rs.UD Secondly, with an increase in order-size from Q* to Q', the number of orders will be reduced. As the ordering cost is assumed to be Rs.F per order irrespective of the order size, there will be a reduction in the total ordering cost. Thus, the reduction in ordering cost. = (The difference between the number of orders with sizes of Q* and Q') x (the cost per order of Rs. F) = Rs. F x ' Q U ' Q U ] ] ] − 64 Thus, the total incremental benefits will be the sum of the above two expressions and is given by Total incremental benefits = Rs. UD + Rs. {U/Q* - U/Q'}x F With an increase in the order-size, there is likely to be an increase in the average value of inventory even after reckoning with the discount per unit of material of Rs.D which will go to reduce the price per unit for the valuation of inventory. The increase in the average value of inventory will result in higher incidence of carrying cost, assumed to be C percent of the average value of inventory. Incremental carrying cost = ( ) 2 PC ' Q 2 C D P ' Q − − The net incremental benefit can be obtained by subtracting the incremental carrying cost from the total incremental benefits. This is given by the expression. Net incremental benefits = Rs. U x D + Rs. ( ) ] ] ] − − − , ` . | − 2 PC ' Q C D P ' Q . Rs F ' Q U ' Q U If the net incremental benefits are positive, then the optimal order quantity becomes Q'. Otherwise Q* will continue to remain valid even in a situation of bulk purchase discount. A numerical illustration is given below to illustrate the procedure to be adopted in a situation of bulk purchase discount. Illustration 4.5 The annual usage of a raw material is 40,000 units for the Hy Fly Co., Ltd. The price of the raw material is Rs,50 per unit. The ordering cost is Rs.200 per order and the carrying cost 20 percent of the average value of inventory. The supplier has recently introduced a discount of 4 percent on the price of material for orders of 1,500 units and above. What was the company's E.O.Q. prior to the introduction of discount? Should the company opt for availing the discount? What would be the optimal order size if the company opts to avail for itself the discount offered? Let us first arrange the data contained in the problem in accordance with the notation familiar to us by now. U = 40,000 units F = Rs.200 per order P = Rs.50 per unit D = Rs.2 per unit C = 0.20 E.O.Q. without discount, For utilizing discount the minimum order size Q' = 1,500 units. As Q* is less than Q', we have to calculate the incremental benefits and incremental costs. Total amount of discount available with an order size of 1,500 units. 65 = U x D = 40,000 units x Rs.2 per unit. = Rs.80,000 .......(1) Savings due to reduction in ordering costs = (32-27) x Rs.200 = Rs.1,000 ......(2) Incremental carrying cost = Rs.7,200-Rs.6,325 = Rs.875 ......(3) Net incremental benefits (=1+2-3) = Rs.80,000 + Rs.1,000 - Rs.875 = Rs.80,125 As the net incremental benefits is a positive sum of Rs.80,125, the company should opt for availing the discount offered. The optimal order-size will be 1,500 units, the minimum order size required for availing of the discount. From the illustration, it is clear that although EOQ value of 1,265 units (Q*) is not relevant in the present situation of bulk purchase discount, the general framework of the EOQ model has provided the necessary basis for subsequent calculations and the decision reached therefrom. Reorder Point Subsystem In the EOQ model discussed we have made the assumption that the lead time for procuring material is zero. Consequently, the reorder point for replenishment of stock occurs when the level of inventory drops down to zero. In view of instantaneous replenishment of stock, the level of inventory jumps to the original level from zero level. In real life situations one never encounters a zero lead time. There is always a time lag from the date of placing an order for material and the date on which materials are received. As a result the reorder level is always at a level higher than zero, and if the firm places the order when the inventory reaches the reorder point, the new goods will arrive before the firm runs out of goods to sell. The decision on how much stock to hold is generally referred to as the order point problem, that is, how low should the inventory be depleted before it is reordered. The two factors that determine the appropriate order point are the procurement or delivery time stock which is the inventory needed during the lead time (i.e., the difference between the order date and the receipt of the inventory ordered) and the safety stock which is the minimum level of inventory that is held as a protection against shortages. .', Reorder Point = Normal consumption during lead time + Safety Stock. Several factors determine how much the delivery time stock and safety stock should be held. In summary, the efficiency of a replenishment system affects amount of much delivery time needed. Since the delivery time stock is the expected inventory usage between ordering and receiving inventory, efficient replenishment of inventory would reduce the need for delivery time stock. And the determination of level of safety stock involves a basic trade-off between the risk of stock-out, resulting in possible customer dissatisfaction and lost sales, and the increased costs associated with carrying additional inventory. 66 Another method of calculating reorder level involves the calculation of usage rate per day, lead time which is the amount of time between placing an order and receiving the goods and the safety stock level expressed in terms of several days' sales. Reorder level = Average daily usage rate x lead time in days. From the above formula it can be easily deduced that an order for replenishment of materials be made when the level of inventory is just adequate to meet the needs of production during lead time. If the average daily usage rate of a material is 50 units and the lead time is seven days, then Reorder level = Average daily usage rate x Lead time in days = 50 units x 7 days = 350 units When the inventory level reaches 350 units an order should be placed for material. By the time the inventory level reaches zero towards the end of the seventh day from placing the order materials will reach and there is no cause for concern. Safety Stock Once again in real life situations one rarely comes across lead times and usage rates that are known with certainty. When usage rate and/or lead time vary, then ' the reorder level should naturally be at a level high enough to cater to the production needs during the procurement period and also to provide some measures of safety for at least partially neutralizing the degree of uncertainty. The question will naturally arise as to the magnitude of safety stock. There is no specific answer to this question. However, it depends, inter alia, upon the degree of uncertainty surrounding the usage rate and lead time. It is possible to a certain extent to quantify the values that usage rate and lead time can take along with the corresponding chances of occurrence, known as probabilities. These probabilities can be ascertained based on previous experiences and/or the judgemental ability of astute executives. Based on the above values and estimates of stock-out costs and carrying costs of inventory, it is possible to work out the total cost associated with different levels of safety stock. Once we realize that higher the quantity of safety stock, lower will be the stock-out cost and higher will be the incidence of carrying costs, the formula for estimating the reorder level will call for a trade-off between stock-out costs and carrying costs. The reorder level will then become one at which the total stock-out costs (to be more precise, the expected stock-out costs) and the carrying costs will be at their its minimum. We consider below through an illustration the way of arriving at the reorder level in a situation where both usage rate and lead time are subject to variation. Illustration 4.6 Below are presented the daily usage rate of a material and the lead time required to procure the material along with their respective probabilities (which are independent) for Sigma Company Ltd. The probabilities and the values of usage rate and lead time are based on optimistic, realistic and pessimistic perceptions of the executives concerned. Average Daily Usage Rate (units) Probability of Occurrence Lead Time (No. of days) Probability of Occurrence 200 0.25 12 0.25 500 0,50 16 0.50 800 0.25 20 0.25 The stock-out cost is estimated to be Rs.10 per unit while carrying cost for the period under consideration is Rs.3 per unit. What should be the reorder level based on financial considerations? From the data contained in the table we can calculate the expected usage rate and expected lead time. The expected usage rate is nothing but the weighted average daily usage rate, where the weights are taken to be the corresponding probability values. Thus, expected daily usage rate = 200 x 0.25 + 500 x 0.5 + 800 x 0.25 67 = 50 + 250 + 200 500 units Similarly expected lead time = 12 x 0.25 + 16 x 0.5 + 20 x 0.25 = 3 + 8 + 5 = 16 days Normal consumption during lead time can be obtained by multiplying the above two values. (i.e.,) Normal consumption during lead time = 500 units per day x 16 days = 8,000 units Since normal consumption during lead time has been obtained as 8000 units, stock-outs can occur only if the consumption during lead time is more than 8,000 units. Let us enumerate the situations with lead time consumption of more than 8,000 units, along with their respective probabilities of occurrence. This can be achieved by considering the possible levels of usage. The possible levels of usage are: Daily usage rate Lead time in days Possible levels of usage Units Probability Units Probability Units Probability 12 0.25 2400 0.0625 200 0.25 16 0.50 3200 0.1250 20 0.25 4000 0.0625 12 0.25 6000 0,1250 500 0.5 16 0.50 8000 0.250 20 0.25 10000 0.1250 12 0.25 9600 0.0625 800 0.25 16 0.50 12800 0.1250 20 0.25 16000 0.0625 From the above table it is clear that the situations with the lead time consumption of more than 8,000 units (normal usage) are 10,000 units with a probability of 0.1250, 9,600 units with 0.0625, 12,800 units with 0.1250 and 16,000 units with 0.0625 probability. And the levels of stock-out are 2,000 units, 1,600 units, 4,800 units and 8,000 units respectively. Thus, safety stock level can be maintained at any of the above levels, and the stock-out cost and carrying cost associated with these various levels are shown in the table. Levels of Safety Stocks and Associated Costs Safety Stock (1) Stockouts (2) Probability (3) Expected Stockout (4) -(2x3) Expected Stockout Cost (5) Carrying Cost (6) Total Cost (7) 8,000 units 0 0 0 0 Rs. 24,000 Rs. 24,000 4,800 units 3,200 units 0.0625 200 units Rs. 2,000 Rs. 14,400 Rs. 16,400 2,000 units 6,000 units 0.0625 375 units Rs. 7,250 Rs. 6,000 Rs. 13,250 2,800 units 0.1250 350 units 725 units 1,600 units 6,400 units 0.0625 400 units Rs. 8,500 Rs. 4,800 Rs. 13,300 3,200 units 0.1250 400 units 400 units 0.1250 50 units 850 units 68 0 8,000 units 0.0625 500 units Rs. 14,500 0 Rs, 14,500 4,800 units 0.1250 600 units 2,000 units 0.1250 250 units 1,600 units 0.0625 100 units 1,450 units If the safety stock of the firm is 8,000 units, there is no chance of the firm being out of stock. The probability of stock-out is, therefore zero. If the safety stock of the firm is 4,800 units, there is 0.0625 chance that the firm will be short of inventory. If the safety stock of the firm is 2,000 units, there is stock-out of 6,000 units with a probability of 0.0625 and 2,800 units with a probability of 0.125 based on the possible usage of 16,000 units with probability of 0.0625 and 12,800 with a probability of 0.125 stock-out and the probability of occurrence of stock-out at other levels are calculated in the same way. Reorder Point Formula Even in a relatively simple situation considered in the illustration above, the amount o'f calculations involved for arriving at the reorder level is large. In real life situations the assumption of independence in the probability distributions made in the illustration above may not be valid and the number of time periods may also be large. In such cases the approach adopted earlier can become much more complex. That is the reason why one can adopt a much simpler formula which gives reasonably reliable results in calculating at what point in the level of inventory a reorder has to be placed for replenishment of stock. The formula along with its application is given below, using the notation developed earlier. Reorder pint = S X L + F ( ) L x R x S Where, S = Usage in units per day L = Lead time in days R = Average number of units per order F = Stockout acceptance factor The stock-out acceptance factor, 'F', depends on the stock-out percentage rate specified and the probability distribution of usage (which is assumed to follow a Poisson distribution). For any specified acceptable stockout percentage the value of 'F' can be obtained from the figure presented below. Figure 4.6 Value of ‘f’ for different stocks out percentage Illustration 4.7 For Apex company the average daily usage of a material is 100 units, lead time for procuring material is 20 days and the average number of units per order is 2000 units, The stockout acceptance factor is considered to be 1.3. What is the reorder level for the company? 69 From the data contained in the problem we have J S = 100 units L = 20 days R = 2,000 units F = -1.3 Reorder level = S x L + F ( ) L x R x S = 100 x 20 + 1.3 ( ) 20 x 2000 x 100 = 2,000 + 1.3 x 2,000 - 4,600 units Reorder for replenishment of stock should be placed when the inventory level reaches 4,600 units. Stock-level Subsystem This stock level subsystem keeps track of the goods held by the firm, the issuance of goods, and the arrival of orders. It maintains records of the current level of inventory. For any period of time, the current level is calculated by taking the beginning inventory, adding the inventory received, and subtracting the cost of goods sold. Whenever this subsystem reports that an item is at or below the reorder point level, the firm will begin to place an order for the item. TOTAL SYSTEM The three subsystems are tied together in a single inventory management system. The inventory management system can also be illustrated in terms of the three subsystems that comprise it. The figure No. 4.7 below ties each subsystem together and shows the three items of information needed for the decision to order additional inventory. Inventory Planning An important task of working-capital management is to ensure that inventories are incorporated into the firm's planning and budgeting process. Sometimes, the level of inventory reflects the orders received by the general manager of the plant without serious analysis as to the need for the materials or parts. This lack of planning can be costly for the firm, either because of the carrying and financing costs of excess inventory or the lost sales from inadequate inventory. The inventory requirements to support production and marketing should be incorporated into the firm's planning process in an orderly fashion. The Production Side The first step in inventory planning deals with the manufacturing mix of inventory items and end products. Every product is made up of a specified list of components. The analyst must recognize the different mix of components in each finished product. Each item maintained in inventory will have a cost. This cost may vary based on volume purchases, lead time for an order, historical agreements, or other factors. For the purpose of preparing a budget, each item must be assigned a unit cost. Figure 4.7 Three Subsystems of the Inventory-Management System 70 Once the mix of components is known and each component has been assigned a value, the analyst can calculate the materials cost for each product which is the weighted average of the components and the individual products. The Marketing Side The second step in inventory planning involves a forecast of unit requirements during the future period. Both a sales forecast and an estimate of the safety level to support unexpected sales opportunities are required. The Marketing Department should also provide pricing information so that higher profit items receive more attention. Inventory Data Base An important component of inventory planning involves access to an inventory data base. A data base is a collection of data items arranged in files, fields and records. Essentially, we are working with a structured framework that contains the information needed to effectively manage all items of inventory, from raw materials to finished goods. This information includes the classification and amount of inventories, demand for the items, cost to the firm for each item, ordering costs, carrying costs, and other data. The first component of an inventory data base deals with the movement of individual items and the second component of inventory management data involves information needed to make decisions on rendering or replenishing the items. OTHER INVENTORY MANAGEMENT TECHNIQUES The ABC system In the case of a manufacturing company of reasonable size the number of items of inventory runs into hundreds, if not more. From the point of view of monitoring information for control it becomes extremely difficult to consider each one of these items. The ABC analysis comes in quite handy and enables the management to concentrate attention and keep a close watch on a relatively less number of items which account for a high percentage of the value of annual usage of all items of inventory. A firm using the ABC system segregates its inventory into three groups - A, B and C. The A items are those in which it has the largest rupee investment. In the Figure 4.7 which depicts the typical distribution of inventory items, A group consists about 10 percent of the inventory items that account approximately for 70 percent of the firm's rupee investment. These are the most costly or the slowest turning items of inventory. The B group consists of the items accounting for the next largest investment. This group consists approximately 20 percent of the items accounting for about 20 percent of the firm's rupee investment. The C group typically consists of a 71 large number of items accounting for a small rupee investment. C group consists of approximately 70 percent of all the items of inventory but accounts for only about 10 percent of the firm's rupee investment. Items such as screws, nails, and washers would be in this group. Dividing its inventory into A, B, and C items allows the firm to determine the level and types of inventory control procedures needed. Control of the A items should be most intensive due to the high rupee investments involved, while the B and C items would be subject to correspondingly less sophisticated control procedures. DEFINING COSTS AND BENEFITS The important principles underlying measurement of costs (outflows) and inflows (benefits) are as follows: • All costs and benefits must be measured in terms of cash flows. This implies that all non-cash charges (expenses) like depreciation which are considered for the purpose of determining the profit after tax must be added back to arrive at the net cash flows for our purpose. (Illustrations 1, 2 and 3 of this chapter clarify this aspect.) • Since the net cash flows relevant from the firm's point of view are what that accrue to the firm after paying tax, cash flows for the purpose of appraisal must be defined in post-tax terms. • Usually the net cash flows are defined from the point of view of the suppliers of long-term funds 4 (i.e., suppliers of equity capital plus long-term loans). • Interest on long-term loans must not be included for determining the net cash flows. The rationale for this principle is as follows: Since the net cash flows are defined from the point of view of suppliers of long-term funds, the post-tax cost of long-term funds will be used as the interest rate for discounting. The post-tax cost of long-term funds obviously includes the post-tax cost of long-term debt. Therefore if interest on long- term debt is considered for the purpose of determining the net cash flows, there will be an error of double- counting. • The cash flows must be measured in incremental terms. In other words, the increments in the present levels of costs and benefits that occur on account of the adoption of the project are alone relevant for the purpose of determining the net cash flows. Some implications of this principle are as follows: • If the proposed project has a beneficial or detrimental impact on say, the other product lines of the firm, then such impact must be quantified and considered for ascertaining the net cash flows. • Sunk costs must be ignored. For example, the cost of existing land must be ignored because money has already been sunk in it and no additional or incremental money is spent on it for the purposes of this project. • Opportunity costs associated with the utilization of the resources available with the firm must be considered even though such utilization does not entail explicit cash outflows. Example, while the sunk cost of land is ignored, its opportunity cost i.e., the income it would have generated if it bad been utilized for some other purpose or project must be considered. • The share of the existing overhead costs which is to be borne by the end product(s) of the proposed project must be ignored. The application of these principles in the measurement of the cash flows of a project are illustrated by the following illustrations: Illustration 4.8 Anand, a chemical engineer with 15 years of experience, and Prakash, a pharmacy graduate with 18 years of experience, are evaluating a pharmaceutical formulation. They have estimated the total outlay on the project to be as follows: Plant & Machinery : Rs.36 lakh Working Capital : Rs.24 lakh The proposed scheme of financing is : Equity Capital : Rs. 16 lakh Term Loan : Rs.26 lakh Trade Credit : Rs.8 lakh Working Capital Advance : Rs. 10 lakh 72 The project has an expected life of 10 years. Plant & Machinery will be depreciated at the rate of 33 1/3 percent per annum as per the written down value method. The expected annual sales would be Rs.80 lakh, and the cost of sales (including depreciation but excluding interest) is expected to be Rs.50 lakh per year. The tax rate of the company will be 50 percent. Term-loan will carry 14 percent interest and will be repayable in 5 equal annual installments, beginning from the end of the first year. Working capital advance will carry an interest rate of 17 percent and, thanks to the 'rollover' phenomenon, will have an indefinite maturity. Define the cash flows for the first three years from the long-term funds point of view. Solution Net Cash Flows Relating to Long-term Funds (Rs. in lakh) Year 0 1 2 3 A Investment (42.00) B Sales 80.00 80.00 80.00 C Operating costs (excluding depreciation) 38.00 42.00 44.67 D Depreciation 12.00 8.00 5.33 E Interest on working capital advance 1.70 1.70 1.70 F Profit before tax 28.30 28,30 28.30 G Tax 14.15 14,15 14.15 H Profit after tax 14,15 14.15 14.15 I Initial flow (42.00) K Operating flow (= H + D) + 1(1 - t) 26.15 22.15 19.48 L Net cash flow (= 1 + K) (42.00) 26.15 22.15 19.48 Explanatory Notes The investment outlay has to be considered from the point of view of the suppliers of long-term funds. In the given Illustration, we find that Rs.18 lakh out of the investment of Rs.24 lakh in current assets is financed by way of trade-credit and working capital advance. The difference of Rs.6 lakh is called the working-capital margin i.e., the contribution of the suppliers of long-term funds towards working capital. Therefore, the investment outlay relevant from the long-term funds point of view will be equal to investment in plant and machinery + working capital margin = Rs.42 lakh. Since depreciation is a non-cash charge which has to be added to the profit after tax, this charge must be disclosed separately in the cash flow statement and not clubbed with other operating costs. Further, the depreciation charge to be considered here will be the tax-relevant charge. In other words, the depreciation must be computed in accordance with the method and rate(s) prescribed by the Income Tax Act, 1961. While interest on long-term debt must be excluded for reasons discussed earlier, interest on short-term bank borrowings must be included in the cash flow statement. In the Illustration discussed above, we have defined the cash flows only over the first three years of the project's life. But in practice cash flows are defined over the entire project life or over a specified time horizon (if the project life is too long). If the cash flows are defined over the entire life of the project, then the estimated salvage value of the investment in plant and machinery and the working capital must be considered for determining the net cash flow in the terminal year. If the cash flows are defined over a specified time horizon, a notional salvage value is taken into account in the final year of the time horizon, The following illustration illustrates this point: Illustration 4.9 73 A capital project involves the following outlays: (Rs. in lakh) Plant and machinery 180 Working Capital 120 The proposed scheme of financing is as follows: (Rs. in lakh) Equity 100 Long-term loans 104 Trade credit 36 Commercial banks 60 The project has a life of 10 years. Plant and machinery are depreciated at the rate of 15 percent per annum as per the written down value method. The expected annual net sales is Rs.350 lakh. Cost of sales (including depreciation, but excluding interest) is expected to be Rs.190 lakh a year. The tax rate of the company is 60 percent. At the end of 10 years plant and machinery will fetch a value equal to their book value and the investment in working capital will be fully recovered. The long-term loan carries an interest of 14 percent per annum. It is repayable in eight equal annual installments starting from the end of the third year. Short-term advance from commercial banks will be maintained at Rs.60 lakh; and will carry interest at IS percent per annum. It will be fully liquidated after 10 years. Trade credit will also be maintained uniformly at Rs.36 lakh and will be fully paid back at the end of the tenth year. Calculate the cash flow stream from the long-term funds point of view. Solution Cash Flows Relating to Lone-Term Funds (Rs in lakh) 0 1 2 3 4 5 6 7 8 9 10 A. Investment (204.00) B. Sales 350.00 350.00 350.00 350.00 350.00 350.00 350.00 350.00 350,00 350.00 C. Cost of sales 163,00 167.05 170.49 173.42 175.91 178.02 179.82 181.34 182.64 183.75 D. Depreciation 27.00 22.95 19.51 16.58 14.09 11,98 10.18 8.68 7.36 6.25 E. Profit before interest and taxes 160.00 160.00 160,00 160-00 160.00 160.00 160.00 160.00 160.00 160.00 F. Interest on ST bank 10.80 10,80 10.80 10.80 10.80 10.80 10.80 10.80 10,80 10.80 borrowing G. Profit before taxes 149.20 149.20 149,20 149.20 149.20 149.20 149-20 149.20 149.20 149.20 H. Tax 89.52 89.52 89.S2 89.52 89.52 89.52 89,52 89.52 89,52 89.52 I. Profit after tax 59.68 59.68 59,68 59.68 59.68 59.68 59.68 59.68 59.68 59.68 J. Net salvage value of fixed assets 35.44 K. Net salvage of current 120.00 assets l. Retirement of trade credit (36.00) M. Payment of ST bank (60.00) borrowing N. Net Cash Flow = -A + I + D + J +J+K-L- M (204.00) 86.68 82.63 79.19 76,26 73,77 71.66 69.86 68.34 67.04 125.37 Explanatory Notes • Net salvage value of fixed assets will be equal to the salvage value of fixed assets less any income tax that 74 may be payable on the excess of the salvage value over the book value. Likewise there will be a tax shield on the loss, if any, incurred at the time of disposing of the fixed assets. According to tax laws, the net salvage value of any individual item off plant and machinery has lost its significance and therefore for our purposes, we will ignore the impact of tax on the salvage value. In other words, we will take only the gross salvage value into consideration. • The depreciation rate assumed in this problem is not indicative of the current rates in force, (The depreciation rates currently applicable to plant and machinery under the Income Tax Act are 25%, 40%, and 100%). • In working out the cash flows, deduction available for a new project under Section 80 I of the Income Tax Act has been ignored. • Our Illustrations have so far been focused on estimating cash flows for a new project The following illustration illustrates estimation of cash flows for a replacement project. Illustration 4.10 Sandals Inc. is considering the purchase of a new leather cutting machine to replace an existing machine that has a book value of Rs.3,000 and can be sold for Rs. 1,500. The estimated salvage value of the old machine in.four years would be zero, and it is depreciated on a straight-line basis. The new machine will reduce costs (before tax) by Rs.7,000 per year, i.e., Rs.7,000 cash savings over the old machine. The new machine has a four year life, costs Rs.14,000 and can be sold for an expected amount of Rs.2,000 at the end of the fourth year. Assuming straight-line depreciation, and a 40% tax rate, define the cash flows associated with the investment. Assume that the straight-line method of depreciation is used for tax purposes. Solution Cash Flows Associated with Replacement Decision (in Rs.) Year 0 1 2 3 4 1. Net investment in new machine (12,500) 2. Savings in costs 7,000 7,000 7,000 7,000 3. Incremetal depreciation 2,250 2,250 2,250 2,250 4. Pre-tax profits 4,750 4,750 4,750 4,750 5. Taxes 1,900 1,900 1,900 1,900 6. Post-tax profits 2,850 2,850 2,850 2,850 • 7. Initial flow ( = (1)) (12,500) 8. Operating flow ( = (6) + (3» 5,100 5,100 5,100 5,100 9. Terminal flow 2,000 10. Net cash flow ( = (7) + (8) + (9)) (12,500) 5,100 5,100 5,100 7,100 Working Notes Computation of depreciation: Existing leather-cutting machine Rs.3,000/4 = Rs.750 per annum New leather-cutting machine Rs.12,000/4 = Rs.3,000 per annum Incremental depreciation = Rs.2,250 per annum 75 Chapter 5 Organization profitability analysis Cost Accounting is a quantitative method that accumulates, classifies, summarizes and interprets financial and non-financial information for three major purposes, viz. • ascertainment of cost of a product or service; • operational planning and control; and • decision-making. Cost Accounting is one of the branches of Accounting and is predominantly meant for meeting the informational needs of the management. Managers need cost information for informed decision-making. Of late, the boundaries of Cost Accounting have increased tremendously. It now refers to the gathering and providing of information for decision needs of all sorts. Modern Cost Accounting is often called Management Accounting. 1 The official terminology of the Chartered Institute of Management Accountants (CIMA), England, defines Cost Accounting as "that part of management accounting which establishes budgets and standard costs and actual costs of operations, processes, departments or products and the analysis of variances, profitability or social use of funds' Management Accounting serves a business to be operated more efficiently and effectively. When cost Accounting is used as a synonym of Management Accounting, the emphasis is clearly put on decision-making. Cost Accounting can provide financial and non-financial information that help decision-making across all functions of the organization. Accounting is regarded us an information system and cost and Management Accounting are two sub-systems of the same. COST CONCEPT AND COST OBJECT Cost is defined as the amount of expenditure (actual or notional) incurred on, or attributable to, a specified thing or activity (CIMA). It also represents a sacrifice, a foregoing or a release of something of value. The Committee on Cost Concepts and Standards of the American Accounting Association (Accounting Review, vol. 31) supports the view that business cost is a release of value for the acquisition or creation of economic resources and is measured in terms of a monetary sacrifice involved. For example, for materials used for production the cost is measured by the amount of money that had to be paid to procure the materials. This is, no doubt, past or historical cost. Costs are, therefore, resources sacrificed or foregone to achieve a specific object. Objects of Cost Accounting are always activities. We want to know the cost of doing something. Cost object is, therefore, any activity or item for which a separate measurement of costs in desired. 3 A synonym is cost objective. The cost object may be an activity or operation, a product or service, a project, a department "or a programme. Cost measurement must be tied to at least one cost object—the term cost by itself is meaningless. Why does management need cost information? Some of the purposes for which managers need cost information are: 1. Periodic profit determination (including valuation of inventory); 2. Budgeting and planning operations (in money terms); 3. Cost control; 4. Pricing; and 5. Day-to-day applications of plans and policies. Historical costs are required for item (1) mentioned above as it involves the matching of costs and revenues on some consistent basis. For item (2), estimated costs, revenue, volume, etc. are relevant while cost control requires the adoption of standards for comparison and involves the measurement of actual costs against the standard costs. Pricing requires a different set of figures, viz., marginal costs plus expected contribution or estimated total cost plus profit. Day-to-day applications of plans and policies may require almost any combination of the above and other types of costs 76 Marginal Costing Marginal Costing is a technique of ascertaining cost used in any particular method of costing. According to this technique: variable costs are charged to cost units and the fixed cost attributable to the relevant period is written-off in full against the contribution for that period.' Under this technique, all costs are classified into two groups: fixed and variable. For this purpose, the fixed and variable elements are also separated from semi-variable or semi-fixed costs and included in respective groups. Since fixed costs are not included in product costs, it becomes easy to find out directly the effect on profit due to changes in volume or type of output. The term marginal costing is generally used in the U.K. while in the U.S.A., direct costing is the more popular term. Although both marginal costing and direct costing may mean one and the same thing, a distinction between the two may also be made. 2 The term cost-volume-profit (CVP) analysis is also frequently used 3 in this context. CVP analysis refers to the study of the effects on future profits of changes in fixed cost, variable cost, sales price, quantity and mix (C1MA). Break-even analysis is one of the important tools under CVP analysis or marginal costing and is used by managers for decision-making. Marginal costing or CVP analysis is based on certain assumptions. They are as follows: 1. Fixed costs will tend to remain constant. In other words, there will not be any change in cost factor, such as change in property tax rate, insurance rate, salaries of staff etc., or in management policy. 2. Price of variable cost factors, i.e., wage rates, price of materials, supplies, services, etc., will remain unchanged, so that variable costs are truly variable. 3. Semi-variable costs can be segregated into variable and fixed elements. 4. Product specifications and methods of manufacturing and selling will not undergo a change. 5. Operating efficiency will not increase or decrease. 6. There will not be any change in pricing policy due to change in volume, competition, etc. 7. The number of units of sales will coincide with the units produced, so that there is no closing or opening stock. Alternatively, the changes in opening and closing stocks are insignificant and that they are valued at the same prices, or at variable cost. 8. Product-mix will remain unchanged. Marginal Cost Economists define marginal cost as "the amount at any given volume of output by which aggregate costs are changed if the volume of output is increased or decreased by one unit". Suppose the cost of production of 10,000 units of a product is Rs. 1,00,000 and that of 10,001 units is Rs. 1,00,008. Therefore, cost of producing an additional unit is Rs. 8 (i.e., Rs. 1,00,008 - 1,00,000). This is the marginal cost of one unit and this marginal cost is the direct cost, comprising the cost of materials used, the labour employed and the variable overhead expenses that would not have been incurred but for producing this additional unit. If the production of the additional unit involves increase in fixed cost along with variable items as above, such increase will be included in marginal cost. But accountants define 4 marginal cost as "the variable cost of one unit of a product or a service, i.e., a cost which would be avoided if the unit was not produced or provided". Thus, marginal cost is the aggregate of variable costs. For example, if Rs. 40,000 for direct materials, Rs. 20,000 for direct labour, Rs. 20,000 for variable overheads and Rs, 20,000 for fixed overheads are incurred for producing 10,000 units of a product, the marginal cost can be ascertained as follows: Materials Rs. 40,000 Direct Labour 20,000 Prime Cost Rs. 60,000 Variable Overheads 20,000 Marginal Cost Rs. 80,000 Production 10,000 units Marginal Cost per unit Rs. 8/- The economist's marginal cost curve is J or U-shaped; the accountant's per unit variable cost is a constant, which, when plotted, is a flat, horizontal line. 77 The theory of marginal costing is based upon the assumption that some elements of cost tend to vary directly with variations in volume of output while others do not. That is why, only variable costs form part of product costs. On the other hand, fixed costs are written-off to Marginal Profit and Loss Account being treated as period costs inasmuch as costs such as supervision, rent, rates, fire insurance, depreciation, etc., are to be incurred during a period irrespective of the volume of production. Since variable costs are included in product costs, under stable conditions, such product costs will be a constant ratio whereas fixed costs will be a constant amount. Even if fixed cost increases due to increase in volume, it will not affect marginal or variable cost, as defined by the accountants. In the above example, direct labour costs are included in marginal cost on the assumption that they are 'variable'. If they are not variable, they should be excluded from marginal cost. It should be noted that even fixed costs may be directly identifiable with the cost object. While all variable costs are generally direct, all direct costs need not be variable. The most important aspect of the direct cost is the cost object. A cost item may be direct cost for one cost object, while it may be an indirect cost for another cost object. In India, labour costs are not variable—they are fixed; only an insignificant portion, say 5 to 10 percentage, is variable (e.g., casual labour engaged to cope with additional volume, overtime premium, salesmen's commission, etc.). Accordingly, cost of labour should be excluded from the computation of marginal or variable cost: it should be added to other fixed costs and treated as such, However, in solving the problems in this Section as well as those in Section II that follows, we have taken labour cost as 'direct and variable' as most of these questions set in various examinations assumed labour cost as such. In reality, the decision-maker should keep in mind the limitation of such textbook approach and analyze cost data according to real-life situation for correct decision. Variable Costs vs Fixed Costs In computing marginal costs, a distinction between variable costs and fixed costs has to be made because only variable costs are treated as product costs and fixed costs are treated as period costs. Semi-variable costs are segregated into variable and fixed elements and included in the respective groups. These costs are discussed in detail in the Overheads chapter (pp. 203-205). A comparison between the two with respect to a few criteria may, however, be summed up as follows: Particulars Fixed costs Variable costs 1. Type of costs Fixed costs tend to remain constant irrespective of the volume of output or activity. Because these costs generally accrue with the passage of time, they are known as 'period costs' or "time costs'. Fixed costs are 'costs of being in the business'. Variable costs tend to vary directly with output or activity. Since these costs tend to fluctuate in proportion to changes in output or activity, they may be called 'activity costs'. Variable costs are 'costs of doing the business'. 2. Relationship to Activity Fixed costs result from the capacity to produce and they are not a result of the performance of that activity. They are not generally influenced by output. So, apart from knowing the incidence of costs per unit, expressing fixed costs per unit does not make any sense. Variable costs vary in proportion to activity rather than to the passage of lime. So, expressing variable costs in relation to time does not make any sense. 3. Relevant Activity Range Fixed costs tend to remain constant only within a given range of output or activity. There are a few, if any, costs that would remain constant over the wide range of output or activity, say, from zero to full capacity. The pattern of variable costs also remains constant within a normal or relevant range of operations; beyond that, these costs may well change. 4. Relevant Period Other things remaining constant, a change in period may lead to a change in fixed costs structure (e.g., due to annual increment, salary bills in two periods will not be identical). All other factors given constant, variable costs cannot be affected due to change in period alone. 5. Controllability .All fixed costs are controllable over the lifespan of an enterprise. Only few items are subject to short-run management control. Many items of fixed costs are dependent entirely on specific management decisions. Therefore, they may be regulated by changing management decisions. Variable costs are generally subject to short- term management control. In some cases, variable costs may also be affected by the discretionary policy decisions of management. For example, a decision to use a less expensive raw material than that currently used (without impairing quality of product) will reduce the amount of variable cost (although the cost is still variable but at a different rate). 78 Determination of Marginal Cost Variable costs, such as direct materials, direct labour, direct expense, etc., can be ascertained without any difficulty and these costs will tend to be a constant amount per unit. In determining these costs, past actuals will be the basis for estimate. Where, however, budgetary control is in operation, company's detailed budget will be a guide. Variable overheads can be ascertained from previous ledger postings or the budget. Fixed costs can also be picked up individually without difficulty. The basic sources of data are the same, i.e., Material Requisition Notes for direct and indirect material, Job Cards or Wages Analysis Sheets for labour booking, Expense Analysis Sheet for expenses, etc. Semi-variable items should be segregated into variable and fixed elements and be included in the respective groups. Semi-variable group frequently represents a significant portion of the total costs incurred. Therefore, the accuracy of marginal costs will depend to a large extent upon the accuracy with which semi-variable costs are segregated into variable and fixed elements. Methods of Segregation of Semi-variable Costs The following methods are generally used in segregating semi-variable costs into their variable and fixed parts: 1. Intelligent estimate of individual expenses. 2. High and Low Points method. 3. Equations method. 4. Methods of Averages. 5. Graphical method. 6. Method of Least Squares. Intelligent Estimates In estimating fixed and variable portions of semi-variable overheads, past overhead expenses at various levels of activity will be analyzed and a tabulation will show the pattern of overhead expenses in relation to volume. Adjustments are to be made for anticipating changes in price, rate, etc. Although this method is not accurate, it is simple to operate. High and Low Points This is also known as Range Method. Segregation with the help of this_ method is not difficult. In this method, the levels of highest and lowest expenses are compared with one another and related to output attained in those periods. Since fixed portion of the costs is expected to remain fixed for the two periods, it becomes clear that the change in the level of the expenses must be due to variable portion of the overheads. From this, the variable cost per unit is easy to ascertain as follows: level output in Change level ense exp in Change Illustration 5.1 Output Semi-variable Month (units) overheads Rs. January 2,500 12,500 February 3,000 14,000 March 3,500 15,500 April 4,700 19,100 May 3,700 16,100 June 4,400 18,200 July 4,500 18,500 August 4,200 17,600 September 4,000 17,000 October 4,300 17,900 November 3,800 16,400 December 2,700 13,100 Now, from the above table, taking highest and lowest output with relative overhead costs, one can segregate 79 the fixed and variable portions as follows: Output (units) Semi-variable overheads Rs. Highest (April) 4,700 19,100 Lowest (January) 2,500 12,500 Change 2,200 6,600 Since variable costs will only change, variable overheads cost per unit will be: Rs. 6,600 4 2,200 = Rs. 3/- Therefore, fixed costs would be: Rs. 19,100 - (4,700 x Rs. 31-) = Rs. 5,0007- This method is not always considered to be scientific. Equation Method Here the straight line equation is used. The equation is: y = mx + c (5.1) where y - total semi-variable cost, c - fixed cost included in semi-variable cost, m = variable cost per unit, and x - output. It is now possible to segregate the fixed and variable portions with the help of the equations with respect to two periods. Illustration 5.2 Taking the figures for January and February from Illustration 5.2: (January) 12,500 = 2,500m + c (I) (February) 14,000 = 3,000m + c (2) Subtracting Eq. (1) from Eq. (2): 1,500 = 500m m = Rs. 37- Putting value of m in Eq. (1): 12,500 = 2,500 x 3 + c .-, c = Rs. 5,000. Method of Averages Under this method, average of two selected groups should be taken out first and then the method of high and low points or the equation method may be used in arriving at variable and fixed portions of semi-variable costs. Illustration 5.3 Average output Average cost Last four months 3,700 units Rs. 16,100 First four months Change 3,425 units Rs. 15,275 275 units Rs. 825 Variable overheads: Rs. 825 4 275 = Rs. 3 per unit Fixed overheads: Rs. 16,100 - (3,700 x Rs. 3) = Rs. 5,000 Graphical Method Semi-variable overheads at various levels of activity will be plotted on a graph paper whose abscissa will represent output at various levels of activity and the ordinate will represent respective semi-variable overheads. The line of regression drawn on the graph paper will show the relation between the variable overheads and 80 output and the point where regression line will cut the ordinate will represent the fixed overheads. The slope of the regression line will show the degree of variability. This method is widely used in practice. Method of Least Squares This method is possibly the most accurate of those discussed so far. This is based on finding out a 'line of best fit' for a number of observations with the help of statistical method. We know the straight line equation y = mx + c. Thus, for each period we have an equation in the following form: y1 = mx1 + c y2 = mx2 + c yn ~ mxn + c Adding ` ∑y = m ∑ x + N.c (5.2) [N = number of observations] Again, multiplying both sides of the linear equation by x, we get: x1y1] = mx2 + c.X1 2 x2y2 = mx2 + c.x2 xnyn = mxn 2 + c.xn and which, when added together, become: ∑ xy - m ∑ x 2 + c. ∑ x (5.3) With the help of Eqs. (5.2) and (5.3), the values 'm* and V can be obtained and the pattern of cost line determined accordingly. Illustration 5.3 Month Output (units) Semi-variable overheads Rs. x Y January 2,500 12,500 February 3,000 14,000 March 3,500 15,500 To reduce labour, let: x = 500 Y y and ; 500 X · Then: x y xy x 2 5 25 125 25 6 28 168 36 7 31 217 49 18 84 510 110 Sx Zy "Lxy Xx 2 Substituting the above values in Eqs. (5.2) and (5.3): 84= 18m + 3c (3) 81 510= 110m + 18c (4) Multiplying Eq. (3) by 6: 504= 108m + 18c (5) Subtracting Eq. (5) from Eq. (4): 6 = 2m ∴ m = 3 Putting this value in Eq. (3): 84 = 54 + 3c c = 10. We now have: y = 3x + 10. Putting y = 500 Y and x = , 500 X the equation becomes: 10 500 X 3 500 Y + · Multiplying both sides by 500: Y = 3X + 5.000 Thus, the above straight line equation shows that Rs. 5,000 is the amount of fixed overheads present in the total semi-variable and the variable overheads are Rs 3/- per unit. Note: The equation Y = 3X + 5,000 gives the pattern of semi-variable overheads line. Thus, if production for any month is, say, 4,000 units, the total overheads will be: Y = 3 x 4,000 + 5,000 = Rs. 17,000 Concept of Profit Profit is known as 'Net Margin'. Net Margin 5 is arrived at after deducting fixed costs from total contribution or 'Gross Margin'. It may be noted that contribution is the difference between sales value and the variable cost of those sales. In short, fixed costs are not included in cost of goods sold or closing stock; they are written-off to Marginal Profit and Loss Account of the period. The argument in favour of this procedure is that no one makes profit per unit manufactured; but profit is made out of total activity during a period. It is generally said that products make contribution and business makes profit. Units produced and sold will, therefore, contribute to a 'profit pool' which will pay for the fixed charges and whatever will be left thereafter will represent net profit. Assuming that a manufacturing company manufactures four products, the diagram overleaf will demonstrate how profit is made. Figure 5.1 It is also clear that no part of the fixed overheads is transferred to the next period by the addition of some 82 arbitrary amount to the value of closing work-in-progress and finished goods. Absorption vs Marginal Costing It follows from the earlier discussion that marginal costing and absorption costing are based on different concepts of profit. The crucial question is whether the total fixed costs incurred during a period should be charged against sales of the period (as is done in marginal costing) or should be spread over more than one accounting period by means of inclusion in closing stocks (as is done in absorption costing). Under marginal costing, the entire amount of fixed costs is charged to Profit and Loss Account in the year in which the costs are incurred, so that closing work-in-progress and finished goods are valued at marginal or variable costs only. Consequently, under marginal costing, profits tend to vary with volume of sales irrespective of movements -in inventory. Therefore, profit and loss statement prepared under marginal costing is more intelligible to management. Under absorption costing, on the other hand, product costs include fixed costs and as a result, a portion of fixed costs is carried forward to the next year by means of inclusion in closing work-in-progress and finished goods. Thus, under absorption costing, periodic profit is affected by changes in inventory as well as in the volume of sales and profit may be shifted from one accounting period to another by increasing or reducing inventories. The effect upon profit under absorption and marginal costing under a number of possibilities may be studied as follows: Possibilities Effect upon Profit under Absorption and Marginal Costing (a) When sales and production coincide Under both methods, total fixed costs incurred during the period are charged against sales or revenues of the period. Hence both yield the same profit. (b) When sales exceed production (i.e., closing stock decreasing) Under absorption costing, fixed costs charged against revenues exceed the amount incurred during the period. This is because fixed costs previously deferred in stock are charged against revenues in the period in which the goods are sold. Therefore, profit is lower than that shown under marginal costing. (c) When production exceeds sales (i.e., closing WIP and Finished goods increasing) Under absorption costing, total fixed costs charged against revenue are lower than the amount incurred inasmuch as a portion of fixed production costs of the period is deferred to future periods by means of inclusion in closing inventories. Therefore, absorption costing shows a higher profit than does marginal costing. (d) When sales volume is constant but production fluctuates Marginal costing shows a constant profit figure because changes in the level of inventory cannot affect the profit. But under the same circumstances, absorption costing yields a fluctuating profit figure. (e) When production volume is constant but sales fluctuate Profit is directly proportional to sales under either of the methods. The profit figure may not be the same in amount but it will move in the same direction. Illustration 5.4 Duo Ltd makes and sells Two products, Alpha and Beta. The following information is available: Period 1 Period 2 Production (units): Alpha 2,500 1,900 Beta 1,750 1,250 Sales (units): Alpha 2,300 1,700 Beta 1,600 1,250 Financial data: Alpha Beta £ £ Unit selling price 90 75 Unit variable costs: Direct materials 15 12 Direct labour (£ 6/hr) 18 12 83 Variable production overheads 12 8 Fixed costs for the company in total were £ 1,10,000 in period 1 and £ 82,000 in period 2. Fixed costs are recovered on direct labour hours. Requirements: (a) Prepare profit and loss accounts for period 1 and for period 2 based on marginal cost principles. (b) Prepare profit and loss accounts for period 1 and for period 2 based on absorption cost principles. (c) Comment on the position shown by your statements. (a) Profit and Loss Accounts for Periods 1 and 2 under Marginal Costing Peri od 1 Period 2 £ £ £ £ Sales 3,27,000 2,46,750 Less: Cost of sales: Opening stock (Wl) — 13,800 Production 1,68,500 1,25,500 1,39,300 Less: Closing stock (Wl) Contribution 13,800 22,800 1,16,500 1,54,700 1,72,300 1,30,250 Less: Fixed costs 1,10,000 82,000 Profit 62,300 48,250 (b) Profit and Loss Accounts for Period 1 and 2 Based on Absorption Costing Period 1 Period 2 £ £ £ Sales 3,27,000 2,46,750 Less: Cost of sales: Opening stock (W2) — 22,800 Production 2, 78,500 2,07,500 2,30,300 Less: Closing stock (W2) 22,800 37,800 2,55,700 1,92,500 Profit 71,300 54,250 (c) Stock levels are rising over period 1 and 2. Absorption costing, which includes a share of fixed costs in the stock valuation, therefore gives a higher reported profit than marginal costing which charges the fixed costs against profit in the period in which they are incurred. Accordingly, the reported profit under absorption costing is £ 15,000 more over the two periods as £ 9,000 of fixed costs are 'carried forward' from period 1 to 2, and a net £ 6,000 are 'carried forward' from period 2 to 3. Workings: Alpha Beta Total Marginal cost per unit (£) 45 32 Period 1: Closing stock: units 200 150 value (£) 9,000 4,800 13,800 Period 2: Closing stock: units 400 150 value (£) 18,000 4,800 22,800 W2 Period 1: Marginal cost (£) 45 32 Overheads (£): £ 1,10,000 (3 x 2,500) + (2 X 1,750) = £ 10 per labour hour 30 20 Total cost per unit (£) 75 52 84 Closing stock: units 200 150 value (£) 15,000 7,800 22,800 Period 2: Marginal cost (£) 45 32 Overheads (£): £ 82,000 (3 x 1,900) + (2 x 1,250) = £ 10 per hour 30 20 Total cost per unit (£) 75 52 Closing stock: units 400 150 value (£) 30,000 7,800 37,800 MARGINAL COST EQUATION It has been pointed out earlier that the difference between sales value and the variable cost of those sales is known as contribution. In other words, products sold will contribute to a fund to meet first the fixed costs and the balance represents the profits of the undertaking. Therefore, contribution is equal to fixed costs and profit (or loss). From this concept, the following Marginal Cost Equation is developed: S - V = F + P [S - V = C; C = F + P] (5.4) where S - Sales; V - Variable or marginal costs; F = Fixed costs, and P - Profit. Thus, if any three factors of the above equation are known, the fourth can be easily found out. Again, this equation is used for ascertainment of break-even point, i.e., at break-even point, there will be no profit or no loss (Total Costs = Total Sales), so that P = 0. i.e., S1=V1 + F (1) (5.5) PROFIT/VOLUME RATIO The Profit/Volume Ratio, popularly known as the P/V Ratio, expresses the relation of contribution to sales. This ratio is also known as Contribution to Sales (C/S) or the Marginal Income Ratio. Symbolically, 85 P/V or C/S Ratio = S V S S C − · (5.6) where C = Contribution, S = Sales, and V - Variable costs. So long as unit selling price and unit variable cost remain constant, P/V ratio can also be found out by expressing change in contribution in relation to change in sales. Similarly, when unit selling price, unit variable cost and fixed cost (total) remain constant, P/V ratio can be determined by expressing change in profit or loss in relation to change in sales. Thus, P/V or C/S ratio = sales in Change on contributi in Change Sales on Contributi · = sales in Change ) loss or ( profit in Change (5.7) The above ratio is generally expressed in percentage form multiplying it by 100. C/S or P/V Ratio determines the increase or decrease in contribution which can be expected from increase or decrease in volume provided that there is no change in any other factors. In normal circumstances, C/S or P/V ratio will indicate relative profitability of different products, processes or departments, so that development of sales strategy is facilitated. For example, a high C/S or P/V ratio indicates that comparatively large amount may be spent by way of advertising and sales promotion for obtaining additional sales inasmuch as the contribution from such sales will be adequate to recover fixed costs and 'contribute further towards profit. Again, for price reduction due to acute competition, the C/S ratio may be used by the management. The effect on profit due to changes in volume may be ascertained with the help of this ratio. The effect on profit may be summed up as follows: (i) If the firm is operating at or above BEP, the increase in net profit will be equal to increase in contribution provided fixed costs remain constant. Illustration 5.5 Sales Variable costs Present volume Rs. 10,000 Additional volume Rs. 1,000 6,000 600 Fixed costs Total costs Net Profit 2,000 _ 8,000 600 2,000 400 Thus, due to additional sales, net profit will be increased by Rs. 400. The same result can be obtained by multiplying the additional sales figure by P/V ratio (here P/V ratio is 40%), i.e., Rs. 1,000 x 40% = Rs. 400. However, it is to be assumed here that selling price and variable costs, the constituents of the ratio, will remain unchanged even for the additional volume. But if they change, the P/V ratio will also change. (ii) If the firm is operating below the BEP, the addition to contribution reduces the loss or changes the loss into profit. Improvement of P/V Ratio CIS or P/V ratio is the function of sales (value and/or volume) and variable costs, Therefore, an improvement of the ratio will mean increasing the gap between sales and variable costs. This can be done by; (a) increasing selling price; (b) reducing variable costs; (c) altering sales mixture, i.e., product having low P/V ratio will be substituted by a product with a higher ratio. 86 BREAK-EVEN CHART A Break-even Chart (BEC) is a graphical representation of marginal costing or CVP analysis. It is an important aid to profit planning. It has been defined as 'a chart which shows the profitability or otherwise of an undertaking at various levels of activity and as a result indicates the point at which neither profit nor loss is made'. The BEC, therefore, depicts the following information at various levels of activity: 1. Variable costs, fixed costs and total costs. 2. Sales value. 3. Profit or Loss. 4. Break-even Point, i.e., the point at which total costs just equal or break-even with sales. This is the activity point at which neither profit is made nor loss is incurred. 5. Margin of Safety. At different activity levels, the interaction of volume, selling price, variable costs and fixed costs, the relevant variables and their impact upon profit are considered simultaneously. Perhaps, in this context, a name for the break-even graph that more clearly describes its function would be profit planning chart. 7 The most important use of the BEC is the ascertainment of a break-even point (BEP) from the chart, which is a valuable guide to the management. The BEP can be determined from a BEC or can be calculated as follows: i. BEP (units) = on Contributi Unit Costs Fixed Total (5.8) ii. BEP (sales value): = ratio V P Costs Fixed Total (5.9) = S x C Costs Fixed Total S C Costs Fixed Total · (5.9) Therefore, when P/V ratio is calculated using unit contribution and unit selling price, we can write: BEP = ice Pr g UnitSellin x on Contributi Unit Costs Fixed Total (5.10) But if P/V ratio is calculated at a given level of activity, i.e., taking total sales and total contribution at that level, the BEP is computed as follows: Sales Total x on Contributi Total Costs Fixed Total (5.11) The fixed costs for the year are Rs. 80,000, variable cost per unit for the single product being made Rs. 4. Estimated sales (at 100% capacity) for the period are 10,000 units. The number of units involved coincides with the expected volume of output. Each unit sells at Rs. 20. BEP (units) = units 000 , 5 4 20 000 , 80 . Rs · − or, 5000 x Rs.20 = Rs.100000 The same result can be obtained by using the last formula: 100000 . Rs 200000 x 160000 80000 . Rs · Check Rs. Sales (5,000 units) 1,00,000 Variable cost @ Rs. 4 20,000 Contribution 80,000 87 Fixed costs 80,000 Profit/Loss Nil It should be noted that in case of a multi-product firm, P/V ratio stands for combined P/V ratio for all the products, at a particular level of activity, by applying which the break-even sales of the firm has to be computed as above. In such a case, formula (i) cannot be applied. Illustration 5.6 From the following data, calculate the break-even sales for a company producing three products. Product Sales Variable cost Rs. Rs. X 10,000 6,000 Y 5,000 2,500 Z 5,000 2,000 20,000 10,500 Total fixed costs amounted to Rs. 5,700. Product X Y Z Total Rs. Rs. Rs. Rs. Sales 10,000 5,000 5,000 20,000 Variable cost 6,000 2,500 2,000 10,500 Contribution 4,000 2,500 3,000 9,500 Break –even Sales = Sales Total x on Contributi Total Cost Fixed = Rs. 12000 . Rs 20000 x 9500 5700 · Check : Product Sales ratio BE Sales in Variable Variable cost Contribution previous ratio cost ratio Rs. Rs. Rs. Rs. X 50% 6,000 60% 3,600 2,400 Y 25% 3,000 50% 1,500 1,500 Z 25% 3,000 40% 1,200 1,800 Total 100% 12,000 6,300 5,700 Fixed costs 5,700 Profit or Loss Nil Once we know the various components of break-even point, it is possible to find out missing information. Illustration 5.7 What will be the C/S ratio and the profit in the following case? Sales Rs. 1,00,000 Fixed cost Rs. 20,000 Break-even point Rs. 40,000 We know: BEP = ratio S / C PC or, C/S ratio = 40000 . Rs 20000 . Rs BEP FC · = 0.50 or 50% ∴Profit = Contribution – Fixed Cost = Rs.(100000 x 0.50) – Rs.20000 = rs.30000 88 Construction of a Break-even Chart A Break-even Chart is drawn on a graph paper. Costs and revenue are plotted on the 'Y' axis and activity or volume is plotted on the 'X' axis. 'X' axis may be expressed in a number of ways, e.g., (a) Percentage level of activity (plant capacity being represented by 100%), (b) Volume in units, (c) Standard Hours, and (d) Sales Value. Where, however, there are a number of products of different measuring units which require different plant capacity, it is difficult to plot them on the basis of percentage activity or volume. Here, Standard Hours may be the appropriate expression. In other cases, sales value is widely used because profit is not realized unless goods are sold. However, when sufficient data are available, it is desirable that a combination of methods of expression is used. The following is an example of EEC drawn from the schedule below on the basis of data as in previous illustration. Sales Fixed Variable Total cost cost cost Units Rs. Rs. Rs. Rs. Nil Nil 80,000 — 80,000 2,500 50,000 80,000 10,000 90,000 7,500 1,50,000 80,000 30,000 1,10,000 10,000 2,00,000 80,000 40,000 1,20,000 Procedure 1. Represent fixed cost Rs. 80,000 by a line parallel to 'X' axis. Plot the variable costs for different levels of activity over fixed cost line. Join the variable cost line to fixed cost line at zero activity level. The resultant line will represent total cost line—variable cost having been added to fixed cost. 2. Similarly, determine sales value at various levels of activity and plot them on the graph paper and join to zero in the graph. This line will represent sales value. 3. The sales 1'ne will cut the total cost line at a point which is known as break-even point. The breakeven sales will be determined by dropping a perpendicular to the 'X' axis from the point of intersection and measuring the horizontal distance from the zero point to the point at which the perpendicular is drawn. Another perpendicular to the 'Y' axis from the point of intersection will indicate (vertically) the break-even sales value. Interpretation The break-even chart will give a vivid picture of profit or loss at different levels of activity. For instance, where the sales line is above the total cost line, there is profit; where it is below the total cost line, there is a loss; and where total cost equals total sales, there is no profit or loss. Alternative form of a BEC In Figure 5.2, fixed cost line has been plotted first. Alternatively, variable cost line may be plotted first and then fixed cost line over the variable cost line. This type of presentation is more helpful to the management for decision-making inasmuch as it shows clearly the contribution margin at any volume of sales. Further, it 89 appears from the chart that below the break-even point, it is the fixed cost which is not being covered fully. Thus, it is in line with the concept of marginal costing. Unless, therefore, there is a contrary instruction, this form of presentation, known as the contribution break-even chart (Fig. 14.2), should be followed. Figure 5.2 Break-even Chart Figure 5.3 Contribution Break-even Chart. Margin of Safety This is represented by excess sales over and above the break-even point. In the preparation of a BEC, one of the assumptions made is that production will coincide sales. Therefore, it may be said that margin of safely is also the excess production over break-even point. In the chart, it is the distance between the BEP and present sales or production. Margin of Safety (M/S) may be expressed in sales volume or value or in percentage, e.g., Present Break-even M/S sales sales Rs. 2,00,000 Rs. 1,00,000 Rs. 1,00,000 or 10,000 units or 5,000 units or 5,000 units 1,00,000 or x l00 2,00,000 = 50% 90 The percentage form of expression is generally used. The Margin of Safety can also be calculated with the help of the formula: Illustration 5.8 (Data same as in Illustration 5.8) M/S is an indicator of the strength of a business, i.e., a high margin will indicate that profit will be made even if there is a substantial falling off in sales of production. For instance, if the sales, in the illustration, falls by even, say, 40%, the company will still be making profits since its margin of safety is very high, i.e., 50%. On the other hand, if the margin is small, a small drop in sales or production will be a serious matter. In such a case, management may take many valuable decisions, such as: 1. increase the level of activity; 2. increase the selling price; 3. reduce costs—fixed and/or variable; 4. substitute the existing products with more profitable products. In inter-firm comparison, margin of safety may be used to indicate relative position of firms. For instance, consider the following statement: Company A Company B Rs. Rs. Total Sales 2,00,000 1,00,000 Break-even Sales M/S 1,00,000 80,000 Rs. 1,00,000 20,000 or 50% or 20% Therefore, it may be concluded that if the rate of profit earned above break-even sales is the same for company A and B, the first mentioned company is in a much stronger position than Company B. Angle of Incidence This is the angle between sales and total cost line (see Fig. 14.1). This angle is an indicator of profit-earning capacity over the break-even point. Therefore, the aim of the management will be to have a large angle which will indicate earning of high margin of profit once fixed overheads are covered. On the other hand, a small angle will mean that even if profits are being made, they are being made at a low rate. This in turn suggests that variable costs form a major part of cost of sales. However, if Margin of Safety and Angle of Incidence are considered together, they will be more informative. For example, a high margin of safety with a large angle of incidence will indicate the most favourable conditions of a business or even the existence of monopoly position. THE PROFIT/VOLUME GRAPH OR PROFIT CHART This shows the relationship between profit and volume. The P/V graph is a simplified form of Breakeven Chart and requires the same basic data for its construction and suffers from the same limitations, (see Fig. 14,3.) A P/V graph can be constructed if any two of the following data are known: (i) Fixed Overheads, 91 (ii) Profit at a given level of activity, and (iii) Break-even point. Figure 5.4 Profit-volume Graph Illustration 5.9 The following data relate to a company for the year ended 31st December, 2005: Units produced: 20,000 Fixed Overheads: Rs. 50,000 Variable cost per unit: Rs. 6 Selling price per unit: Rs. 10 Prepare a P/V graph. In order to construct a graph, it is necessary to ascertain profit at the present level of activity. Thus, Sales: 20,000 units @ Rs. 10 Rs. 2,00,000 Variable cost (@ Rs. 6 per unit) Contribution 1,20,000 80,000 Fixed Overheads 50,000 Net Profit 30,000 Procedure This can be summarized below: 1. The graph is divided into two areas—the vertical axis above the zero line represents profit area and the vertical axis below the zero line represents the loss or fixed cost area. 2. A scale for sales on the horizontal (zero) axis is selected. 3. A scale for profit and fixed cost on the vertical axis is also selected. 4. Points are plotted for profits and fixed cost and they are then connected by a straight line which intersects the sales line at the horizontal axis. The point of intersection is the break-even point. Thus, from the graph, the following can be ascertained: Break-even point : Rs. 1,25,000 Margin of Safety : Rs. 75,000 A profit-volume graph may be used for a variety of purposes, viz., determining break-even point and showing the impact on profits of selling at different prices for a product, forecasting costs and profits resulting from changes in sales volume, showing the deviations of actual profit from anticipated profit, relative profitability under conditions of high or low demand for a product, etc. Two such uses are shown below. (a) Relative profitability under conditions of high and low demands: When two firms are identical in some respects and operate in the same marketplace facing the same kind of competition, their profitability under conditions of changing demand may be compared using the profit graph. In reality, 'high-tech' company will have a higher amount of fixed cost and hence would be exposed to a greater degree of operating risk. The 'low- tech' company, having lower amount of fixed cost, would have to face lower degree of operating risk in the event of fall in demand. 92 Illustration 5.10 Two businesses A. B. Ltd and C. D. Ltd sell the same type of product in the same type of market. Their budgeted profit and loss accounts for the year 2005 are as follows: Rs. A. B. Ltd Rs. Rs. C. D. Ltd Rs. Sales 1,50,000 1,50,000 Less: Variable cost 1,20,000 1,00,000 Fixed cost 15,000 35,000 1,35,000 — — — — — 1,35,000 Net budgeted profit 15,000 15,000 You are required to: (a) calculate the break-even point of each business, and (b) state which business is likely to earn greater profits in conditions of— (i) heavy demand for the product; (ii) low demand for the product. (a) A. B. Ltd C. D. Ltd Rs. Rs. Sales 1,50,000 1,50,000 Less: Variable cost 1,20,000 1,00,000 Contribution 30,000 50,000 P/Vratio(§x100 V S ) 20% 33 1% Break-even Sales (Fixed cost + P/V ratio) Rs. 15,000 Rs. 35,000 20% 33--% = Rs. 75,000 = Rs. 1,05,000 Margin of Safety (Present sales - Break-even sales or Profit 4- P/V ratio) Rs. 75,000 Rs. 45,000 (b) Although total costs of both the firms are the same, the fixed costs of A. B. Ltd are lower than that of C. D. Ltd. As a result, the break-even point in the former case is reached sooner (i.e., at a lower level of activity), as will be evident from the following graph. Figure 5.5 Comparative Profit-volume Graphs It appears from the graph that for sales below Rs. 1,50,000, A. B. Ltd will earn greater profit than C. D. Ltd once break-even point has been reached. At volume of Rs. 1,50,000, both will earn same profit. Since the rate of profit-earning in case of C. D. Ltd is greater than that of A. B. Ltd (vide angles of incidence), for volume above Rs. 1,50,000, C. D. Ltd will earn more profit than A. B. Ltd. Thus, in case of heavy demand, C, D. Ltd will earn greater profits while A. B. Ltd will earn greater profits in condition of low demand for the product. (b) Profit chart for different product prices: The effect on break-even point and profit of charging different prices for a product can be seen from the profit chart. Since different prices are being compared, the use of units is desirable. 93 A profit chart is shown in Figure 5.6. The chart is based on the following information: Variable cost per unit : Rs. 4 Fixed cost (total) : Rs. 10,000 Alternative selling prices of a product : Rs. 8, Rs. 10 and Rs. 12 Maximum sales units : 3,000. Figure 5.6 Profit-volume Graph at Different Prices. MULTI-PRODUCT BREAK-EVEN CHART When a company deals in a number of products, it is possible, and indeed desirable, to draw a break-even chart for the company as a whole (i.e., considering all the products in one chart). In such a case, the breakeven point is where the average contribution line cuts the fixed cost-line (Fig. 14.6), assuming proportions of sales- mix remain unchanged. Figure 5.7 Multi-Product Break-even Chart. The procedure for drawing up a multi-product break-even chart may be summarized as follows: 1. Calculate P/V ratio for each product and arrange the products in descending order on the basis of P/V ratios. 94 2. 'X'-axis would represent sales value while Y-axis would represent contribution and fixed cost, 3. Plot the total fixed cost line. 4. Take the product having the highest P/V ratio and plot its contribution against sales; then take the product having second highest P/V ratio and plot cumulative contribution against cumulative sales; the process will end with plotting by the product having the lowest P/V ratio. 5. Obtain the average contribution slope by joining the origin to the end of the last line plotted. The break-even point is the point of intersection of average contribution line and fixed cost line. Illustration 5.11 ABC Co. Ltd produces and sells three products—Y, X and Z. From the following information relating to these products for a period, draw up a break-even chart to determine the breakeven point: Y X Z Total Sales (Rs.) 25,000 40,000 35,000 1,00,000 Variable costs (Rs.) 15,000 20,000 28,000 63,000 Fixed costs (Rs.) 18,500 The P/V ratio of each product should be calculated first, and then in order of importance of P/V ratios a table for cumulative sales and contribution should be prepared and plotted on the graph paper. P/V ratio : S V S ) ( − X 100 Product Y : (10,000/25,000) x 100 = 40% X : (20,000/40,000) x 100 = 50% Z : (7,000/35,000) x 100 = 20% Sales Contribution Product P/V ratio Productwise Cumulative Productwise Cumulative Rs. Rs. Rs. Rs. X 50% 40,000 40,000 20,000 20,000 Y 40% 25,000 65,000 30,000 30,000 Z 20% 35,000 1,00,000 7,000 37,000 Thus, the break-even sales can be read from the chart as Rs. 50,000. Note: The break-even sales determined graphically can be verified by applying the formula: B/E sales = sales Total x on contributi Total t cos Fixed = 50000 . Rs 100000 x 37000 18500 . Rs · DIFFERENT TYPES OF BREAK-EVEN CHART Different break-even charts may be prepared to suit different purposes. Some of the most common types of charts (in addition to those already discussed) are: 1. Detailed break-even chart 2. Cash break-even chart 3. Control break-even chart 4. Break-even chart to determine optimum volume. Break-even charts with the exception of the last-mentioned one are discussed below, one by one, in a nutshell. Determination of optimum volume and selling price through break-even chart is shown later on (vide Section II). Detailed Break-even Chart 95 In this type, details of variable costs—direct materials, direct labour, variable overheads—are plotted in the graph. In addition, profit appropriations—income tax, preference dividend, equity dividend and retentions—are shown. If the chart contains only details of appropriations of profit, it is called Profit Appropriations Breakeven Chart. Detailed analysis, particularly of various elements of variable costs, helps management in both policy decisions and control functions. A detailed break-even chart is shown in Figure 5.8. The chart is based on the following information: Marginal cost per unit: Rs. Direct Material 2 Direct Labour 1 Variable Factory Overheads 1 Variable Selling and Distribution Overheads 1 (see p. 559 for other information.) Rs. 5 Figure 5.8 Detailed Break-even Chart Fixed cost (total) : Rs. 10,000. Income-tax : 40% of profit Dividends : Rs. 2,000 Maximum Sates : 4,000 @ Rs. 10 per unit. Cash Break-even Chart In this type, fixed costs are divided into two groups: 1. Fixed costs requiring cash outlay during the period covered by the chart (e.g., salaries, rent, rates, insurance, etc.) 2. Fixed costs not requiring immediate cash, e.g., depreciation, deferred expenses such as research and development, advertisement, etc. 96 The former (type 1) is shown at the base, i.e., parallel to X-axis like the conventional break-even chart while fixed costs not requiring immediate cash outlay (type 2) are shown last, i.e., after variable costs. Variable costs, which are assumed to be payable in cash during the period, are plotted as usual. If, however, credit transactions are involved here, the portion of variable costs not requiring immediate payment should be treated like type 2 fixed costs. Cash break-even charts are used in cash flow analysis and are extremely useful to enterprises running short of required solvency. It is a valuable guide in both short-run investment and financing decisions. A cash break-ever chart is shown in the figure. The chart is based on the information given overleaf. Figure 5.9 Cash Break-even chart Sales 4,000 units @ Rs. 10 Variable cost per unit Rs. 5 Fixed costs: Rs. Requiring immediate cash payment 5,000 Not requiring cash payment (Depreciation) 3,000 Rs. 8,000 Tax: 50% of profit Preference Dividends: Rs. 2,000. Control Break-even Chart When Budgetary Control and Marginal Costing are combined, break-even chart comparing budgeted and actual costs, sales, profits and break-even points is prepared. By pinpointing deviations between budgeted/standard and actual figures, it serves as an extremely useful tool in management control and is known as control break- even chart. But detailed analysis of deviations or variances according to originating causes and also into controllable and non-controllable portions is not possible graphically. Such analysis should, however, supplement the control chart. A control break-even chart is shown in Figure 5.10. 97 Figure 5.10 Control Break-even chart ADVANTAGES AND LIMITATIONS OF A BREAK-EVEN CHART Advantages 1. It is simple to compile and understand. Facts presented to the management in a graphical way are understood by them more easily than those contained in the Profit and Loss Account, Operating Statements, Cost Schedules, etc. 2. A break-even chart is a useful tool to guide management in studying the relationships of cost, volume and profits. The chart may depict the effect on profits of changes in (a) selling price, (b) variable cost, (c) fixed costs, and/or (d) volume of sales so that management may take many important decisions. 3. The strength of the business and the profit-earning capacity can be ascertained from the break-even chart by studying margin of safety and angle of incidence together. Many policy decisions, such as (a) increase the activity level, (b) reduce the costs, (c) increase the selling price, and (d) substitute the existing products by more profitable products, etc. may be taken on the basis of margin of safety and angle of incidence in the break-even chart, 4. The effect of alternative product mixes on profits can also be shown in break-even charts. This will help in selecting the most profitable product-mix. Limitations In the simple chart, we have seen that the cost line and sales line look like straight lines. This is possibly due to a number of assumptions mentioned earlier. But, in practice, a break-even chart is unlikely to be a series of straight lines. If that is so, there might be several break-even points at different levels of activity. Therefore, a break-even chart can be used only if the following limitations are kept in mind. 98 1. The break-even chart shows a static picture and hence may become out-of-date if the assumptions or conditions prevailing change after it is being made. For instance, it is assumed that selling price, fixed costs and unit variable costs will remain constant at different levels of activity. But competition, demand factor, efficiency in production, policy decisions, etc., may bring about changes in selling price, unit variable cost and total fixed costs. In actual practice, therefore, a break-even chart is quite unlikely to look like a straight- line graph; it may take the form of Figure 5.11. Thus, a typical breakeven chart (i.e., where unit variable cost and selling price do not remain constant and fixed cost rises in steps) may show a number of break-even points. But there will be only one optimum production level where profits will be higher than at any other level. This optimum level is that point where the gap between the sales line and the total cost line is maximum. At this point, marginal costs equal marginal revenue. 2. Break-even analysis related to the total costs and sales of a company which manufactures a variety of products will not be explanatory of the position in regard to any one product, The effect of various product- mixes on profits cannot be studied from a single break-even chart. But a profit graph can overcome this objection. 3. A break-even chart does not generally take into consideration capital employed which is one of the vital factors in many policy decisions, Therefore, policy decisions dependent wholly on break-even Figure 5.11 Break-even Chart When fact rather than theory is considered, a break-even chart is unlikely to be a series of straight lines. It would look like the above chart and it would not be surprising to see even several break-even points at different levels of output and sales. chart may not be safe and reliable. But even in break-even analysis, it is possible to include, for the purpose of policy decisions, additional calculation showing the interaction of the following ratios: IMPACT ON PROFITS DUE TO CHANGES IN VARIOUS FACTORS Marginal costing or CVP analysis is used for studying the results of various changes in factors other than volume, such as: • changes in fixed costs; • changes in variable costs; • changes in selling price; and • changes in sales mixture. 99 The effect on profits due to above changes can be shown in a simplified way in a break-even chart. However, we shall study the effect of above changes on: 1. Break-even Point, 2. Margin of Safety, and 3. Profit Volume Ratio. Change in Fixed Costs A change in fixed costs will change the break-even point by an equal percentage provided variable costs and selling price remain constant. Once break-even point is changed, it will also affect the margin of safety but the effect will be reverse as compared to break-even point, i.e., if BEP comes down, it will increase the M/S and vice versa. But a change in fixed costs will have nothing to do with the P/V Ratio. Illustration 5.12 (Data same as in Illustration above) Fixed costs increase by 10%. Break-even Point = 16 88000 . Rs 16 % 10 80000 . Rs · + = 5500 units, or Rs.110000 Margin of Safety = Rs.200000 – 110000 = Rs.90000 or 45% P/V Ratio = % 80 100 x 20 16 · Change in Variable Cost A change in variable cost without any corresponding change in selling price and fixed costs will change the BEP, M/S and P/V ratio. Illustration 5.13 Variable costs increase by 10% BEP = ( ) 40 . 4 20 ., e . i 60 . 15 80000 . Rs − x 20 = Rs.102564. M/S = Rs.200000 – 102564 = Rs.97436 or 49%. P/V Ratio = 00 . 20 60 . 15 x 100 = 78%. Change in Selling Price Similarly, a change in selling price, without a corresponding change in variable costs and fixed costs, will change the BEP, M/S and P/V ratio. Illustration 5.14 10% decrease in selling price. BEP = 102857 . Rs 18 x 14 . Rs 80000 . Rs · M/S = Rs.180000 – 102857 = Rs.77143 or 43%. P/V Ratio = % 7 . 77 100 x 18 14 · Thus, 10% decrease in selling price has a greater effect on BEP. M/S and P/V Ratio than 10% increase in variable cost. Change in Sales Mixture Where sales revenue is a composite figure consisting of sales of several types of products having different individual P/V ratios, the overall P/V ratio will change with changes in the sales mixture. In such a case, even if budgeted sales volume is met, the actual profit will be lower than that budgeted if the proportion of low-margin products sold exceeds that anticipated. Thus, change in sales mixture will also change the BEP and hence the M/S. 100 Illustration 5.15 Assuming the budgeted sales of Rs. 6,000 represent sales of four products—A, B, C and D— which are expected to be sold in the mixture below, profit of Rs. 630, a break-even point of Rs. 4,200, a margin of safety of Rs. 1,800 (or 30%) and a P/V ratio of 35% will result as follows; A B C D Total Rs. Rs. Rs. Rs. Rs. Sales 2,000 2,500 1,000 500 6,000 Marginal Cost 1,200 1,700 800 200 3,900 Contribution 800 800 200 300 2,100 Fixed Costs 1,470 Profit 630 P/V Ratio {%) 40 32 20 60 35 % of total sales 33 100 If, however, sales should shift towards a larger proportion of the products carrying lower P/V ratios, the result would be as follows: A B C D Total % of sales changed to 25% 36 1% 33-% 5% 100% 3 3 Rs. Rs. Rs. Rs. Rs. Sales 1,500 2,200 2,000 300 6,000 Marginal Cost 900 1,496 1,600 120 4,116 Contribution 600 704 400 180 1,884 Fixed Costs 1,470 Profit 414 P/V Ratio (%) 40 32 20 60 31.4 Budgeted Actual Variance (unfav.) Contribution Rs. 2,100 1,884 216 P/V Ratio 35.0% 31.4% 3.6% Two other important areas of cost-volume-profit analysis are to find out: (i) volume necessary to achieve a desired profit, and (ii) effects of multiple changes upon sales. These are discussed in brief. Required Sales Volume to Achieve a Desired Profit Very often, management may fix up sales target for a period based on a desired amount of profit. In such a case, the desired sales volume would be determined as follows: Fixed costs + Desired profit (before tax) Unit contribution 101 Illustration 5.16 Unit selling price Rs. 10 Marginal costs per unit Rs. 6 Total fixed cost p.a. Rs. 10,000 Capacity 8,000 units p.a. What would be volume of sales for a desired profit (before tax) of Rs. 6,000 p.a.? Required sales = . a . p units 4000 unit per 4 . Rs 6000 . Rs 10000 . Rs · + When desired profit is taken after tax, the above formula has to be modified as follows: on contributi Unit rate tax 1 tax after profit Desired + costs Fixed − Illustration 5.17 Assuming 40% tax rate in Illustration 14.18, the required sales volume would be computed thus: It may be mentioned that to find out sales value needed to achieve a profit (before or after tax), the above formulae should be adjusted to divide by the P/V ratio instead of unit contribution. Effects of Multiple Changes The management of a firm may sometimes be confronted with multiple changes in its environment. It may be by way of reduction in unit selling price to take advantage of increased sales volume, some changes in production methods which may again reduce unit variable cost but increase fixed cost substantially, and so on. Even in such cases, the required sales to earn a desired amount of after-tax profit may be computed by bringing all these changes together simultaneously by the formula: Required sales volume (in value) = unit per ice Pr Selling unit per t cos Variable I rate tax 1 tax after profit Desired ts cos Fixed − − + But when desired profit is given as a percentage of total sales which are required to be determined, we have to form an equation based on the basic principles of marginal costing and solve it to arrive at the results. Illustration 5.18 Unit selling price Rs. 20 Unit variable cost Fixed cost p. a. Rs. 33.750 Corporate tax rate 40% Required; (a) What will be sales to earn a 15% return on sales before tax? (b) What will be sales to earn a 15% return on sales after tax? (a) Sales = Variable expenses + Fixed expenses + Target profit Let desired sales = X 102 Statement of Profit Sales Rs. 96,429 Less: Variable Costs (40%) 38,572 Contribution 57,857 Less: Fixed cost 33,750 Profit before tax 24,107 Less: Tax (40%) 9,643 Profit after tax (15% of sales) 14,464 USE OF PROBABILITIES Under conditions of risk and uncertainty, probabilities may be used to estimate the likelihood that a 'critical' outcome might or might not happen. One of the obvious examples of this is to estimate the probability that an organization will at least break-even with its sales. ADVANTAGES AND DISADVANTAGES OF MARGINAL COSTING The possible advantages of marginal costing, as compared to that of absorption costing, are stated below. 1. Greater control over costs is possible. This is so because fixed costs are excluded from product costs and management can concentrate on marginal cost which is a constant ratio. 2. It is an aid to management in taking many valuable decisions. Under marginal costing, data are presented in a manner revealing marginal costs and contribution that it facilitates making policy decisions in many problems, such as: (i) introduction of a product; (ii) quoting selling prices and tendering for contracts in times of competition; (iii) whether to make or buy; (iv) reduction of prices in times of competition or depression; (v) selecting the most profitable product or sales-mix; (vi) alternative methods to be employed in manufacturing; (vii) limiting factors; (viii) utilization of spare capacity; (ix) profit planning—break-even charts, profit-volume graphs may be used in profit planning; (x) assessment of capital projects to be undertaken; and (xi) selection of the most profitable level of activity, etc. 3. For all practical purposes, marginal costs will be the product costs and hence there will be no vitiation of costs due to change in level of performance as marginal costs will tend to be a constant ratio. Under absorption costing, unit cost will vary depending upon the level of activity and this may lead to confusion. 4. Closing stocks of finished goods and work-in-progress are valued at marginal costs. Apart from simplicity in the valuation of stocks, this will lead to greater accuracy in arriving at profits. 5. The marginal cost statements are understood by management more easily than those produced under absorption costing. For instance, the foremen will be more interested in those costs which are variable and which can be controlled by their actions. It is, therefore, very simple to understand and can be combined with Standard Costing. 103 6. Since fixed costs are excluded, it eliminates the strenuous task of allocating, apportioning and absorbing overheads. As a result, there will be no under- or over-recovery of fixed overheads. The oft-mentioned disadvantages are: 1. It is difficult to analyze overheads into fixed and variable elements because many expenses considered to be variable or fixed may not be exactly the same at various levels of activity. Moreover, in marginal costing, there is no place of semi-variable or semi-fixed overheads which are to be segregated into fixed and variable elements. The segregation of semi-variable costs is also a difficult task. 2. There is the danger of taking policy decisions on the basis of information presented under marginal costing technique. For example, in the long run, selling price should not be fixed simply by looking at contribution as it may result in losses or low profits. The other important factors such as fixed costs, capital employed, etc., should also be taken into consideration in fixing selling prices. 3. There is also the danger of valuing finished stocks, work-in-progress, transfer from one process to another, etc. at marginal costs only. The arguments against valuing stocks at marginal costs may be summarized as follows: (a) In case of loss by fire, full loss cannot be recovered from the insurance company. (b) Profits will be lower than that shown under absorption costing and hence may be objected to by the tax authorities. (c) For Balance Sheet purpose, closing stocks are to be valued at lower of market price and cost. Marginal costs may not be acceptable to the auditor as true costs for this purpose. (d) Circulating assets will be understated in the Balance Sheet and thus the Balance Sheet will not exhibit a 'true and fair view' of the state of affairs. 4. Cost control can also be achieved with the help of other techniques such as Standard Costing and Budgetary Control. In Standard Costing, volume variance will show the effect of change in output on fixed costs and hence there will be no vitiation of costs. Problems and Solutions Problem 1 (Marginal vs Absorption Costing) The following data have been extracted from the budgets and standard costs of Hewitson Ltd, a company which manufactures and sells a single product. Selling price £ per unit 45.00 Direct materials cost 10.00 Direct wages cost 4.00 Variable overheads cost 2.50 Fixed production overhead costs are budgeted at £ 400,000 per annum. Normal production levels are thought to be 320,000 units per annum. Budgeted selling and distribution costs are as follows: Variables £ 1.50 per unit sold Fixed £ 80,000 per annum Budgeted administration costs are £ 120,000 per annum. 104 The following pattern of sales and production is expected during the first six months of 2005: January—March April— June Sales (units) 60,000 90,000 Production (units) 70,000 100,000 There is to be no stock on 1 January, 2005. You are required to: (a) prepare profit statements for each of the two quarters, in a columnar format, using (i) marginal costing; and (ii) absorption costing. (b) reconcile the profits for the quarter January-March 2005 in your answer to (a) above. (c) write up the fixed production overhead control account for the quarter to 31 March, 2005, using absorption costing principles. Assume that the fixed production overhead costs incurred amounted to £ 102,400 and the actual production was 74,000 units. Solution (a) (i) Marginal Costing Profit Statement q/e 31 March, 2005 q/e 30 June, 2005 £'000 £'000 £'000 £'000 Sales (@ £ 45) 2,700 4,050 Less: Variable cost of sales Opening stock _ 165 Production costs (@ 10 + 4 + 2.5 = 16.5) 1155 1,650 1,815 Less: Closing stock (@ 16.5) 165 330 990 1,485 Variable selling and distribution costs 90 1,080 135 1,620 Contribution 1,620 2,430 MA Less: Fixed costs X (400 +80+120) \12 ) Profit 150 150 1470 2280 (ii) Absorption Costing Profit Statement q/e 31 March, 2005 q/e 30 June, 2005 £'000 £'000 £'000 £'000 Sales (@ £ 45) 2,700 4,050 Less: Cost of sales Opening stock — 177.5 Production costs [@ £ 17-75 (Wl)] 1,242.5 1,775 1,952.5 Less: Closing stock (@ 17.75) 177.5 1,065 355 1,597.5 Gross Profit 1,635 2,452.5 Less: Under-recovery of 105 overheads (W2) 12.5 — Add: Over-recovery of overheads (W3) — 25 1,622.5 2,477.5 Less: Selling and distribution cost Variable 90 135 Fixed |ix80| 20 20 U Administration costs P-X120) U 30140 30 185 Profit for the quarter 1,482.5 2,292.5 Workings: (Wl) £ Total absorption cost per unit = Direct materials 10.00 + Direct wages 4.00 + Variable overheads (£400,000 [320,000 units 2.50 + Fixed overheads 1.25 17.75 (W2) Normal quarterly production level = - x 320,000 = 80,000 units 4 Actual first quarter production = 70,000 units .-. Under-recovered fixed production overheads - 10,000 x £ 1.25 = £ 12,500 (W3) Actual second quarter production = 100,000 units Over-recovered fixed production overheads = 20,000 x £ 1.25 = £ 25,000 (b) Reconciliation of Profits Reported for the Quarter Ended 31 March, 2005 £'000 Profit as per marginal costing 1,470 Add: Fixed production overheads c/f in closing stock (written-off in marginal costing, deferred in absorption costing) 10,000 units x £ 1.25/unit 12.5 Profit as per absorption costing 1,482.5 (c) Fixed Production Overhead Control Account £'000 £'000 Actual overheads incurred 102.4 Fixed overheads to work-in-progress 92.5 (74,000 x 1.25) - Variance to Profit and Loss A/c 9.9 102.4 102.4 Problem 2 (Overall Break-even Point and Productwise break-up) Raj Ltd manufactures three products—X, Y and Z. The unit selling prices of these products are Rs. 100, Rs. 160 and Rs. 75 respectively. The corresponding unit variable costs are Rs. 50, Rs. 80 and Rs. 30. The proportions (quantitywise) in which these products are manufactured and sold are 20%, 30% and 50% respectively. The total fixed costs are Rs. 14,80,000. 106 Calculate overall break-even quantity and the productwise break-up of such quantity. Solution Let Q be the overall break-even point of Raj Ltd. Then the productwise break-up of overall break-even point in units would be: X = 0.200; Y = 0.30Q and Z = 0.50Q. From productwise unit contribution and total contribution at break-even point (= fixed cost), we can find productwise break-up of overall break-even quantity as follows: X Y Z Rs. Rs. Rs. Unit selling price 100 160 75 Less: Unit variable cost 50 80 30 Unit contribution 50 80 45 Contribution at break-even point 10 Q 24Q 22.5Q (Rs. 50 x 0.202) (Rs. 80 x 0.300 (Rs. 45 x 0.500 At BEP : Contribution = Fixed Cost Hence, 100 + 24Q + 22.50 = Rs. 14,80,000 Rs. 14,80,000 or, Q = 26195units (overall break-even point) Productwise break-up of break-even quantity: Product X : 26,195 X 0,20 = 5,239 units Y : 26,195 x 0.30 = 7,859 units Z : 26,195 x 0.50 = 13,097 units Problem 3 (P/V Ratio, BEP and M/S) The following details are obtained from XYZ Co. Ltd for a calendar year: Present production and sales: 8.000 units Selling price per unit Rs. 20.00 Variable cost per unit: Direct materials Rs. 5.00 Direct labour Rs. 2.50 Variable overheads 100% of direct labour cost Fixed cost (total) Rs. 40,000 (a) Calculate P/V ratio, break-even point and margin of safety from the above data. (b) Find the effect on P/V ratio, break-even point and margin of safety of changes in each of the following: (i) 10% increase in selling price; (ii) 10% increase in variable cost; (iii) 10% decrease in. fixed cost; and (iv) 10% decrease in sales volume. 107 Solution Particulars (a) (b) (0 (ii) (iii) (iv) P/V Ratio (Contribution Sales) 10 1 20 2 or 50% 12 6 22 == 11 or 54.55% — or 45% 20 No effect on P/V ratio No effect on P/V ratio Break-even Sales (Fixed Cost P/V Ratio) Rs. 40,000 Rs. 80,000 Rs. 40,000 X 6 Rs. 73,333 Rs. 40,000 20 _ Rs. 88,888 Rs. 36,000 x = Rs. 72,000 No effect on BEP Margin of Safety (Total Sales - BE Sales) Rs. 1,60,000 - 80,000 = Rs. 80,000 or 50% Rs. 1,76,000 - 73,333 = Rs. 1,02,667 or 58.33% Rs. 1,60,000 - 88,888 = Rs. 71,112 or 44.44% Rs. 1,60,000 - 72,000 = Rs. 88,000 or 55% Rs. (7,200 x 20) - 80,000 = Rs, 64,000 or 44.44% Problem 4 (Target Sales with a given C/S Ratio) Total Surveys Limited conducts market research surveys for a variety of clients. Extracts from its records are as follows: 2004 2005 Total costs £ 6 million £ 6.615 million Activity in 2005 was 20% greater than in 2004 and there was general cost inflation of 5%. Activity in 2006 is expected to be 25% greater than in 2005 and general cost inflation is expected to be 4%. Requirements: (a) Derive the expected variable and fixed costs for 2006. (b) Calculate the target sales required for 2006 if Total Surveys Limited wishes to achieve a contribution to sales ratio of 80%. Solution (a) Before using the 'high and low' method on the data given to estimate the variable element due to change in activity level, the data must be adjusted onto a comparable inflation basis. Thus, the 2004 cost will initially be inflated by 5% to convert it to '2005 £s': £6 million x 1.05 = £ 6.3 million Change in total (adjusted) cost from 2004 to 2005 = £(6.615 - 6.3)m = £ 315,000 This is attributable to a 20% increase in activity, i.e., the variable cost for 100% activity (2004 level) = £ 315,000/0.2 = £ 1.575 million (in 2005 £s), giving a variable cost for 2005 = £ 1.575 m x 1.2 = £ 1.89 million. Thus, the variable cost for 2006, taking account of a further 25% increase in activity and 4% inflation, would.be: = 1.89 m x 1.25 x 1.04 = £ 2.457 million. Fixed cost for 2005 = Total cost - Variable cost = £(6.615 - £ 1.89) m = £ 4.725 million. Thus, the fixed cost for 2006, taking account of further 4% inflation, would be: = £ 4.725 m x 1.04 = £ 4.914 million. 108 Problem 5 (P/V Ratio, BEP and Target Profit and Sales) The following data are obtained from the records of a company: First year Second year Rs. Rs. Sales 80,000 90.000 Profit 10,000 14,000 Calculate: (a) P/V ratio; (b) break-even point; (c) profit or loss when sales amount to Rs. 50,000; and (d) sales required to earn a profit of Rs. 19,000. Solution Sales Profit Rs. Rs. (a) Second year 90,000 14,000 First year 80,000 10,000 Change 10,000 4,000 Assuming that the change in fixed cost is nil, the marginal cost equation can be used as follows: S-V =F + P 10,000 - V = 0 + 4,000 V = 6,000 C = F + P or, F = C - P Thus, F = 40% of Rs. 80,000 - 10,000 = Rs. 32,000 - 10,000 = Rs. 22,000 Alternatively, F = 40% of Rs. 90,000 - 14,000 = Rs. 36,000 - 14,000 = Rs. 22,000 109 (c) Sales Rs. 50,000 P/V ratio 40% Contribution = 40% of 50,000 = Rs. 20,000 We know: C =F + P Rs. 20,000 = 22,000 + P or, P = (-) Rs. 2,000. When sales are Rs. 50,000, loss would be Rs. 2,000. (d) To earn a profit of Rs. 19,000, required contribution: Rs. 22,000 + 19,000 = Rs. 41,000 [ v C = F + P] 102500 . Rs % 40 41000 . Rs ratio V / P on contributi quired Re sales quired Re · · · ∴ Problem 6 (BEP of Pair of Plants) Find the cost break-even points between each pair of plants whose cost functions are: Plant A = Rs. 6,00,000 + Rs. 12X Plant B = Rs. 9,00,000 + Rs. I0X Plant C = Rs. 15,00,000 + Rs. 8X (where X is the number of units produced) Solution It is assumed that the selling price per unit is the same between each pair of plants. Then, cost break-even points between each pair of plant are as follows: Plants A and B: Rs. 6,00,000 + Rs. 12X= Rs. 9,00,000 + Rs. I0X 12X - 10*= 9,00,000 - 6,00,000 X= 1,50,000 units Plant A is better for the output below 1,50,000 units since its fixed cost is lower than that of Plant B. Plants B and C: Rs. 9,00,000 + Rs. 10X= Rs. 15,00,000 + Rs. 8X X = 3,00,000 units Plant B is better for the output below 3,00,000 units. Plants A and C: Rs. 6,00,000 + Rs. 12X= Rs. 15,00,000 + Rs. 8X 12X - 8X= 15,00,000 - 6,00,000 X = 2,25,000 units 110 Plant A is better for the output below 2,25,000 units and Plant C is better beyond 2,25,000 units. Reconciliation —Plants A and B: Selling Price Rs. 16 per unit (Wl) Particulars A B Per unit Amount Per unit Amount (Rs.) (Rs. lakhs) (Rs.) (Rs. lakhs) Sales 1,50,000 units 16.00 24.00 16.00 24.00 Variable cost 12.00 18.00 10.00 15.00 Contribution 4.00 6.00 6.00 9.00 Fixed cost 6.00 9.00 Profit Nil Nil Selling Price Rs. 13 per unit (W2) Particulars B C Per unit (Rs.) Amount (Rs./lakhs) Per unit (Rs.) Amount (Rs./lakhs) Sales 3,00,000 units 13.00 39.00 13.00 39.00 Variable cost 10.00 30.00 8.00 24.00 Contribution 3.00 9.00 5.00 15.00 Fixed cost 9.00 15.00 Profit Nil Nil Workings: 1. At BEP, Total costs = Total sales. ∴ Sales for 1,50,000 units = Rs. 6,00,000 + Rs, 12 x 1,50,000 = Rs. 24,00,000. Selling Price per unit = Rs. 24,00,000 -f 1,50,000 = Rs. 16. 2. Similarly, Selling Price per unit = 300000 300000 x 10 900000 . Rs + = Rs.13. Problem 7 (Profitability of Alternative Machines) A company has the option of buying one machine. Two machines are available, Machine E and Machine F. From the information given below, calculate (a) the break-even point for each; (b) the level of sales at which both are equally profitable, and (c) the range of sales at which one is more profitable than the other: Machine E Machine F Output p.a. (units) 10,000 10,000 Fixed costs p.a. (Rs.) 30,000 16,000 Profit at full capacity (Rs.) 30,000 24,000 Both the machines will produce identical products. The annual market demand for such product is 10,000 units @ Rs. 10 per unit. Solution Machine E Machine F Sales (10,000 @ Rs. 10) Rs. 1,00,000 Rs. 1,00,000 Contribution Rs. 60,000 Rs. 40,000 (C = F + P) P/V ratio 60% 40% 111 (a) Break-even sales Rs. 50,000 Rs. 40,000 or, 5,000 or, 4,000 units units Contribution per unit Rs. 6 Rs. 4 Variable cost per unit Rs. 4 Rs. 6 (b) Unit selling price of the products produced by either of the machines being the same, both machines will be equally profitable at that level of activity where total cost (fixed plus variable) of production produced by each machine exactly equals. Let X be the number of units where both the machines are equally profitable. .'. In case of Machine E, total costs would be; 4X + 30,000 While in case of Machine F, it would be: 6X + 16,000 Since at this level of output, total cost of production by each machine will be the same, 4X + 30,000 = 6X + 16,000 X = 7,000 units. Thus, at 7,000 units, both the machines will be equally profitable. (c) The break-even point of Machine F is 4,000 units while it is 5,000 for Machine E. At 7,000 units, both the machines are equally profitable. Thus, Machine F is more profitable at an output range of 4,000 to 6,999. The P/V ratio of Machine E is greater than that of F. Therefore, above 7,000 units, the rate of profit-earning by E would be greater than that of F. Thus, E would be more profitable at an output range of 7,001 to 10,000 units. SECTION II Marginal Costing and Management Decisions APPLICATION OF MARGINAL COSTING The concepts of marginal costing have been discussed in the previous section. How the various concepts may be applied to serve the day-to-day needs of management in taking many strategic decisions will be illustrated in this section. The following are some of such important areas. Diversification of Products Sometimes, a product may be proposed to be introduced to the existing product or products to utilize idle facilities, to capture a new market, or for any other purpose. A decision has, therefore, to be taken as to the profitability of the new product. The new product may be manufactured if it is capable of contributing something towards fixed costs and profit after meeting its variable costs of sales. Fixed costs are not taken into consideration on the assumption that these costs will not change or, in other words, the product can be manufactured by the existing resources, manpower, etc. But for taking decision in this matter, if the cost data are presented under total cost method, it may appear that the new product is not at all profitable; instead, the old product may appear to be more profitable owing to arbitrary apportionment of fixed costs. Illustration 5.19 The following data are available in respect of Product X produced by ABC Co. Ltd. 112 Rs. Sales 50,000 Direct Materials 20,000 Direct Labour 10,000 Variable Overheads 5,000 Fixed Overheads 10,000 The company now proposes to introduce a new Product Z so that sales may be increased by Rs. 10,000, There will be no increase in fixed costs and the estimated variable costs of Product Z are: Materials Rs. 4,800; Labour Rs. 2,200; and Overheads Rs. 1,400. Advise whether Product Z will be profitable or not Under absorption costing method Product X (i) Existing position Rs. Direct materials 20,000 Direct labour 10,000 Variable overheads 5,000 Fixed overheads Tolal cost 10,000 45,000 Sales Profit 50,000 5,000 (11) Proposed position Product X Product Z Total Rs. Rs. Rs. Direct materials 20,000 4,800 24,800 Direct labour 10,000 2,200 12,200 Variable overheads 5,000 1,400 6,400 Fixed overheads (apportioned on the basis of sales value) 8,333 1,667 10,000 Total cost 43,333 10,067 53,400 Sales 50,000 10,000 60,000 Profil/(-) Loss 6,667 (-)67 6,600 The above statement will show that Product X has now become more profitable (its cost having been reduced from Rs. 45,000 to Rs. 43,333) and that the entire profit is earned by Product X while Product Z will incur a loss of Rs. 67. But if the data are presented under marginal costing technique as follows, the position will be quite different. Product X Rs. Product Z Rs. Total Rs. Direct materials 20,000 4,800 24,800 Direct labour 10,000 2,200 12,200 Prime cost 30,000 7,000 37,000 Variable overheads Marginal cost 5,000 1,400 6,400 35,000 8,400 43,400 Sales 50,000 10,000 60,000 Contribution 15,000 1,600 16,600 Fixed overheads 10,000 Profit 6,600 Thus, it is clear that with the introduction of Product Z there will be no change in the profitability of Product X and that Product Z is also yielding a contribution of Rs. 1,600 towards fixed costs and profit. Therefore, Product Z may be introduced assuming that the capacity that will be utilized for Product Z cannot otherwise be more profitably utilized. Where, however, introduction of a product is associated with 'specific' or 'identifiable fixed costs', such costs 113 should be deducted from contribution of the proposed product for the purpose of taking decisions. Thus, in such a case, fixed costs will be divided into two groups: specific, i.e., which will have bearing on the decision, and general, i.e., which is expected to remain constant and hence has nothing to do with the proposed decision (see Closing down or suspending activities post). Fixation of Setting Prices It is one of the principal functions of modern business management. Product-pricing is necessary: 1. under normal circumstances; 2. in times of competition and/or trade depression; 3. in accepting additional orders for utilizing spare capacity; and 4. in exporting, etc. In majority of the cases, marginal costing will be of great help to the price-fixer. However, price under normal circumstances for a long period should be preferably based upon total costs. Of course, it can also be based upon marginal costs if a 'high margin' is added to marginal cost to contribute towards fixed costs and profits. When marginal costing technique is used for pricing, the principle that should govern is that price should be equal to marginal costs plus a certain amount; the amount to be added will vary depending upon demand and supply, competition, nature and variety of products, policy of pricing, and other related factors. If the price is equal to marginal costs, the amount of loss will be equivalent to total fixed costs. The figure for loss will be the same, or even lower, if production is discontinued. Therefore, even for a short period, selling price should be ordinarily higher than marginal cost. But pricing at or below marginal costs may be considered desirable for a shorter period in certain special circumstances, such as: 1. When a new product is introduced in market or to popularize it; 2. When foreign market is to be explored—against foreign exchange earned, government sometimes allow import quotas from which profits may be made far in excess of loss on export; 3. When a weaker competitor is to be driven out of the market; 4. When it is feared that future markets will go out of hand; 5. When employees cannot or should not be retrenched and production is to be maintained; 6. When the plant should be kept ready for "full production" ahead; 7. When the sale of one product will push up the sales of other conjoined profitable products; 8. When the goods are of perishable nature, (a) Pricing in depression Illustration 5.20 C Ltd has been working well below normal capacity due to recession. The directors of C Ltd have been approached by a company with an enquiry for a special purpose job. The costing department estimated the following in respect of the job: Direct materials Rs. 10,000 Direct labour 500 hours @ Rs. 2 per hour Overhead costs: Normal recovery rates: Variable Re. 0.50 per hour Fixed Re. 1/- per hour The directors ask you to advise them on the minimum price to be charged, Assume that there are no production difficulties regarding the job. Under absorption Job No. costing Rs. Under marginal costing Job No ....... Rs. Direct materials 10,000 Direct materials 10,000 Direct labour — 500 hours Direct labour — 500 hours @ Rs. 2 1,000 @ Rs. 2 1,000 Overheads @ Rs. 1.50 Variable Overheads @ Re. 0.50 per hour Total cost 750 per hour Marginal cost 250 11,750 11,250 Here the absolute minimum price is Rs. 11,250, i.e., total of marginal costs. As this will not make any 114 contribution, a proportion of fixed costs of Rs. 500 may be added to make the job worthwhile. The amount to be added will depend upon the circumstances of the case. (b) Accepting additional orders, exporting, exploring additional markets, etc.: When additional orders are quoted below normal price, it should be ensured that they will not affect the normal market or the goodwill of the company or the relationship with its customers. So far as foreign markets are concerned, the effect of direct and indirect benefits 8 , such as prestige of exporting, import entitlements, subsidies or any other special favours from government, should not be lost sight of in fixing the price. It may also be assumed that the capacity proposed to be utilized for the purpose cannot be otherwise more profitably utilized. Illustration: A factory produces 1,000 articles for home consumption at the following costs: Rs. Rs. Materials 40,000 Wages 36,000 Factory Overheads Fixed 12,000 Variable 20,000 32,000 Administration Overheads (Fixed) 18,000 Selling and Distribution Overheads: Fixed 10,000 Variable 16,000 26,000 Total 1,52,000 The home market can consume only 1,000 articles at a selling price of Rs. 155 per article: it can consume no more articles. The foreign market for this product can however consume additional 4,000 articles if the price is reduced to Rs. 125. Is the foreign market worth trying? Per Article 4,000 Articles Rs. Rs. Materials 40 1,60,000 Wages 36 1,44,000 Prime cost 76 3,04,000 Variable Overheads: Factory 20 80,000 Selling and Distribution 16 64,000 Marginal cost of sales 112 4,48,000 Sales 125 5,00,000 Contribution 13 52,000 The foreign market will yield an additional contribution of Rs. 52,000 (@ Rs. 13 for 4,000 units), Since the factory is operating above the break-even point, an increase in contribution will lead to similar increase in profit. Hence, the export order is worth trying. Note: It is assumed that the additional 4,000 articles can be produced without any rise in fixed costs and that the articles will not be re-exported to home market. It is also assumed that the capacity which is utilized for producing 4,000 additional articles cannot be otherwise more profitably utilized. Selection of Profitable Product-mix Suitable product-mix will denote the ratios in which various products are produced and/or sold. The technique of marginal costing may be applied in the determination of most profitable product or sales-mix. In the absence of any limiting factor, contribution under each mix will be considered and the mix that will give the highest contribution will be the most profitable one. So long as fixed costs remain constant, the most profitable sales- mix is deterrninable on the basis of contribution only. But when changes in product-mix are associated with changes in fixed costs, relative profitability of mixes will have to be assessed on the basis of 'net profit' and not on 'contribution basis'. Of course, the management should study various effects and problems arising out of a change in the mix. Some of them are: 1. Effect on raw materials necessitating an adjustment in the purchase programme; 115 2. Expected change in the labour composition or labour training programme; 3. Change in the machine load; 4. Requirements of additional space for production, storage, etc.; and 5. Change in the sales programming. In short, the effect on all physical and financial programmes due to change in product-mix should be considered. Illustration 5.21 The directors of a company are considering sales budget for the next budget period. From the following information, you are required to show clearly to management: (i) the marginal product cost and the contribution per unit; and (ii) the total contributions resulting from each of following sales mixtures. Product A Rs. Product B Rs. Direct materials 10 9 Direct wages 3 2 Fixed expenses (total) Rs. 800 (Variable expenses are allotted to products as 100% of direct wages) Selling price 20 15 Sales mixture (a) 100 units of Product A and 200 of Product B; (b) 150 units of Product A and 150 of Product B; (c) 200 units of Product A and 100 of Product B, Recommend which of the sales-mixtures should be adopted. Product A Product B Rs. Rs. (0 Direct materials 10 9 Direct wages 3 2 Variable expenses 3 2 Marginal cost 16 13 Selling price 20 15 (iii) Since the P/V ratio of Product A is higher than that of B, Product A is more profitable and therefore the mixture that takes into account the maximum number of Product A would be the most profitable one. This is evident from the following statement: (iv) Products Contribution per unit Rs. Sales Mixtures Units (a)Contributi on Rs. Units (b) Contribution Rs. Units (c) Contribution Rs. A 4 100 400 150 600 200 800 B Total 2 200 400 150 300 100 200 300 800 300 900 300 1,000 Sales Mix (c) will yield highest contribution. Therefore, it should be adopted. The problem of product or sales-mix is generally linked up with the problem of limiting factor. For principles 116 underlying the selection of sales-mix of this nature, refer to the discussion under next heading. Problems of Limiting Factor Limiting factor is a factor that limits production and/or sales. This is also known as the key factor. It may represent shortage of materials, labour, plant capacity or sales demand. (For an illustrative list of limiting factors, see Principal Budget Factor, pp. 659-660). In such a case, a decision has to be taken on whether to make one product or another instead. Ordinarily, when there is no limiting factor, product selection will be on the basis of P/V ratio, i.e., one having the highest P/V ratio will be selected. But when resources are scarce, selection of profitable product will be on the basis of contribution per unit of limiting factor. This is applicable when there is one limiting factor. In short, the higher the contribution per unit of limiting factor, the more profitable is the product or product line and vice versa. When an optimum safes-mix has to be determined in the context of limiting factor, the product preference, for the purpose of such sales-mix, should be strictly according to relative profitability of products based on contribution in relation to the limiting factor. Illustration 5.22 (a) The following particulars are extracted from the records of a company; Per unit Product A Product B Sales (Rs.) 100 120 Consumption of material (kg) 2 3 Material cost (Rs.) 10 15 Direct wages cost (Rs.) 15 10 Direct expenses (Rs.) 5 6 Machine hours used 3 2 Overhead expenses: Fixed (Rs.) 5 10 Variable (Rs.) 15 20 Direct wages per hour is Rs. 5. Comment on profitability of each product (both use the same raw material) when— (i) Total Sales potential in 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 factor. (b) Assuming Raw Material as the Key factor, availability of which is 10,000 kg, and maximum sales potential of each product being 3,500 units, find out the product mix which will yield the maximum profit, (a) Per unit Product A Product B Rs. Rs. Direct materials 10 15 Direct wages 15 10 Direct expenses 5 6 Prime cost 30 31 Variable overhead 15 20 Marginal cost 45 51 Sales 100 120 Contribution Rs. 55 Rs. 69 P/V ratio 0.55 0.575 Contribution per kg of materials Rs. 27.50 Rs. 23 Contribution per machine hoar Rs. 18.33 Rs. 34.50 Thus, profitability of each product will be determined on the basis of the principle: the higher the contribution per unit of limiting factor, the more profitable is the product. Accordingly, a statement of profitability under different 117 conditions may be prepared thus: Limiting factor Ranking of products Ranking based on (i) Sales volume BA Unit contribution (ii) Sales value BA P/V ratio (iii) Raw material AB Contribution per kg (iv) Production capacity (machine hours) BA Contribution per machine hour (c) Product preference will be in the same order as (a) (iii) subject to the condition that maximum demand for each of the two products is 3,500 units. In other words, 3,500 units of more profitable product will be produced first. The balance of available raw materials will then have to be utilized for the production of less profitable product. Thus, the optimum product-mix would be: (d) Total Product Units Raw Materials Raw Materials per unit required (kg) (kg) A 3,500 2 7,000 B 1,000* 3 3,000 10,000 1(10,000 - 7,000) -s- 3 = 1,000 units] In addition to one limiting factor from the production side, limitation may also come from the market in the form of demand. Here, ranking will be based on relative contribution per unit of limiting factor and product selection will be done in that order. But the number of units of a product to be selected in the mix will be restricted to the number as per demand for that product. Illustration 5.23 (a) A chemical company manufactures five different products from a single raw material. There is an abundant supply of raw material at a rate of Rs. 1.50 per kg. The labour rate is Rs. 2 per hour for all products. For a certain budget period, the plant has an effective capacity of 21,000 labour hours. Present equipment can produce all the products. The factory overhead rate also is Rs. 2 per hour (Rs. 1.40 fixed and Re. 0.60 variable). The selling commission is 10 per cent of the product price. With the following data as basis, you are required to suggest a suitable sales-mix which will maximize the company's profits. What will be the maximum profit? Market Selling Labour hours Raw material Product demand price required per required per (units) (Rs.) unit unit (in gm) A 4,000 8.00 1.0 700 B 3,600 7.50 0.8 500 C 4,500 12.00 1.5 1,500 D 6,000 9.00 1.1 1,300 E 5,000 11.00 1.4 1,500 (b) Suppose, in the above situation (a), overtime working up to a maximum of 3,500 hours is possible. Overtime will add Rs. 5,000 to fixed overheads, a doubling of labour rates and a 50% increase in variable overheads. Do you recommend overtime working? (a) For suggesting an optimum sales-mix, product profitability is to be determined first on the basis of contribution per hour which is the limiting factor. This is done in the following statement. 118 Direct Direct Variable Selling Marginal Selling Contribution Contribution Rank Product Material Labour Fy. O.H. Commissi on Cost of sales price per unit per hour Rs. Rs. Rs. Rs. Rs. Rs. Rs. Rs. A 1.05 2.00 0.60 0.80 4.45 8.00 3.55 3.55 2 B 0.75 1.60 0.48 0.75 3.58 7.50 3.92 4.90 1 C 2.25 3.00 0.90 1.20 7.35 12.00 4.65 3.10 3 D 1.95 2.20 0.66 0.90 5.71 9.00 3.29 2.90 4 E 2.25 2.80 0.84 1.10 6.99 11.00 4.01 2.86 5 Thus, under condition of limited plant capacity (labour hours), product preference would be in the following order: In determining the sales-mix based on above preference, another limiting factor, i.e., demand, has to be given due consideration. In other words, the product preference according to profitability analysis would be the same subject to the number of units equivalent to market demand. The optimum sales-mix, and the amount of profit thereof, accordingly, would be: Product Market Demand (units) Labour Hours reqd. Contribution per unit (Rs.) Total Contribution (Rs.) B 3,600 2,880 3.92 14,112 A 4,000 4,000 3.55 14,200 C 4,500 6,750 4.65 20,925 D 6,000 6,600 3.29 19,740 20,230 E 550* 770 4.01 2,206 21,000 71,183 Less: Factory Fixed Overheads (21,000 @ Rs. 1.40) 29,400 Total Profit Rs. 41,783 ('Market demand 5,000 units. Hours available 770, which can produce 770 •*• 1.40 - 550 units only. Therefore, for E the target should be 550 units.) (b) 3,500 additional hours can produce 2,500 units (i.e., 3,500 •*• 1.4) of E. The financial effect of the proposal is shown below: Rs. Sales (2,500 units @ Rs. 11) 27,500 Less: Marginal cost of sales: Cost per unit as per (a) Rs. 6.99 Add: Increase in labour rate (Rs. 2 x 1.4) 2.80 Increase in Overheads (Re. 0.30 x 1.40) 0.42 Rs. 10.21 x 2,500 25,525 Additional contribution Rs. 1,975 Less: Increase in fixed cost 5,000 Loss Rs. 3,025 Hence, the proposal should be rejected. If the number of resources in limited supply increases to more than just one in a particular decision situation, the ranking given by contribution per unit of one limiting factor may conflict with that given by the contribution per unit of another limiting factor and consequently the decision rule slated earlier in this context becomes ambiguous. The complexity increases with the increase in the number of limited resources. In such a case, the measurement of the effect on alternatives must cope with the complexities introduced by the interactions between scarcities. Mathematical techniques like Linear Programming are to be applied for handling such 119 problems. Alternative Methods of Manufacture Marginal costing techniques are often used in comparing the alternative methods of manufacture, i.e., whether one machine is to be employed instead of another; number of operators to work with a machine; machine work or hand work, etc. When fixed costs remain constant, the basis of selection will be the relative contribution available from each method. In short, the method of manufacture that will give the largest contribution is to be selected. Where, however, fixed costs change, the decision will be taken on the basis of relative amount of profit. In the process of selection, limiting factor, if any, should not be lost sight of. Where, however, time taken in production is stated, weight should be given to time factor. Illustration 5.24: Product A can be produced either by Machine X or by Machine Y. Machine X can produce 10 units of A per hour and Y, 20 units per hour. Total machine hours available are 3,000 hours per annum. Taking into account the following comparative costs and selling price, determine the profitable method of manufacture: Per unit of Product A Machine X Machine Y Rs. Rs. Direct materials 20 20 Direct labour 10 13 Overheads: Variable 12 14 Fixed 3 3 Total costs -45 50 Selling Price 60 60 Profitability Statement Machine X Machine Y Machine hours p.a. 3,000 3,000 Output per hour 10 units 20 units Per unit Rs. Rs. Direct materials 20 20 Direct labour 10 13 Variable overheads 12 14 Marginal costs 42 "47 Selling price 60 60 Contribution Ts 73 Contribution per hour Rs. 180 Rs. 260 Annual Contribution Rs. 5,40,000 7,80,000 Hence, production in Machine Y will be more profitable. Make or Buy; Insourcing or Outsourcing A company may have unused capacity which may be utilized for making component parts or similar items instead of buying them from market. Decisions about whether a firm will make or buy are also known as insourcing versus outsourcing decisions. Outsourcing is the process of purchasing goods and services from outside vendors/producers rather than producing the same goods or providing the same services within the organization, which is called insourcing. In taking such 'make or buy' decisions, the marginal cost of manufacturing the component part(s) should be compared with price quoted by outside vendors. If (he variable or marginal costs are lower than purchase price, it will be more profitable to manufacture the component parts in the factory. Fixed costs are excluded on the assumption that they having been already incurred, the manufacture involves only variable costs. Fixed costs are not relevant 9 here. If manufacture involves increase in fixed costs (avoidable), it is necessary to include them in product cost. Under such a situation, one may ascertain the minimum volume which would justify 'making' as compared to 'buying'. At this volume, both the alternatives are equally profitable. This volume is determined as follows: 120 [* Purchase price less Variable cost of production.] Nevertheless, in a 'make or buy 1 decision, the qualitative factors should also be taken into consideration. For example, quality, and dependability of suppliers are very important factors that need to be considered. Illustration 5.25 A manufacturing company traditionally purchases its component part No. A-104 for its final product. During any one year, the company will require 10,000 units that can be acquired for Rs. 30 per unit. The company currently has underutilized capacity that can be used 10 manufacture the component part. Total manufacturing costs of Rs. 32 per unit include Rs. 16 raw material, Rs. 6 direct labour, Rs. 3 variable overheads, Rs. 3 fixed overheads (avoidable) and Rs. 4 other fixed overheads (allocated on the basis of capacity utilized). (i) Should the company make or buy these parts? (ii) Determine the range of production at which one is more profitable than the other. (i) (a) Bought out price per unit or component part No. A-104 Rs.30 (b) Cost to make per unit of component part No. A- 104; Rs. Direct Material 16 Direct labour 6 Prime cost 22 Variable overheads 3 Marginal cost 25 Fixed overheads (avoidable) 3 Total relevant cost 28 The company should make component part No. A-104 as cost of manufacture per unit of A-104 is lower than its purchase price. Note: Fixed costs (allocated) are not relevant to the issue. Rs. (ii) (a) Bought-out price per unit 30 (b) Marginal cost per unit 25 Savings per unit (a - b) 5 On comparison of bought-out price and marginal cost of manufacture, it appears that making is, as if, more profitable than buying and in that case there will be a saving of Rs. 5 per unit. But making will involve an additional fixed overhead (avoidable) of Rs. 30,000, i.e., Rs 3 x 10,000. Therefore, inclusion of avoidable fixed cost will change the profitability, i.e., buying will be more profitable until additional fixed cost is recovered. But once the increase in fixed cost is recovered, making will be more profitable than buying. We now determine the volume at which both the alternatives are equally profitable: Hence, below this volume, buying will be more profitable and above it, making will be more profitable. In other words, from 1 to 5,999 units, buying will be more profitable and from 6,001 to 10,000 units, making will be more profitable. When it is necessary to increase the capacity of the firm 'to make', the increase in fixed costs may be significant and in such a case the minimum volume or the break-even point has to be determined as above and a decision may accordingly be taken. When the manufacturing resources of the firm are limited and it becomes necessary to buy out some products if market demands are to be met, the products to be manufactured must be selected on the basis of opportunity costs. Where there is only one resource in limited supply, the selection should be based upon the contribution made by each product per unit of limiting factor of output. The initial comparison made for each product should be between the purchase price and the corresponding marginal cost where fixed costs do not change. Where the purchase price exceeds the marginal cost and there is a limiting factor of production, those products earning 121 the highest rates of contribution per unit of limiting factor should be retained. Illustration 5.26 Four types of components are currently being produced using a company's own facilities. However, the company is working at full capacity and is considering buying one or more types of component from an outside supplier. The total fixed costs will remain unaffected for the company as a whole with the making in or buying out of the component. Relevant data per unit of component are given below: Components A B C D Time per unit: Labour hours 0.40 0.50 0.50 0.30 Machine hours 0.10 0.20 0.40 0.50 Cost per unit: Rs. Rs. Rs. Rs. Marginal costs 10 12 15 15 Fixed costs (allocated) 2 4 5 15 Total costs 12 16 20 B Bought-out price 9 17 22 24 Which component or components would you recommend to be bought out when: (i) labour time is the limiting factor; (ii) machine time is the limiting factor? A B C D Rs. Rs. Rs. Rs. Bought-out price 9 17 22 24 Marginal costs 10 12 15 15 Contribution per unit (-) 1 5 7 9 Contribution per: Labour hour (Rs.) (-) 2.5 10 14 30 Machine hour (Rs.) (-) 10.0 25 17.5 18 Fixed costs have not been given any consideration as they do not change for the firm as a whole with the making in or buying out of the components. Component which is showing negative unit contribution should be bought under all circumstances. Hence, A should be bought out. If a limitation on a resource still exists after removing A, selection of a further component or components for buying out should be made in order of lower contribution per unit of limiting factor. Thus, when labour time is the limiting factor, the order of selection of components for buying, if necessary, would be: B C D When machine hour is the limiting factor, the same order would be changed to: C D B Working Extra Shift If fixed costs remain constant, the decision will be taken on the basis of additional contribution expected from opening of extra shift work. When, however, fixed costs increase, the decision will be taken based on additional profit (additional contribution less increase in fixed cost). In other words, the decision should be taken on the basis of whether the costs of the shift are exceeded by the benefits to be obtained. Illustration 5.27 XYZ Co. Ltd currently operates a single production shift. The operating results of the company for the year just 122 ended show the following Sales (10,000 units) Direct materials Direct labour Variable overheads Contribution Fixed overheads Profit £ 1,20,000 1,00,000 20,000 £ 3,60,000 2,40,000 1,20,000 90,000 30,000 The company is planning for the activity of the next year. Sales demand exists for an extra 6,000 units (at the existing sales price) which could be made in a second shift. The labour costs in the second shift would be the same as in the first shift plus a second-shift premium. The second shift is paid at time-and-a-quarter. Additional fixed overheads of £ 10,000 would be incurred, but a bulk purchase discount of 5% would be obtained on all quantities of material bought. Should the second shift be opened up? Profitability of Extra Shift Work £ £ £ Additional sales (6,000 @ £ 36) 2,16,000 Less: Additional variable costs: Direct materials: Current cost 1,20,000 Total cost of materials with second shift: (16,000 x £ 12 x 0.95) 1,82,400 62,400 Direct labour: (£ 1,00,000 x ].25) 1,25,000 Less: Fixed portion of labour 1,00,000 25,000 Variable Overheads (6,000 X £ 2) 12,000 99,400 Additional contribution 1,16,600 Less: Additional fixed cost: Labour 1,00,000 Overheads 10,000 1,10,000 Additional profit £ 6,600 Hence, second shift should be worked. Level of Activity Planning The contribution technique may also be used in planning the level of activity. Illustration 5.28 A company hat, a capacity of producing 1,00,000 units of certain product in a month, The Sales Department 123 reports that the following schedule of sale prices is possible: Volume of Selling price Production (%) per unit (Re.) 60 0.90 70 0.90 80 0.75 90 0.67 100 0.61 The variable cost of manufacture between these levels is Re. 0.15 per unit and fixed cost, Rs. 40,000. At which volume of production will the profit be maximum? Capacity 60% 70% 80% 90% 100% Units 60,000 70,000 80,000 90,000 1,00,000 Rs. Rs. Rs. Rs. Rs. Sales 54,000 63,000 60,000 60,300 61,000 Variable cost Contribution 9,000 10,500 12,000 13,500 15,000 45,000 52,500 48,000 46,800 46,000 Contribution at 70% level or activity is maximum. Fixed cost being constant at all levels of production, profit is also maximum at this level. Effect of Change in Selling Price Another problem which is very frequently raised is the effect on profit of a change in sales price. When management consider expansion programme, a price reduction may be contemplated to attract a wider market. It is, therefore, necessary to ascertain the effect of such a proposal. Illustration 5.29 The directors of a company are considering the results of trading during the last year. The Profit and Loss Statement of the company appeared as follows: Rs. Rs. Sales 7,50,000 Direct materials 2,25,000 Direct wages 1,50,000 Variable overheads 60,000 Fixed overheads 2,20,000 6,55,000 Profit 95,000 The budgeted capacity of the company is Rs. 10,00,000, but the key factor is sales demand. The sales manager is proposing that in order to utilize existing capacity, the selling price of the only product manufactured by the company should be reduced by 5%. You are requested to prepare a forecast statement which should show the effect of the proposed reduction in selling price and to include any changes in costs expected during the coming year. The following additional information is given: Sales forecast: Rs. 9,50,000. Direct material prices are expected to increase by 2%. Direct wages rates are expected to increase by 5% per unit. Variable overhead costs are expected to increase by 5% per unit. Fixed overheads will increase by Rs. 10,000. Statement Showing the Effect of Change in Selling Price 124 Rs. Rs. Sales 9,50,000 Direct materials 3,06,000 Direct waees 2,10,000 - Variable overheads 84,000 6,00,000 Contribution 3,50,000 Fixed overheads 2,30,000 Profit 1,20,000 The above statement will show that although costs have increased and selling price has been reduced, the profit forecast for the coming year is still more than that achieved last year. This is because increased volume of sales at the reduced sales price has resulted in increased contribution more than sufficient to cover increase in costs—variable and fixed. Notes: (a) Sales (after 5% price reduction) Rs. 9,50,000 Add: Reduction in Selling Price , ` . | 950000 95 5 X 50,000 Sales before price reduction 10,00,000 Less: Sales last year 7,50,000 Increase in Sales Rs. 2.50.000 which is to be taken into account in adjusting increase in cost. Thus, (b) Direct Materials: Rs. Last year's figure 2,25,000 Add: 33-% due to increase in volume 75,000 3,00,000 Add: 2% increase in Price (c) Direct wages: Last year's figure 6,000 Rs. 3,06,000 1,50,000 Add: 33% 50,000 2,00,000 Add: 5% increase in rate (d) Variable overheads: 10,000 Rs, 2,10,000 Last year's figure 60,000 Add: 33% 20,000 80,000 Add: 5% increase in rate 4,000 Rs. 84,000 Alternative Courses of Action Very often, management may be confronted with the problem of taking decisions as to the effect of alternative courses of action. The problem of taking the appropriate decision in such a case can be tackled effectively if the cost data are presented under marginal costing technique. Illustration 5.30 The management of a concern, manufacturing two products, X and Y, have the following independent possibilities before them: (a) To produce and sell 16,000 additional units of Y but only if the production of X is reduced by 20,000 units. (b) To reduce the price of X by Re. 0.20 per unit. This will result in a 25% increase in the sale of X without any change in the activity of Y. (c) To produce and sell 55,000 units of X and 1,05,000 units of Y. Product X Product Y Total 125 Sales (in units) 50,000 1,00,000 Sales (value) Rs. 2,50,000 Rs. 8,50,000 Cost of sales Rs. 1,50,000 Rs. 6,00,000 Rs.3,50,000 Gross Margin Rs. 1,00,000 Rs. 2,50,000 Selling and distribution expenses Rs.60,000 Rs. 1,50,000 Net Margin Rs. 40,000 Rs. 1,00,000 Rs.1,40,000 Direct costs included in total costs amount to Rs. 1,20,000 for Product X and Rs. 3,40,000 for Product Y. Present the information to the management in a suitable form giving your recommendation. The alternative proposals to the management have been given in a suitable form on page 607 based on an analysis of unit direct costs and total fixed costs of Products X and Y as shown below. 126 Product X Product Y Total 50,000 Per 1,00,000 Per 1,50,000 Units Unit Units Unit Units Rs. Rs. Rs. Rs. Rs. Sales 2,50,000 5.00 8,50,000 8.50 11,00,000 Direct costs 1,20,000 2.40 3,40,000 3.40 4,60,000 Contribution 1,30,000 2.60 5,10,000 5.10 6,40,000 Fixed costs (Costs of sales + S. and D. costs - Direct costs) 90,000 4,10,000 5,00,000 Net Profit 40,000 1,00,000 1,40,000 Selection of Optimum Volume and Selling Price (Using Break-even Chart) Where the demand for a product is elastic, it may be contemplated to reduce the selling price more and more to attract a greater volume of sale and thereby earn a higher total contribution. When sales volume at varying selling prices is ascertainable, the problem arises as to the determination of the volume of sales and selling price at which profit will be maximum. A break-even chart may be of significant help in such a case. If the sales value and costs at different volume of sales are plotted on a graph paper, it is possible to determine the volume and selling price at which the margin of profit appears to be the greatest. In other words, the point at which the margin of profit is the greatest is the optimum volume and the selling price at this volume is the optimum selling price. Illustration 5.31 Given the information below, you are required to determine graphically at what volume of sales and selling price a company can maximize profits. Selling price per unit Sales forecast Rs. (units) 10.00 1,000 9.50 2,000 9.00 3,000 8.50 4,000 8.00 5,000 7.50 6,000 7.00 6,800 6.50 7,500 6.00 8,000 5.50 8,400 The variable unit cost is Rs. 2.50. The fixed costs of the company amount to Rs. 12,000 but to increase output beyond 3,000 units, additional capital expenditure would be necessary and fixed costs would therefore rise to Rs. 16.000. In order to plot the data on a graph paper, sales value and costs at the varying volume of sales are tabulated as follows: Units Sales value Variable costs Fixed costs Total costs Rs. Rs. Rs. Rs. 1,000 10,000 2,500 12,000 14,500 2,000 19,000 5,000 12,000 17,000 3,000 27,000 7,500 12,000 19,500 4,000 34,000 10,000 16,000 26,000 5,000 40,000 12,500 16,000 28,500 6,000 45,000 15,000 16,000 31,000 6,800 47,600 17,000 16,000 33,000 7,500 48,750 18,750 16,000 34,750 8,000 48,000 20,000 16,000 36,000 8,400 46,200 21,000 16,000 37,000 127 Figure 5.11 Break-even chart determining the optimum volume. Thus, the margin of profit, i.e., the margin by which the sales value curve is higher than the total cost curve, is seen to be the greatest at a sales volume of 6,800 units. Therefore, this is the optimum volume and profit will be maximized at this volume at the given selling price. Application of Prof It/Volume or C/S Ratio The Profit/Volume Ratio may be applied in a variety of problems, namely: 1. Determination of break-even point and margin of safety (see p. 547 and p. 551). 2. Determination of variable cost for any volume of sales (this is done by deducting P/V ratio from 100% and multiplying the sales by the resultant figure). Problem 1 (Product Mix) A manufacturer with an overall (interchangeable among the products) capacity of one lakh machine hours has been so far producing a standard mix of 15,000 units of Product A and 10,000 units of Products B and C each. On experience, the total expenditure exclusive of his fixed charges is found to be Rs. 2.09 lakhs and the cost ratio among the products approximates 1 : 1.5 : 1.75 respectively per unit. The fixed charges come to Rs. 2.00 per unit. When the unit selling prices are Rs. 6.25 for A, Rs. 7.50 for B and Rs. 10.50 for C, he incurs a loss. He desires to change the product mix as under: Mix 1 Mix 2 Mix 3 A 18,000 15,000 22,000 B 12,000 6,000 8,000 C 7,000 13,000 8,000 As a Cost Accountant what mix you recommend? Solution Product Units Variable cost Total Variable cost Variable cost ratio per unit (1) x (2) in total ratio per unit (4) •*- (1) Rs. Rs. (1) (2) (3) (4) (5) A 15,000 1.00 15,000 66,000 4.40 B 10,000 1.50 15,000 66,000 6.60 C 10,000 1.75 17,500 77,000 7.70 35,000 47,500 2,09,000 128 3. Determination of profit at a particular volume of sales (see p. 572), 4. Determination of sales volume for a desired amount of profit (see p. 565). 5. Fixing selling prices. 6. Selecting the most profitable line or lines of products when there is no limiting factor. 7. Determining the additional sales required to maintain the present profit level in the event of contemplated price reduction. 8. Determination of the sales-mix to maximize profit. Some of the applications have been shown in the previous chapter. In addition, the following two illustrations would explain how P/V ratio serves the day-to-day needs of the management. Illustration 5.32 A company proposes to introduce a product in the market. There is sufficient demand for the product. The sales manager estimates that it is possible to sell 5,000 units. It is the policy of the company to maintain 30% P/V ratio. Given the following costs, you are required to ascertain the selling price that the company should quote: Per unit Rs. Direct materials 100 Direct labour 30 Variable overheads 10 140 Selling price can be found out by dividing variable cost by variable cost ratio (i.e., 100% - P/V%). Thus, Therefore, to maintain a 30% P/V ratio, the selling price should be Rs. 200. Illustration 5.33 The directors of ABC Ltd propose to reduce the selling price of Product X by 10%. By doing so, they anticipate that sales volume may be increased and that present profit may be maintained. On the basis of the following information, advise management as to the proposal: Rs. Selling price 10 Variable cost 6 Fixed cost 20,000 Present production and sales 8,000 units. Present Profit = 40% of sales - fixed cost = 40% of Rs. 80,000 - Rs. 20,000 = Rs. 12,000 If selling price is reduced 'by 10%, the P/V ratio will come down to 33 — % To maintain the same profit, the required total safes will be: 129 Total Fixed Cost: 35,000 x Rs. 2 = Rs. 70,000 A B C Rs. Rs. Rs. Selling Price 6.25 7.50 10.50 Marginal or Variable cost Contribution 4.40 6.60 7.70 1.85 0.90 2.80 Unit Profitability Statement Mix 1 Mix 2 Mix 3 Product Contribution Units Contribution Units Contribution Units Contribution Rs. Rs. Rs. Rs. A 1.85 18,000 33,300 15,000 27,750 22,000 40,700 B 0.90 12,000 10,800 6,000 5,400 8,000 7,200 C 2.80 7,000 19,600 13,000 36,400 8,000 22,400 Total 37,000 63,700 34,000 69,550 38,000 70,300 Less: Fixed cost 70,000 70,000 70,000 Net Profit/(-) Loss (-) 6,300 (-) 450 300 Hence, Mix (3) is recommended. Problem 2 (Limiting Factor and Product-mix) A market gardener is planning his production for next season and he asked you, as a Cost Accountant, to recommend the optimal mix of vegetable production for the coming year. He has given you the following data relating to the current year: Potatoes Turnips Parsnips Carrots Area occupied (in acres) 25 20 30 25 Yield per acre (in tonnes) 10 8 9 12 £ £ f £ Selling price per tonne 100 125 150 135 Variable costs per acre: fertilizers 30 25 45 40 seeds 15 20 30 25 pesticides 25 15 20 25 direct wages 400 450 500 570 Fixed overheads per annum: £ 54,000 The land which is being used for the production of carrots and parsnips can be used for either crop, but not for potatoes or turnips. The land being used for potatoes and turnips can be used for either crop, but not for carrots or parsnips. In order to provide an adequate market service, the gardener must produce each year at least 40 tonnes each of potatoes and turnips and 36 tonnes each of parsnips and carrots. (a) You are required to present a statement to show: (i) the profit for the current year; and (ii) the profit for the production mix which you would recommend. (b) Assuming that the land could be cultivated in such a way that any of the above crops could be produced and there was no market commitment, you are required to: (i) advise the market gardener on which crop he should concentrate his production; (ii) calculate the profit if he were to do so; and (iii) calculate in sterling the break-even point of sales. Solution 130 (a) (i) Profit Statement for the Current Year Potatoes Turnips Parsnips Carrots Total Acres 25 20 30 25 100 £ £ £ £ £ Revenue (see workings) 25,000 20,000 40,500 40,500 126,000 Variable costs 11,750 10,200 17,850 16,500 56,300 Contribution 13,250 9,800 22,650 24,000 69,700 Fixed overheads 54,000 Profit 15,700 Workings; Potatoes Turnips Parsnips Carrots Variable cost per acre £ 470 £ 510 £ 595 £ 660 Tonnes per acre 10 8 9 12 Revenue per tonne £ 100 £ 125 £ 150 £ 135 Revenue per acre £ 1,000 £ 1,000 £ 1,350 £ 1,620 (a) (i) Profit Statement for Recommended Mix Area A (45 acres) Area B (55 acres) Potatoes Turnips Parsnips Carrots Contribution per acre £ 530 £ 490 £ 755 £ 960 Best area crops Potatoes - - Carrots Minimum tonnes J!9 40 36 36 Acres required ~5 ~4 3 Balance 36 ~ - 48 Recommended mix (acres) 0 5 4 51 Contribution £ 21,200 £ 2,450 £ 5,020 £ 48,960 Total £ 75,630 Fixed overheads £ 54,000 Profit from recommended mi? £ 21,630 (b) (i) Production should be concentrated on carrots which have the highest contribution per acre (£ 960) £ (ii) Contribution from 100 acres of carrots 96,000 Fixed overheads 54,000 Profit from carrots 42,000 (iii) Contribution to sales ratio of carrots = £24,000/£40,500 X 100 [(from (a)(i)] = 59.259% Break-even point in sterling = Fixed overheads/CS ratio - £54,000/59.259 x 100 = £91,126 Problem 3 (Limiting factor/make or buy) ABC Ltd makes three products, all of which use the same machine which is available for 50,000 hours per period. The standard costs of the products per unit are: Product A Product B Product C £ £ £ 131 Direct materials 70 40 80 Direct labour Machinists (£ 8 per hour) 48 32 56 Assemblers (£ 6 per hour) 36 40 42 Total variable cost 154 112 178 Selling price per unit 200 158 224 Maximum demand (units) 3,000 2,500 5,000 Fixed costs are £ 300,000 per period. ABC Ltd could buy in similar quality products at the following unit prices: A £ 175 B £ 140 C £ 200. You are required to: (a) calculate the deficiency in machine hours for the next period; (b) determine which product(s) and quantities (if any) should be bought out; (c) calculate the profit for the next period based on your recommendations in (b). Solution (a) Machine hours deficiency Product A Product B Product C Maximum demand (units) 3,000 2,500 5,000 Hours per unit (48/8) 6 (32/8) 4 (56/8) 7 Total hours 18,000 10,000 35,000 Total hours to meet maximum demand 63,000 Hours available Deficiency 50,000 13,000 hours (b) Make or buy First we have to decide whether it is worth trying to meet full demand for all products, even if some units have to be bought out. Since all products will still have a positive contribution (selling price -variable costs) even if they are bought out (in which case variable cost = buy-out price), it will be worth buying out as necessary to meet full demand. The next decision to be made is the choice of product(s) that should be made in-house and those that should be bought out (wholly or partially). The quickest approach is to assess each product in terms of the benefit of making-in over buying-out per-hour of machining time used—key factor analysis. The benefit of making, in over buying, out is measured by the difference between make-in cost (variable cost) and buy-out price. Buy-out price per unit Product A £ 175 Product B £ 140 Product C £ 200 Variable cost per unit £ 154 £ 112 £ 178 Saving from making-in per unit £21 £28 £22 Make-in machine hours per unit 6 4 7 Saving per machine hour (£) 3.5 7 3.1 Thus, manufacturing priority should be given to Product B, then Product A and then Product C. Meeting maximum demand for Products B and A would use 10,000 -f 18,000 - 28,000 hours [see (a)], leaving 22,000 hours available for Product C. This will be sufficient to manufacture 22,000 + 1 = 3,142 units of C. 132 Thus, 5,000 - 3,142 = 1,858 units of Product C should be bought out. (c) Profit for next period Product A Product B Product C Total Sales (units) 3,000 2,500 5,000 Contribution per unit From making-in (selling price - variable cost) £ 46 £ 46 £ 46 (3,142 units) From buying-out (selling price - buy-out price) £ 24 (1,858 units) £ £ £ £ Total contribution From making-in 138,000 115,000 144,532 397,532 From buying-out 44,592 44,592 442,124 Less: Fixed costs 300,000 Profit 142,124 Problem 4 (Export Order/Limiting Factor) V. Ltd operating at 75% level of activity produces and sells two products A and B. The cost sheets of these two products are as under: Product A B Units produced and sold 600 400 Rs. Rs. Direct materials 2.00 4.00 Direct labour 4.00 4.00 Factory overheads (40% fixed) 5.00 3.00 Selling and administration overheads (60% fixed) 8.00 5.00 Total cost per unit 19.00 16.00 Selling price per unit 23.00 19.00 Factory overheads are absorbed on the basis of machine hour which is the limiting (key) factor. The machine hour rate is Rs. 2 per hour. The company receives an offer from Canada for the purchase of Product A at a price of Rs. 17.50 per unit. Alternatively, the company has another offer from the Middle East for the purchase of Product B at a price of Rs. 15.50 per unit. In both the cases, a special packing charge of fifty paise per unit has to be borne by the company. The company can accept either of the two export orders and in either case the company can supply such quantities as may be possible to produce by utilizing the balance of 25% of its capacity. You are required to prepare: (i) statement showing the economics of the two export proposals giving your recommendations as to which proposal should be accepted; and (ii) statement showing the overall profitability of the company after incorporating the export proposal recommended by you. Solution 133 (i) Statement Showing Economics of Export Proposals Order from Canada Order from Middle for A East for B Per unit Per unit Rs. Rs. Direct materials 2.00 4.00 Direct labour 4.00 4.00 Prime cost 6.00 8.00 Variable overheads: Factory 3.00 1.80 Selling and Distribution 3.20 2.00 12.20 11.80 Special Packing 0.50 0.50 Marginal cost 12.70 12.30 Export price 17.50 15.50 Conlribution 4.80 3.20 Machine hours per unit 2.50 1.50 Contribution per hour Rs. 1.92 Rs. 2.13 Machine hours being the limiting factor, contribution per hour should be the criterion for determining the relative profitability of two export proposals. Thus, Product B will yield higher contribution per hour than that of Product A. Therefore, the offer from Middle East for Product B should be accepted in preference to that from Canada for Product A. (ii) Statement of Overall Profitability A B Total Units 600 867 _ Rs. Rs. Rs. Safes 13,800 14,839 28,639 Less: Marginal costs 7,320 10,464 17,784 Contribution 6,480 4,375 10,855 Less: Fixed cost 5,760 Profit Rs. 5,095 Problem 5 (Shift Work) BSE Veterinary Services is a specialist laboratory carrying out tests on cattle to ascertain whether the cattle have any infection. At present, the laboratory carries out 12,000 tests each period but, because of current difficulties with the herd, demand is expected to increase to 18,000 tests a period, which would require an additional shift to be worked. The current cost of carrying out a full test is: £ per test Materials 115 Technicians' wages 30 Variable overheads 12 Fixed overheads 50 Working the additional shift would: (i) require a shift premium of 50% to be paid to the technicians on the additional shift, (ii) enable a quantity discount of 20% to be obtained for all materials if an order was placed to cover 18,000 tests, (iii) increase fixed costs by £ 700,000 per period. 134 The current fee per test is £ 300. You are required to: (a) prepare a profit statement for the current 12,000 capacity; (b) prepare a profit statement if the additional shift was worked and 18,000 tests were carried out; and (c) comment on three other factors which should be considered before any decision is taken. Solution (a) 12,000 capacity (£ '000) (£ '000) Fees (12,000 x £ 300) 3,600 Variable costs: Materials (12,000 x £ 115) 1,380 Wages (12,000 x £ 30) 360 Variable overheads (12,000 x £ 12) 144 1,884 Contribution 1,716 Fixed overheads (12,000 X £ 50) 600 Profit 1,116 (b) 18,000 tests with additional shift (£ '000) (£ '000) Fees (18,000 x £ 300) 5,400 Variable costs: Materials ( 18 1,380x80% 1,656 \ YL ) Wages (360 + 6 x £ 30 x 150%) 630 Variable overheads 144x 216 V l2y 2,502 Contribution 2,898 Fixed overheads (600 + 700) 1,300 Profit 1,598 (c) The following are to be considered before taking any decision. (1) The duration of the higher level of demand: If it is expected to continue over longer periods, it may be worth employing extra staff rather than paying overtime premiums. Also, the commitment to extra fixed overheads may extend over a longer period than the extra demand. (2) The pricing policy: The urgency of the need for extra tests may mean that fees can be increased without significantly affecting demand. The quality of the work done, material used, etc.: Increasing activity by 50% using current resources may well lead to a drop in the quality of output—i.e., unreliable test results—which could have an adverse effect on future demand. 135 Chapter 6 Corporate restructuring and Finance Before going into the details of financial distress, let us try to begin with its background and the consequences. We first start with the basic causes of a business failure and then try to go in to the consequences of such failure in the context of financial distress and bankruptcy. Causes of Business Failure The basic causes of business failure can be categorized into four major heads - the economic factors, the financial factors, factors relating to neglect, disorder and fraud and some other factors. The economic factor relate to the industry weakness and the poor location of the firm. The financial factor relate to the over burdening debt capacity and the insufficient capital. The importance of the different factors varies over the time, depending on such things as the state of the economy and the level of interest rates. Apart from this, sometimes some factors produce a combining effect so as to make the business unsustainable. Studies have provided further evidence that the causes of financial distress are a result of a series of errors, misjudgments and interrelated weaknesses that can be attributed directly or indirectly to the management of the firm. In a recent study, Dun & Bradstreet has assigned percentage values to the causes of business failures. The following table reveals the same. Table 6.1: Causes of Business Failure Cause of business failure Percentage of total Economic factors 37.1% Financial factors 47.3% Neglect, disorder and fraud 14.0% Other factors 1.6% MEANING OF BANKRUPTCY A firm is said to be bankrupt if it is unable to meet its current obligations to the creditors. Bankruptcy may occur because of a number of external and internal factors. DEFINITIONS SICK INDUSTRIAL COMPANY The Sick Industrial Companies (Special Provisions) Act, 1985 or SICA defines a sick industry as "an industrial company (being a company registered for not less than five years) which has at the end of any financial year accumulated losses equal to or exceeding its net worth". WEAK UNIT A non-SSI industrial unit is defined as 'weak' if its accumulation of losses as at the end of any accounting year resulted in the erosion of fifty percent or more of its peak net worth in the immediately preceding four accounting years. It is clarified that weak units will not only include those which fall within the purview of Sick Industrial Companies (Special Provisions) Act, 1985 (of industrial companies) but also other categories such as partnership firms, proprietory concerns, etc. A weak Industrial Company should be termed as "potentially sick" company. SICK SSI UNIT A small-scale industrial (SSI) unit, as per the RBI is classified as sick when: a. Any of its borrowal accounts has become a doubtful advance, i.e. principal or interest in respect of any of its borrowal accounts has remained overdue for periods exceeding 2 V2 years and b. There is erosion in net worth due to accumulated cash losses to the extent of 50 percent or more of its peak net worth during the preceding two accounting years. In case of tiny/decentralized sector units, if requisite financial data is not available, a unit may be considered as sick if the loan/advance in which any amount to be received has remained past due for one year or more. 136 FACTORS LEADING TO BANKRUPTCY External Factors a. Change in government policies affecting the firm b. Increased competition c. Scarcity of raw material d. Prolonged power cuts e. Changes in consumer buying pattern f. Shrinking demand g. Natural calamities h. Cost overruns i. Inadequate funds. Internal Factors a. Mismanagement b. Fraudulent practices and misappropriation of funds by the management c. Labor unrest d. Technological obsolescence e. Disputes among promoters. Table 6.2: An RBI Study Causes of Bankruptcy Percentage Mismanagement 52 Faulty initial planning 14 Labor trouble 2 Market recession 23 Others 9 100 SYMPTOMS OF BANKRUPTCY A firm goes bankrupt gradually. Before a firm goes bankrupt, it exhibits a number of symptoms, which when diagnosed and corrected in time can save the company from bankruptcy. Some of these symptoms are • Production - Low capacity utilization High operating cost - Failure of production lines Accumulation of finished goods • Sales and Marketing - Declining/Stagnant sales Loss of distribution network to competitors • Finance Increased borrowing at exorbitant rates - Increased borrowing against assets - Failure to pay term loans Failure to pay current liabilities, salaries etc. Failure to make statutory payments 137 • Others A declining trend in market price of share Rapid turnover of key personnel - Persistent cash losses Frequent changes in accounting policies to enhance profits Frequent change of accounting years for undeclared reasons. PREDICTION OF BANKRUPTCY As the incidence of sickness became more frequent, a need was felt to evolve techniques and methods to predict failure of a firm. While symptoms listed earlier are good indicators of the financial health, they are not the best predictors of sickness. A number of models are available to accurately predict sickness of a firm. These models provide early warning signals, so that a potentially disastrous situation can be averted. Most of these techniques involve financial ratio analysis. A study has revealed that financial ratios are useful in predicting the failure of a firm for a period up to 5 years before sickness accurately. A number of Indian models are also available. Some of the models are discussed below, International Models • Beaver Model • The Wilcox Model • Blum Marc's Failing Company Model • Altman's Z Score Model • Argenti Score Board. Indian Model • L.C.Gupta Model Beaver Model Beaver was the first to make a conscious effort to use financial ratios as predictors of failure. He defined failure as "inability of a firm to pay its financial obligation as they mature." He used 30 ratios classified under 6 categories. Beaver tested these ratios to predict the failure of a company. The ratio of cash flow to total debt was found to be the best single predictor of failure. The study further revealed that financial ratios are useful in prediction of failure of at least five years prior to the event. The Wilcox Model Wilcox proposed that the net liquidation value of a firm is the best indicator of its financial health. The net liquidation value can be obtained by the difference in liquidation value of firm's assets and the liquidation value of liabilities. Liquidation value is the market value of assets and liabilities, if liquidated at that point of study. Blum Marc's Failing Company Model Blum Marc's model predicts the financial health of a firm using 12 ratios divided into 3 groups: Liquidity ratios, Profitability ratios and Variability ratios. Using these ratios, Blum Marc tried to accurately predict failure and draw a distinction between bankrupt and non-bankrupt firms. Altman's Z Score Model Airman improved upon the earlier models using ratio analysis to predict failure. Altman's model is based on the fact that various ratios when used in combinations, can have better predictive ability than when used individually. 22 ratios were considered in various combinations as predictors of failure. He used a statistical technique called the Multiple Discriminant Analysis (MDA) to distinguish between bankrupt and non-bankrupt firms. Out of these 22 ratios, a final set of 5 ratios were selected as they were found to be better predictors of failure. Weights were given to these ratios on the basis of their significance to predict health of the model. He developed a discriminant score called the Z-score on the basis of these ratios. Z = 1.2X, + 1.4X2 + 3.3X, + 0.6X4 + 1.0XS where, Z = Discriminant score 138 X1 = Working capital/Total assets X2 = Retained earnings/Total assets X3 = EBIT/Total assets X4 = Market value of equity/Book value of debt X5 = Sales/Total assets. If Z score for a firm is less than 1.81, the firm is likely to go bankrupt. If Z score is more than 2.99, it is regarded as a healthy company. The range between LSI - 2.99 is treated as an area of ignorance. Z Score Classification <1.81 Bankrupt firm 1.81-2.99 Area of ignorance >2.99 Healthy firm Argenti Score Board J. Argenti in his famous article 'Company Failure - Long Range Prediction is Not Enough', developed a score board for evaluating the health of the firm. The model is based on numerical assessment of the firms' weaknesses. The weaknesses are classified as defects (management and accounting), mistakes and symptoms. He has delineated a list of factors to be looked into along with the respective scores. All the scores are to be summed up. The cut-off point for a "healthy firm" is a score of 25. This model has been criticized for being "subjective" and "arbitrary." Box 6.1 Defects In management - Score The chief executive is an autocrat He is also the chairman Passive board - an autocrat will see to that 2 Unbalanced board - too many engineers or too many finance types Weak finance director Poor management depth 15 Poor response to change, old-fashioned product, obsolete factory, old directors, out-of-date marketing In accountancy - 3 No budgets or budgetary controls (to assess variance, etc.) 3 No cash flow plans, or not updated 3 No costing system. Cost and contribution of each product unknown Total Score 43 Pass should be less than 10 Mistakes 15 High leverage, firm could get into trouble by stroke of bad luck 15 Overtrading. Company expanding faster than its funding. Capital base too small or unbalanced for the size and type of business 15 Big project gone wrong. Any obligation which the company cannot meet if something goes wrong Total Score 45 Pass should be less than 15 Symptoms 4 Financial signs, such as Z-score, appear near failure 4 Creative accounting. Chief executive is the first to see signs of failure and, in an attempt to hide it from creditors and the banks, accounts are "glossed over" by, for instance, overvaluing stocks, using lower depreciation, etc. Skilled observers can spot these things. 4 Non-financial signs, such as untidy offices, frozen salaries, chief executive "ill", high staff turnover, low morale, rumors Total Score 12 Total possible score 100 Pass should be less than 25 L.C. Gupta Model 139 L.C. Gupta's model was the first Indian model proposed to predict failure. He used 56 ratios and sought to determine the best set of ratios to predict failure. These were categorized as profitability ratios and balance sheet ratios. He applied these ratios to a sample of sick and non-sick companies and arrived at the best set of ratios. These are given below: Profitability Ratios • EBDIT/Net Sales • OCF/Sales (Operating Cash Flow/Sales) • EBDIT/(TotaI Assets + Accumulated Depreciation) • OCF/Total Assets • EBDIT/(Interest + 0.25 Debt). Balance Sheet Ratios • Net Worth/Total Debt • All Outside Liabilities/Tangible Assets. The model was found to have a high degree of accuracy in predicting sickness for 2/3 years before failure, Issues facing by a Firm in Times of Financial Distress The primary cause of a firm encountering financial distress starts when it finds it difficult to meet the scheduled payments or when the cash flow projections of the firm are indicative of the fact that it will soon be unable to do so. Few of the pivotal issues that arise in due course are as follows: a. Primary cause of failure on part of the firm to meet the debt obligations. To ascertain whether such a failure is due to a temporary cash flow problem or because of the fact that the asset values of the firm has fallen much below its debt obligation. b. If it is found out that the problem is a temporary one, then an agreement with the creditors of the firm can be worked out so that the firm has time to recover and satisfy every one. But in case the long run asset values have truly declined then the firm is said to have incurred economic losses. In such a situation it is important to ascertain, who should bear the losses and how much of share should be given to each. c. To ascertain the value of the firm both on liquidation as well as on working conditions and to take the decision on whether it is profitable to continue the business or liquidate it based on the valuations. d. Whether the firm should file protection under chapter 11 of Bankruptcy Act, or should it go for informal procedures. It is to be noted here that in both the cases of reorganization and liquidation a firm can either resort to informal procedures or work under the direction of the bankruptcy Court. e. Ascertaining the controlling force of the firm while it is being liquidated or rehabilitated. To ascertain whether the existing management be left in charge or should a trustee be placed in charge. Settlements without going through formal bankruptcy When a firm goes through the period of financial distress, it is very important for its management and creditors to decide whether the problem is a temporary one and it is possible for the firm to continue its operations or whether the problem is more serious and permanent in nature that has the possibility of endangering the life of the firm. So having done this, the parties involved in the process decides upon solving the problem either through the intervention of the bankruptcy court or through informal process. If the firm goes for filing a formal bankruptcy under chapter 11 of the Bankruptcy Act it involves certain costs. Coupled to this, there is also the possibility of the fact that when the creditors come to know that the firm has resorted to the Court, it might lead to disruptions. Thus it is preferable to go for reorganization and liquidation through informal means. Here we first start our discussion with the informal reorganization and then go into the details of the procedures of the formal bankruptcy. Informal Reorganization Those companies that possess more strong economic fundamentals, are always prepared to work with these companies so as to help then to come out of their distress conditions and to re-establish themselves on a sound financial basis. Such voluntary plans rendered by the creditors, generally termed as the "workouts", involves restructuring of the firm's debt; because of the fact that the current cash flows of the firm are insufficient to service the existing debt. The restructuring process typically consists of extension and composition. In the former case, the creditors postpone the dales of the interest or the principal payments as well as both. In case 140 of the latter, the creditors voluntarily reduce their claims on the debt by accepting a lower principal amount or by reducing the interest rate on the debt. They may even take equity for debt or they may resort to the combination of all these three possible ways. The process of debt restructuring begins with the initiation of both the firm's managers and the creditors meeting for seeking a proper balance. The creditors form a committee with four to five representatives of the larger creditors and a few of the smaller ones so that each side is equally represented. The meeting is often arranged and conducted by an adjustment bureau that is associated with and run by local credit manager's association. The first step involves drawing up a list of creditors with the amount of debt that is owed to each. This follows by developing the information that shows the value of the firm in different scenarios. One such scenario may be the firm going out of business, selling off its assets and then distributing the proceeds to the various creditors as per the importance of the claim that is associated with each of them with the surplus going to the common stock holders. The firm may even take help of an appraiser who can appraise the value of the firm's property that can be used as a basis for ascertaining the value of the firm in different scenarios. Other scenarios may include continued operations, frequently with some improvements in the capital equipments, marketing and perhaps some management changes. This information is then shared with the bankers and the creditors of the firm. It has been frequently observed that the debt capacity of the firm exceeds its liquidation value and it is further observed that the legal fees and the other costs that are associated with the formal liquidation process under the bankruptcy lowers the proceeds available to the creditors. Added to this, the process of resolving the case through formal procedure is also very time consuming, it may take a year or even more than a year. This reduces the present value of the proceeds to much lower level. When the creditors are supplied with this information, they might be somewhat convinced to accept something less than their full value of the claim. In case where the management and the primary creditors agree for a resolution, then a formal plan is drafted and is presented to all the creditors providing them the reasons why they should be willing to compromise on their claims. While framing the reorganization plan, creditors offer extension because that promises them their full payment at some point of time. In certain cases, the creditors may agree to not only postpone the date of payment but also to subordinate the existing claims to the vendors who show their willingness to extend new credit during the workout period. In a similar way, the creditors may also be willing to accept a lower interest rate on the loans during the extension period. This may be perhaps in exchange for a pledge of collateral. Because of the sacrifices that are involved, the creditors should have more faith than the debtor firm will able to solve the problems. In comparison to this, the creditors agree to reduce their claims. Typically, the creditors receive the cash and the new securities that have a combined market value that is less than the amounts owed to them. Generally it is observed that bargaining is taking place between the debtors and the creditors over the savings that in turn results from avoiding the cost of legal bankruptcy, administrative cost, legal fees, and investigative cost and so on. In addition to get away from such costs the debtor feels relieved that the stigma of bankruptcy is not put on him. It is also sometimes seen that the bargaining process may lead to the process of restructuring that may involve both extension as well as composition. As an example, the settlement may provide for a cash payment of 25% of the debt amount immediately, along with a new note that promises six future installments of 10% each for a total payment of 85%. The process of voluntary settlement is both informal as well as simple. They are also relatively cheap because the legal and the administrative expenses that are associated with it are limited to the minimum amount as a result of which the voluntary procedures normally result in the maximum return to the creditors. Although the creditors do not receive the payments immediately, and may some times have to accept an amount that is lower than that owed to them, they generally recover more money and sooner than in case the firm were to file a bankruptcy. Restructuring process also enjoys the benefit of avoiding the loss that is incurred by the creditors. So a bank that is facing distress with its regulators over weak capital ratios may even agree to extend further loans that may be used to pay the interest on the earlier loans in order to keep the bank from having to write down the values of the earlier loans. It is to be kept in mind that the informal voluntary settlements are not limited to the smaller firms. Recent studies have confirmed that they can extensively be used even by the larger firms. The biggest problem that is encountered by informal reorganization is getting all the parties to agree to the voluntary plan. This problem termed as the hold out problem is discussed in the chapter. Informal Liquidation When the management of the firm realizes that the value of the firm is more when it is dead than it is alive, it may resort to informal procedures to liquidate the firm. Assignment is an informal procedure for the purpose of liquidating a firm. This process generally yields them a greater return that they would have received in formal bankruptcy liquidation. However, the feasibility of the assignments finds its significance only when the firm is small and the affairs of the firm are not that complex. Assignments enjoy certain advantages over the process 141 of liquidation in the American bankruptcy Courts, in terms of time, legal formality, and expense. The assignee has more flexibility in disposing a property than does a federal bankruptcy trustee. So an action can be taken much faster when the inventory becomes obsolete or the machine rusts. At the same time it is to be remembered that the assignment does not automatically result in a full and legal discharge of all the debtors liabilities and neither does it protect the creditors against fraud. Formal liquidation in bankruptcy can help in solving both these problems. Causes and Effects of Financial Distress Before going in for a detailed analysis of the causes and effects of financial distress, let us first try to find an answer to the following questions. These questions basically revolve round the primary reasons for a firm experiencing financial distress; the effects of the distressed firms etc., let us answer these questions using a top-down approach. The discussion will be dealt in two separate sections. The first will speak more about the macroeconomic growth and the government policies and the regulations that center around the financial distress rates. The second section will deal with the ways by which the financial distress can be related to the industrial factors. It is to be borne in mind that the concept of financial distress is nothing new in the area of corporate finance. Here we try to focus more on the causes and effects of the financial distress that is encountered by firms around the globe. Macro Level factors affecting the Financial Distress, Liquidity and Recession In his study, Bernanke (1981) made some key findings on the relationship among liquidity, economic growth and financial distress. His argument stressed on the fact that the existence of bankruptcy risk plays a role in the propagation of recession for both the firms as well as individuals. He says, that bankruptcy leads to social costs, as a result of which almost all the agents try to avoid the consequence of bankruptcy costs. From the viewpoint of the consumers, they try to avoid it by retaining considerable amount of liquid assets so as to meet their fixed expenses, the banks and the tenders try to avoid it by being selective as far as their borrowers are concerned and by limiting the size of the loan with recession creeping into any system, there is the reduction in the cash flow income that is available to meet the current obligation. This, in turn, increases the uncertainty about the future liquidity needs. There is also the general demand to bring solvency which consequently results in a reduced demand for consumer and producer durables, which again may generate further income reduction. Bernanke's study focused on the critical relationship among the changes in liquidity, financial distress and recession for both the consumer and firms. He postulates, that recession leads to the creation of financial distress by bridging the gap of margin between cash flow and debt service. When there is a constrained flow, the fall in the current income reduces the expenditure on illiquid, long lived assets. Two reasons can be attributed for this. The first being, the lower level of current income enhances the short run probability, so that the flow constraint has to be satisfied through expensive means. Say for example, the distress rate of assets, borrowing at unfavorable terms, severe reduction in the current standards of living or even the last possible resort, the bankruptcy of the firm. The other reason being, the fall in the current level of income, reflects a hazy implication for the estimate by the consumer of the future income flows and thus too, for the level of durables holding consistent with maintenance of solvency in the long run. It must be remembered that, firms must bring together and balance the long-term spending plans with the need for having the cash flow so as to meet the short-term obligations. With a low level of internal liquidity, coupled with many fixed expenses, there is the possibility of increase in the level of financial embarrassment, for at least they raise the cost of new financing. At the same time, postponement of capital expenditures is a proper defence mechanism of the balance sheet, against any expected fall in the current income. Bernanke has also stated the cause of bankruptcy. His suggestion is somewhat based on moral hazard. It is not possible for the tenders to perceive the objective conditions on which borrowers base their portfolio decisions. If a tender does not build a reputation for pressing his claims the borrowers will have an incentive to become more of illiquid so as to force an improvement in terms. MONETARY POLICY Bernanke's study on the liquidity takes us back to the critical role of the monetary policy on the overall liquidity of a nation. The overall liquidity of the US is governed by the Federal Reserve Board through its open market transactions. These operations may include the Fed's buying and selling of the US treasury bills out of its considerable inventory, so as to have an effect on its liquidity on either ways. When the Fed buys the bills, as an expansionary mechanism, it adds on to the legal reserves to the banking industry, that the nation's banks can use in creation of new loans on a multiplied basis. On the other hand, selling of the T-bills has a contractionary effect. The short-term interest rates fall when the Fed is pursuing an expansionary policy and rises when the contractionary policy is followed. The primary duty of the Fed is protecting the purchasing power of the dollar, while at the same time ensuring a sustainable level of real growth in the economy. The operation of the Fed is under the assumption that inflation and real economic growth is positively correlated. But, if the 142 real economic growth is weak, the Fed can pursue an expansionary policy without concerning much about inflation. In situations, where the economy is growing at a high and presumably at a rate that is unsustainable, the Fed steps in to make corrections. It is the contractionary policy to bring down the level of inflation. At the same time, it is to be remembered that, as a result of such monetary policies, the interest rates also rise, and entail a much tighter limit on the availability of the short-term loans. These events, along with the subsequent slow down of the economy itself, leads to an increase in the financial distress of all firms, particularly those firms that are relatively weak in financial terms or those that are highly levered. Reversal Fortune: From Diversification to Focus The effect of the reversal on financial distress can be viewed from many angles, in one instance, it was found that when the changes to the corporate focus began to take shape, many of the inefficient conglomerates that were facing keener competition became financially distressed. The traditional thinking says that, the economies of scope have been reversed in the 1980s. Managers of today tend to focus more on the core business, and they are more likely to rationalize mergers and growth strategies, as well as divestitures and restructuring, as a reflection of a strategy for specialization. This particular view is a deviation from the steady increase in diversification since the 1950s, and from the several theoretical justifications for diversification that have since been evolved. They may include - i. Managerial economies of scale ii. Economies of scope in production and marketing iii. Financial synergies. Industry Level Causes of Financial Distress The industry level causes of financial distress can be said to be a three tier system, They are competition, industry shocks and deregulation. Let us now discuss each of these factors in detail. Competition For identifying the possible industry level causes of financial distress, one can resort to Michael Porter's five forces model. The five forces that are included in it are a. Barriers to entry b. Bargaining power of suppliers c. Bargaining power of buyers d. Threat of substitute products e. Rivalry among the competing firms. Each of the above stated factors is associated with the financial distress of an individual firm that operates within the industry. One of the possible implications of the stated factors is that the firms in the different industries display different level of competition as well as different profit sensitivities to the changes in the macroeconomic and industry conditions over time. Financial distress is likely to be more in case of larger firms than that of the smaller ones as per conclusions drawn from Williams analysis. The author further states that a highly leveraged firm will commit to riskier projects as well as aggressive product market strategies so as to prevent other firms from entry. Industry Shocks Any negative shock to the demand of the product or its cost, especially over a period of time, eventually forces a shakeout of firms in the industry. The weakest of the firms are forced into bankruptcy or they must consider being taken over by a stronger firm in the industry. Studies conducted by Mitchell & Mulherin (1996) tested the proposition that industry shocks contribute to the frequency of takeover and restructuring activities. The shocks include, deregulation, changes in input costs of innovations in financial technology that brings about changes in the industry structures. In a separate study, Long and Srulz (1992) examined the effect of bankruptcy announcements by one firm on the values of other firms in the industry. They tested for two contradicting effects. One may be the contagion effect. The market may pull down the values of other firms within the industry because of the fact that the bankruptcy announcement brings new, negative information about the status of the industry as a whole. On the other hand, the market may also raise the value of other firms in the industry because one of their rival firms has failed. It has been found out that the balance between these contrary views is dependent on the financial characteristics of the firm, within the industry. Industry Deregulation 143 The process of deregulation in an industry can bring in financial distress in many firms. This is mainly because of the fact, that deregulation within the industry brings forth a change in the economic structure of the industry. Let us now try to focus on some of the studies that reveal the effects of financial position of a firm due to deregulation creeping in. In their studies conducted in 1986, Chen and Mercrilte studied the forced break up of AT&T, that was initiated by Court Order on first of January 1984, and continued for almost two years. The authors concentrated on the issue on whether the break up resulted in wealth transfers among the security claimants of AT&T and other stakeholders as well. The findings of their studies showed that economically significant events took place during the deregulation process, which resulted in the transfer of funds from third parties to the operating company shareholders. At the same time, it was also observed that, no transfer of wealth from the bondholders to stockholders took place during the deregulation process. In another study, Kote and Lehn (1999) examined the effects of the Airlines Deregulation Act of 1978, along with the associated increase in competition, on airline firm's governance structures. They were able to develop several hypotheses about the expected effects based on the agency theory. They stated that deregulation may bring in the concentration of equity ownership. Deregulation may also lead to the increase in the costs of monitoring managers. This can have a dual effect. The first being, the outside shareholder will engage in monitoring only if his private benefits, which are proportional to his equity stake, exceed the cost of monitoring. The other effect being, in order to internalize the agency problems that are associated with higher monitoring costs, the managers themselves may own larger stakes so that they can have a larger proportion of wealth associated with their decisions. The authors also made predictions regarding the increase in the level of executive compensation for the airline executives, and also involving a change in the form of the compensation provided. They also put forth the argument that before the process of deregulation, the executives pay would relatively be more sensitive towards the firm's earnings, whereas it would be more sensitive towards the stock's price after the process of deregulation. 144 Chapter 7 Valuation Most important business decisions require capital. For example, when Daimler-Ben decided to develop the Mercedes ML 320 sports utility vehicle and to build a plat is Alabama to produce it, Daimler had to estimate the total investment that would be re quired and the cost of the required capital. The expected rate of return exceeded the cost of the capital, so Daimler went ahead with the project. Microsoft had to make a I similar decision with Windows 2000, Pfizer with Viagra, and Harcourt when it de- cided to publish this textbook. Mergers and acquisitions often require enormous amounts of capital. For example. I Vodafone Group, a large telecommunications company in the United Kingdom, spent I £60 billion to acquire Air7buch Communications, a U.S. telecommunications com- pany, in 1999. The resulting company, Vodafone AirTouch, later made a $124 billion I offer for Mannesmann, a German company. In both cases, Vodafone estimated the in- cremental cash flows that would result from the acquisition, then discounted those cash flows at the estimated cost of capital. The resulting values were greater than the I targets' market prices, so Vodafone made the offers. As these examples illustrate, the cost of capital is a critical element in business de- cisions. When the decision involves a single project, it is called a "capital budgeting decision." Companies that consistently make wise capital budgeting choices create value for their investors, hence it is important for managers to understand the capital budgeting process. The cost of capital is also necessary to estimate the value of an entire company. When evaluating a potential acquisition, it is vital to have a reliable estimate of the company's value,. It is also important for a company to de- velop a corporate valuation model for itself. Such a model provides insights into the sources of the company's value, and it can be used to guide managers when they evaluate alternative courses of action. Recent survey evidence indicates that almost half of all large companies use com- pensation plans based on the concept of Economic Value Added (EVA). EVA is the difference between net operating profit after-taxes (NOPAT) and a charge for capital, where the capital charge is calculated by multiplying the amount of capital by the cost of capital. Thus, the cost of capital is an increasingly important component of compensation plans. The cost of capital is also a key factor in decisions relating the use of debt versus equity capital. Finally, the cost of capital is an important factor in the regulation of electric, gas, and telephone companies. These utilities are natural monopolies in the sense that one firm can supply service at a lower cost than could two or more firms. Because it has a monopoly, your electric or telephone company could, if it were unregulated, exploit you. Therefore, regulators (1) determine the cost of the capital investors have provided the utility and (2) then set rates designed to permit the company to earn its cost of capital, no more and no less. The Weighted Average Cost of Capital What precisely do the terms "cost of capital" and "weighted average cost of capital" mean? To begin, note that it is possible to finance a firm entirely with common equity. However, most firms employ several types of capital, called capital components, with common and preferred stock, along with debt, being the three most frequently used types. All capital components have one feature in common: The investors who provided the funds expect to receive a return on their investment. If a firm's only investors were common stockholders, then the cost of capital used in capital budgeting would be the required rate of return on equity. However, most firms employ different types of capital, and, due to differences in risk, these different securities have different required rates of return. The required rate of return on each capital component is called its component cost, and the cost of capital used to ana-lyze capital budgeting decisions should be a weighted average of the various components' costs. We call this weighted average just that, the weighted average cost of capital, or WACC. Most firms set target percentages for the different financing sources. For example, National Computer Corporation (NCC) plans to raise 30 percent of its required capital as debt, 10 percent as preferred stock, and 60 percent as common equity. This is its target capital structure. but for now simply accept NCC's 30/10/60 debt, preferred, and common percentages as given. Although NCC and other firms try to stay close to their target capital structures, they frequently deviate in the short run for several reasons. First, market conditions may be more favorable in one market than another at a particular time. For example, if the stock market is extremely strong, a company may decide that now is a good time to issue common stock. The second, and probably more important, reason for deviations relates to flotation costs, which are the costs that a firm must incur to issue securities. Flotation costs are addressed in detail later in the chapter, but note that these costs are to a large extent fixed, so they become prohibitively high 145 if small amounts of capital are raised. Thus, it is inefficient and expensive to issue relatively small amounts of debt, preferred stock, and common stock. Therefore, a company might issue common stock one year, debt in the next couple of years, and preferred the following year, thus fluctuating around its target capital structure rather than staying right on it all the time. This situation can cause managers to make a serious error in their capital budgeting. To illustrate, assume that NCC is currently at its target capital structure, and it is now considering how to raise capital to finance next year's projects. NCC could raise a combination of debt and equity, but to minimize flotation costs it will raise either debt or equity, but not both. Let's suppose it decides to issue debt, at a cost of 8 percent. The argument is sometimes made that the cost of capital this year is 8 percent, because only debt at 8 percent will be used. However, this is incorrect. If NCC finances this year's projects with debt, it will move away from its target capital structure. Then, as expansion occurs in the future, it will at some point find it necessary to raise additional equity. Now suppose NCC borrows heavily at 8 percent during 2 002, using up its debt capacity in the process, to finance projects that yield 10 percent. In 2003, it has new projects available that yield 13 percent, well above the return on the 2002 projects. However, because it used up its debt capacity in 2002, it must issue equity, which costs 15.3 percent. Therefore, the company might reject these 13 percent projects because they would have to be financed with 15.3 percent money. However, this entire capital budgeting process would be incorrect. Why should a company accept 10 percent projects one year and then reject 13 percent projects the next? Note also that if NCC had reversed the order of its financing, raising equity in 2002 and debt in 2003, it would have reversed its capital budgeting decisions, rejecting all projects in 2 002 and accepting them all in 2 003. Does it make sense to accept or reject projects just because of the more or less arbitrary sequence in which capital is raised? The answer is no. To avoid such errors, managers should view companies as ongoing concerns, and calculate their costs of capital as weighted averages of the various types of fonds they use, regardless of the specific source of financing employed in a particular year. The following sections discuss each of the component costs in more detail, and then we show how to combine them to calculate the weighted average cost of capital. Cost of Debt, kd (1 - T) The first step in estimating the cost of debt is to determine the rate of return debtholders require, or kd. Although estimating kd is conceptually straightforward, some problems arise in practice. Companies use both fixed and floating rate debt, straight and convertible debt, and debt with and without sinking funds, and each form has a somewhat different cost. It is unlikely that the financial manager will know at the start of a planning period the exact types and amounts of debt that will be used during the period: The type or types used will depend on the specific assets to be financed and on capital market conditions as they develop over time. Even so, the financial manager does know what types of debt are typical for his or her firm. For example, NCC typically issues commercial paper to raise short-terrn money to finance working capital, and it issues 30-year bonds to raise long-term debt used to finance its capital budgeting projects. Since the WACC is used primarily in capital budgeting, NCC's treasurer uses the cost of 30-year bonds in her WACC estimate. Assume that it is January 2002, and NCC's treasurer is estimating the WACC for the coming year. How should she calculate the component cost of debt? Most financial managers would begin by discussing current and prospective interest rates with their investment bankers. Assume that NCC's bankers state that a new 30-year, non-callable, straight bond issue would require an 11 percent coupon rate with semiannual payments, and that it would be offered to the public at its $1,000 par value. Therefore, kd is equal to 11 percent. Note that the 11 percent is the cost of new, or marginal, debt, and it will probably not be the same as the average rate on NCC's previously issued debt, which is called the historical, or embedded, rate. The embedded cost is important for some decisions but not for others. For example, the average cost of all the capital raised in the past and still outstanding is used by regulators when they determine the rate of return a public utility should be allowed to earn. However, in financial management the WACC is used primarily to make investment decisions, and these decisions hinge on projects' returns versus the cost of new, or marginal, capital. Thus, for our purposes, the relevant cost is the marginal cost of new debt To be raised during the planning period. Suppose NCC had issued debt in the past, and its bonds are publicly traded. The financial staff could use the market price of the bonds to find their yield to maturity (or yield to call if the bonds sell at a premium and are 146 likely to be called). The YTM (or YTC) is the rate of return the existing bondholders expect to receive, and it is also a good estimate of kj, the rate of return that new bondholders would require. If NCC had no publicly traded debt, its staff could look at yields on publicly traded debt of similar firms. This too should provide a reasonable estimate of kd The required return to debtholders, kd, is not equal to the company's cost of debt because, since interest payments are deductible, the government in effect pays part of the total cost. As a result, the cost of debt to the firm is less than the rate of return required by debtholders. The after-tax cost of debt, kd(1 - T), is used to calculate the weighted average cost of capital, and it is the interest rate on debt, kd, less the tax savings-that result because interest is deductible. This is the same as kd multiplied by (1 — T), where T is the firm's marginal tax rate:" After –tax component cost of debt = Interest rate – Tax savings = kd - kdT = kd (1 - T) Therefore, if NCC can borrow at an interest rate of 11 percent, and if it has a marginal federal-plus-state tax rate of 40 percent, then its after-tax cost of debt is 6.6 percent: kd(l -T) - 11%(1.0 - 0.4) - 11% (0.6) = 6-6%. Cost of Preferred Stock, kps A number of firms, including NCC, use preferred stock as part of their permanent financing mix. Preferred dividends are not tax deductible. Therefore, the company bears their full cost, and no tax adjustment is used -when calculating the cost of preferrd stock. Note too that while some preferreds are issued without a stated maturity date, today most have a sinking fund that effectively limits their life. Finally, although it is not mandatory that preferred dividends be paid, firms generally have every intention of doing so, because otherwise (1) they cannot pay dividends on their common stock, (2) they will find it difficult to raise additional funds in the capital markets, and (3) in some cases preferred stockholders can take control of the firm. The component cost of preferred stock used to calculate the weighted average cost of capital, kps, is the preferred dividend, Dps, divided by the net issuing price, Pm which is the price the firm receives after deducting flotation costs: Component cost of preferred stock = kps = n ps P D Flotation costs are higher for preferred stock than for debt, hence they are incorporated into the formula for preferred stocks' costs. To illustrate the calculation, assume that NCC has preferred stock that pays a $10 dividend per share and sells for $100 per share. If NCC issued new shares of preferred, it would incur an underwriting (or flotation) cost of 2.5 percent, or $2.50 per share, so it would net $97.50 per share. Therefore, NCC's cost of preferred stock is 10,3 percent: kps- $10/$97.50 = 10.3%. Cost of Common Stock, ks Companies can raise common equity in two ways: (1) by issuing new shares and (2) by I retaining earnings. If new shares are issued, what rate of return must the company earn to satisfy the new stockholders? In Chapter 6, we saw that investors require a return of ks. However, a company must earn more than ks on new external equity to provide this rate of return to investors because there are commissions and fees, called flotation costs, when a firm issues new equity. Few mature firms issue new shares of common stock. 4 In fact, less than 2 percent of all new corporate funds come from the external equity market. There are three reasons for this: 1. Flotation costs can be quite high, as we show later in this chapter. 147 2. Investors perceive issuing equity as a negative signal with respect to the true value of the company's stock. Investors believe that managers have superior knowledge about companies' future prospects, and that managers are most likely to issue new stock when they think the current stock price is higher than the true value. Therefore, if a mature company announces plans to issue additional shares, this typically causes its stock price to decline. 3. An increase in the supply of stock will put pressure on the stock's price, forcing the company to sell the new stock at a lower price than existed before the new issue was announced. There are times when companies should issue stock in spite of these problems, hence we discuss stock issues later in the chapter. However, for the most part we assume that the companies in our examples, like most, do not plan to issue new shares. Does new equity capital raised by retaining earnings have a cost? The answer is a resounding yes. If some of its earnings are retained, then stockholders will incur an opportunity cost—the earnings could have been paid out as dividends (or used to repurchase stock), in which case stockholders could then have reinvested the money in stocks, bonds, real estate, and so on. Thus, the firm should earn on its reinvested earnings at least as much as its stockholders themselves could earn on alternative investments of equivalent risk. What rate of return can stockholders expect to earn on equivalent-risk investments? The answer is ksp, because they expect to earn that return by simply buying the stock of the firm in question or that of a similar firm. Therefore, ks is the cost of common equity raised internally by retaining earnings. If a company cannot earn at least ks on reinvested earnings, then it should pass those earnings on to its stockholders and let them invest the money themselves in assets that do provide ks. Whereas debt and preferred stock are contractual obligations that have easily determined costs, it is more difficult to estimate ks... However, we can employ the principles described in Chapters 6 and 10 to produce reasonably good cost of equity estimates. Three methods typically are used: (1) the Capital Asset Pricing Model (CAPM), (2) the discounted cash flow (DCF) method, and (3) the bond-yield-plus-risk-premium approach. These methods are not mutually exclusive—no method dominates the others, and all are subject to error when used in practice. Therefore, when faced with the task of estimating a company's cost of equity, we generally use all three methods and then choose among them on the basis of our confidence in the data used for each in the specific case at hand. The CAPM Approach To estimate the cost of common stock using the Capital Asset Pricing Model (CAPM) as discussed in Chapter 6, we proceed as follows: Step 1. Estimate the risk-free rate, kRF. Step 2. Estimate the current expected market risk premium, RPM-' Step 3. Estimate the stock's beta coefficient, b,, and use it as an index of the stock's risk. The i signifies the ith company's beta. Step 4. Substitute the preceding values into the CAPM equation to estimate the required rate of return on the stock in Question: ks = kRF + (RPM)bF Equation 11-3 shows that the CAPM estimate of ks begins with the risk-free rate, kRfh I to which is added a risk premium set equal to the risk premium on the market, RPM, I scaled up or down to reflect the particular stock's risk as measured by its beta coefficient. The following sections explain how to implement the four-step process. Estimating the Risk-Free Rate The starting point for the CAPM cost of equity estimate is kRF, the risk-free rate, There is really no such thing as a truly riskless asset in the U.S. economy. Treasury securities are essentially free of default risk, but nonindexed long-term T-bonds will suffer capital losses if interest rates rise, and a portfolio of short-term T-bills will provide a volatile earnings stream because the rate earned on T-bills varies over time. Since we cannot in practice find a truly riskless rate upon which to base the CAPM, what rate should we use? A recent survey of highly regarded companies shows that about two-thirds of the companies use the rate on long-term Treasury bonds. We agree with their choice, and here are our reasons: 148 1. Common stocks are long-term securities, and although a particular stockholder may not have a long investment horizon, most stockholders do invest on a long-term basis. Therefore, it is reasonable to think that stock returns embody long-term inflation expectations similar to those reflected in bonds rather than the short-term expectations in bills. 2. Treasury bill rates are more volatile than are Treasury bond rates and, most experts agree, more volatile than ks... 3. In theory, the CAPM is supposed to measure the expected return over a particular holding period. When it is used to estimate the cost of equity for a project, the theoretically correct holding period is the life of the project. Since many projects have long lives, the holding period for the CAPM also should be long. Therefore, the | rate on a long-term T-bond is a logical choice for the risk-free rate. In light of the preceding discussion, we believe that the cost of common equity is more closely related to Treasury bond rates than to T-bill rates. This leads us to favor T-bonds as the base rate, or kRF, in a CAPM cost of equity analysis. T-bond rates can, be found in The Wall Street Journal or the Federal Reserve Bulletin, Generally, we use the yield on a 10-year T-bond as the proxy for the risk-free rate. Estimating the Market Risk Premium The market risk premium, RPM, is the expected market return minus the risk-free rate, kM — kRF. It can be estimated on the basis of (1) historical data or (2) forward-looking data. Historical Risk Premium A very complete and accurate historical risk premium study, updated annually, is available from Ibbotson Associates, who examine market data over long periods of time to find the average annual rates of return on stocks, T-bills, T-bonds, and a set of high-grade corporate bonds. For example, Table 7.1 summarizes some results from their 2000 study, which covers the period 1926-1999. TABLE 7.1 Selected Ibbotson Associates Data, 1926-1999 Arithmetic Mean Geometric Mean Average Rates of Return Common stocks 13.3% 11.3% Long-term corporate bonds 5.9 5.6 Long-term government bonds 5.5 5.1 Treasury bills 3.8 3.8 inflation rate 3.2 3.1 Implied Risk Premiums Common stocks over T-bills 9.5% 7.5% Common stocks over T-bonds "7,8 6.2 Note that common stocks provided the highest average return over the 74-year period, while Treasury bills gave the lowest. T-bills barely covered inflation, while common stock provided a substantial real return. Table 7- 1 also reports the implied risk premiums, or differences, between stocks and Treasury securities. Note that the risk premium of stocks over long-term T-bonds is about 7.8 percent when using the arithmetic average and about 6.2 percent when using the geometric average. This leads to the question of which average to use. Keep in mind that the logic behind using historical risk premiums to estimate the current risk premium is the basic assumption that the future will resemble the past. If this assumption is reasonable, then the annual arithmetic average is the theoretically correct predictor for next year's risk premium. On the other hand, the geometric average is a better predictor of the risk premium over a longer future interval, say, the next 20 years. However, it is not at all clear that the future will be like die past. For example, the choice of the beginning and ending periods can have a major effect on the calculated risk premiums. Ibbotson Associates used the longest period available to them, but had their data begun some years earlier or later, or ended earlier, their results would have been very different. In fact, using data for the past 3 0 or 40 years, the arithmetic average market risk premium has ranged from 5 to 6 percent, which is quite different than the 7.8 percent over the last 74 years. Note too that using periods as short as 5 to 10 years can lead to bizarre results. Indeed, over many periods the Ibbotson data would indicate negative risk premiums, which would lead to the conclusion that Treasury securities have a higher required return than common stocks. That, of course, is contrary to both financial theory and common sense. All this suggests that historical risk premiums should be approached with caution. As one businessman muttered after listening to a professor give a lecture on the CAPM, "Beware of academicians bearing gifts" 149 forward-Looking Risk Premiums The historical approach to risk premiums used by Ibbotson Associates assumes that investors expect future results, on average, to equal past results. However, as we noted, the estimated risk premium varies greatly depending on the period selected, and, in any event, investors today probably expect results in the future to be different from those achieved during the Great Depression of the 1930s, the World War II years of the 1940s, and the peaceful boom years of the 1950s, all of which are included (and given equal weight with more recent results) in the bbotson data. The questionable assumption that future expectations are equal to past realizations, together with the sometimes nonsensical results obtained in historical risk I premium studies, has led to a search for forward-looking, or ex ante, risk premiums. The most common approach to forward-looking premiums is to use the discounted cash flow (DCF) model to estimate the expected market rate of return, kM = kM, then to calculate RPM as kM — kRF, and finally to use this estimate of RPM in the Security Market Line. This procedure recognizes that if markets are in equilibrium, the expected rate of return on the market is also its required rate of return, so when we estimate kM) we are also estimating kM: Since Dj for the market as measured by the S&P 500 or some other index can be predicted quite accurately, and since the current market value of the index (used for P0}is I also known, the major task is to estimate g, the average expected long-term growth rate for the market index. Even here, however, the estimation task is simplified because one can reasonably assume a constant long-term growth rate for a portfolio of mature stocks such as those in the S&P 500. Financial services companies such as Value Line publish, on a regular basis, a forecast based on DCF methodology for the expected rate of return on the market, kM. One can subtract the current T-bond rate from such a market forecast to obtain an estimate of the current market risk premium, RPM- Two potential problems arise when we attempt to use data from organizations such as Value Line. First, what we really want is the marginal investor's expectations, not those of a security analyst. However, this is probably not a major problem, since several studies have proved beyond much doubt that investors, on average, form their own expectations on the basis of professional analysts' forecasts. The second problem is that there are a number of securities firms besides Value Line, and, at any given time, different analysts' forecasts of future market returns are somewhat different. This suggests that it would be most appropriate to obtain a number of forecasts of kM and then to use the average value to estimate RPM for use in the SML. Several services (including Zacks and Institutional Brokers Estimate System, or IBES) publish data on the forecasts of essentially all widely followed analysts. Therefore, one can use the Zacks or IBES aggregate growth rate forecast, along with an aggregate dividend yield, to develop a consensus RPM forecast and thus avoid potential bias from the use of only one organization's estimate. However, we have followed the forecasts of several of the larger organizations over a period of several years, and we have rarely found their kM estimates to differ by more than ±0.3 percentage point from one another. Note, though, that ex ante risk premiums are not stable: they vary over time. Therefore, when using the CAPM to estimate the cost of equity, it is best to use a current estimate of the ex ante RPM. In recent years, the forward-looking risk premium has been in the range of 4.5 to 6.5 percent. Our View on the Market Risk Premium After reading the previous sections, you might well be confused about the correct market risk premium, since the different approaches give different results. Using the historical Ibbotson data over die last 74 years, it appears that the market risk premium is somewhere between 6.2 and 7.8 percent, depending on whether you use an arithmetic average or a geometric average. However, in the past 30 to 40 years, the historical premium has been in the range of 5 to 6 percent. Using the forward-looking approach, it appears that the market risk premium is somewhere in the area of 4.5 to 5.5 percent. To further muddy the waters, the previously cited survey indicates that 37 percent of responding companies use a market risk premium of 5 to 6 percent, 15 percent use a premium provided by their financial advisors (who typically make a recommendation of about 7 percent), and 11 percent use a premium in the range of 4 to 4.5 percent. Moreover, it has been toward the low end of the range when interest rates were high and toward the high end when rates were low. Here is our opinion. The risk premium is driven primarily by investors' attitudes toward risk, and there are good reasons to believe that investors are less risk averse today than 50 years ago. The advent of pension plans, Social Security, health insurance, and disability insurance means that people today can take more chances with their investments, which should make them less risk averse. Also, many households have dual incomes, which 150 also allows investors to take more chances. Finally, the historical average return on the market as Ibbotson measures it is probably too high due to a survivorship bias. Patting it all together, we conclude that the true risk premium in 2001 is almost certainly lower than the long-term historical average of more than 7 percent. But how much lower is the current premium? In our consulting, we typically use a risk premium of 5 percent; hut we would have a hard time arguing with someone who used a risk premium in the range of 4.5 to 5.5 percent. The bottom line is that there is no way to prove that a particular risk premium is either right or wrong, although we are extremely doubtful that the premium market is less than 4 percent or greater than 6 percent. Estimating Beta Recall from Chapter 6 that beta is usually estimated as the slope coefficient in a regression, with the company's stock returns on the y-axis and market returns on the x-axis. The resulting beta is called the historical beta, since it is based on historical data. Although this approach is conceptually straightforward, complications quickly arise in practice. We described these complications in detail in Chapter 7, but it is worthwhile to repeat some of them here. First, there is no theoretical guidance as to the correct holding period over which to measure returns. The returns for a company can be calculated using daily, weekly, or monthly time periods, and the resulting estimates of beta will differ. Beta is also sensitive to the number of observations used in the regression. With too few observations, the regression loses statistical power, but with too many, the "true" beta may have changed during the sample period. In practice, it is common to use either four to five years of monthly returns or one to two years of weekly returns. Second, the market return should, theoretically, reflect every asset, even the human capital being built by students. In practice, however, it is common to use only an index of common stocks such as the S&P 500, the NYSE Composite, or the Wilshire 5000. Even though these indexes are highly correlated with one another, using different indexes in the regression will often result in different estimates of beta. Third, some organizations modify the calculated historical beta in order to produce what they deem to be a more accurate estimate of the "true" beta, where the true beta is the one that reflects the risk perceptions of the marginal investor. One modification, called an adjusted beta, attempts to correct a possible statistical bias by adjusting the historical beta to make it closer to the average beta of 1.0. Another modification, called a fundamental beta, incorporates information about the company, such as changes in its product lines and capital structure. Fourth, even the best estimates of beta for an individual company are statistically imprecise. The average company has an estimated beta of 1.0, but the 95 percent confidence interval ranges from about 0.6 to 1.4. For example, if your regression produces an estimated beta of 1.0, then you can be 95 percent sure that the true beta is in the range of 0.6 to 1.4. So, you should always bear in mind that while the estimated beta is useful when calculating the required return on stock, it is not absolutely correct. Therefore, managers and financial analysts must learn to live with some uncertainty when estimating the cost of capital. An Illustration of the CAPM Approach To illustrate the CAPM approach for NCC, assume that kRF = 8%, RPM = 6%, and bi = 1.1, indicating that NCC is somewhat riskier than average. Therefore, NCC's cost of equity is 14.6 percent: It should be noted that although the CAPM approach appears to yield an accurate, precise estimate of kg, there are actually several problems with it. First, if a firm's stockholders are not well diversified, they may be concerned with stand-alone risk in addition to market risk. In that case, the firm's true investment risk would not be measured by its beta, and the CAPM procedure would understate the correct value of kj.. Further, even if the CAPM method is valid, it is hard to know the correct estimates of the inputs required to make it operational because (1) it is hard to estimate the beta that investors expect the company to have in the future, and (2) it is difficult to estimate the market risk premium. 151 Dividend – Yield – plus –Growth – Rate, or Discounted Cash Flow (DCF), Approach In Chapter 10, we saw that both the price and the expected rate of return on a share of common stock depends on the dividends expected on the stock: P0 = ( ) ( ) . . . k 1 D k 1 D 2 s 2 1 s 1 + + + + = ( ) ∑ − − + 1 t t s t k 1 D Here PQ is the current price of the stock; Dt is the dividend expected to be paid at the end of Year t; and ks is the required rate of return. If dividends are expected to grow at a constant rate, then Equation 11-4 reduces to P0 = g k D s 1 − We can solve for ks to obtain the required rate of return on common equity, which for the marginal investor is also equal to the expected rate of return: Ks = ks = 0 1 P D + Expected g. Thus, investors expect to receive a dividend yield, Di/P0, plus a capital gain, g, for a total expected return of ks. In equilibrium this expected return is also equal to the required return, ks. This method of estimating the cost of equity is called the discounted cash flow, or DCF, method. Henceforth, we will assume that equilibrium exists, hence ks = ks, so we can use the terms ks and ks interchangeably. Estimating inputs for the DCF Approach Three inputs are required to use the DCF approach: the current stock price, the current dividend, and the expected growth in dividends. Of these inputs, the growth rate is by far the most difficult to estimate. The following sections describe the most commonly used approaches for estimating the growth rate: (1) historical growth rates, (2) the retention growth model, and (3) analysts' forecasts. Historical Growth Rates First, if earnings and dividend growth rates have been relatively stable in the past, and if investors expect these trends to continue, then the past realized growth rate may be used as an estimate of the expected future growth rate. We illustrate several different methods for estimating historical growth in the file Ch 11 Tool Kit.xls on the textbook's CD-ROM. For NCC, these different methods produce estimates of historical growth ranging from 4.6 percent to 11.0 percent, with most estimates fairly close to 7 percent. As the Ch 11 Tool Kit.xls shows, one can take a given set of historical data and, depending on the years and the calculation method used, obtain a large number of quite different growth rates. Now recall our purpose in making these calculations: We are seeking the future dividend growth rate that investors expect, and we reasoned that, if past growth rates have been stable, then investors might base future expectations on past trends. This is a reasonable proposition, but, unfortunately, we rarely find much historical stability. Therefore, the use of historical growth rates in a DCF analysis must be applied with judgment, and also be used (if at all) in conjunction with ^-' ~r growth estimation methods as discussed next. Retention Growth Model Another method for estimating the growth rate is to use the retention growth model; G = b(r) Here r is the expected future return on equity (ROE), and b is the fraction or its earnings that a firm is expected to retain (1 — Payout ratio). Equation 11-7 produces a constant growth rate, but when we use it we are, by implication, making four important assumptions: (1) We expect the payout rate, and thus the retention rate, b = 1 -Payout, to remain constant; (2) we expect the return on equity on new investment, r, to equal the firm's 152 current ROE, which implies that we expect the return on equity to remain constant; (3) the firm is not expected to issue new common stock, or, if it does, we expect this new stock to be sold at a price equal to its book value; and (4) future projects are expected to have the same degree of risk as the firm's existing assets. Bond – Yield-plus-Risk –Premium Approach Some analysts use a subjective, ad hoc procedure to estimate a firm's cost of common equity: they simply add a judgmental risk premium of 3 to 5 percentage points to the interest rate on the firm's own long-term debt. It is logical to think that firms with risky, low-rated, and consequently high-interest-rate debt will also have risky, high-cost equity, and the procedure of basing the cost of equity on a readily observable debt cost utilizes this logic. For example, if an extremely strong firm such as BellSouth had bonds which yielded 8 percent, its cost of equity might be estimated as follows: ks = Bond yield + Risk premium = 8% 4- 4% - 12%. The bonds of NCC, a riskier company, have a yield of 10.4 percent, making its estimated cost of equity 14-4 percent: ks - 10.4% + 4% - 14.4%. Because the 4 percent risk premium is a judgmental estimate, the estimated value of ks. is also judgmental. Empirical work in recent years suggests that the risk premium over a firm's own bond yield has generally ranged from 3 to 5 percentage points, so this method is not likely to produce a precise cost of equity. However, it can get us "into the right ballpark." Comparison of the CAPM, DCF, and Bond-Yield-plus –Risk – Premium Methods We have discussed three methods for estimating the required return on common stock. For NCC, the CAPM estimate is 14.6 percent, the DCF constant growth estimate is 14.5 percent, and the bond-yield-plus-risk- premium is 14.4 percent. The overall average of these three methods is (14.6% + 14.5% + 14.4%)/3 = 14.5%. These results arc unusually consistent, so it would make little difference which one we used. However, if the methods produced widely varied estimates, then a financial analyst would have to use his or her judgment as to the relative merits of each estimate and then choose the estimate that seemed most reasonable under the circumstances. A 2000 research paper that reported the results of two surveys found that the CAPM approach is by far the most widely used method. Although most firms use more than one method, almost 74 percent of respondents in one survey, and 85 percent in the other, used the CAPM,' This is in sharp contrast to a 1982 survey, which found that only 30 percent of respondents used the CAPM. Approximately 16 percent now use the DCF approach, down from 31 percent in 1982. The bond-yield-plus-risk-premium is used primarily by companies that are not publicly traded. People experienced in estimating equity capital costs recognize that both careful analysis and sound judgment are required. It would be nice to pretend that judgment is unnecessary and to specify an easy, precise way of determining the exact cost of equity capital. Unfortunately, this is not possible—finance is in large part a matter of judgment, and we simply must face that fact. Composite, or Weighted Average, Cost of Capital, WACC As we shall see in Chapters 16 and 17, each firm has an optimal capital structure, defined as that mix of debt, preferred, and common equity that causes its stock price to be maximized. Therefore, a value-maximizing firm will establish a target (optimal) capital structure and then raise new capital in a manner that will keep the actual capital structure on target over time. In this chapter, we assume that the firm has identified its optimal capital structure, that it uses this optimum as the target, and that it finances so as to remain constantly on target. How the target is established will he examined in Chapters 16 and 17. The target proportions of debt, preferred stock, and common equity, along with the component costs of capital, are used to calculate the firm's-WACC. To illustrate, suppose NCC has a target capital structure calling for 30 percent debt, 10 percent preferred stock, and 60 percent common equity. Its before-tax cost of debt, kd, is 11 percent; its after-tax cost of debt is kd(l - T) = 11%(0.6) - 6.6%; its cost of preferred stock, kps, is 10.3 percent; its cost of common equity, It,, is 14.5 percent; its marginal tax rate is 40 percent; and all of its new equity will come from retained earnings. We can calculate NCC's weighted average cost of capital, WACC, as follows: 153 WACC = wdkd(1 - T) + wpskps + wceks - 0.3(11.0%)(0.6) + 0.1(10.3%) + u.o(14.5%) - 11.7%. Here w(], wps, and wce are the weights used for debt, preferred, and common equity, respectively. Every dollar of new capital that NCC obtains will on average consist of 30 cents of debt with an after-tax cost of 6.6 percent, 10 cents of preferred stock with a cost of 10.3 percent, and 60 cents of common equity with a cost of 14.5 percent. The average cost of each whole dollar, the WACC, is 11.7 percent. Two points should be noted. First, the WACC is the weighted average cost of each new, or marginal, dollar of capital—it is not the average cost of all dollars raised in the past. We are primarily interested in obtaining a cost of capital for use in capital budgeting, and for this purpose the cost of the new money that will be invested is the relevant cost. On average, each of these new dollars will consist of some debt, some preferred, and some common equity. Second, the percentages of each capital component, called weights, could be based on (1) accounting values as shown on the balance sheet (book values), (2) current market values of the capital components, or (3) management's target capital structure, which is presumably an estimate of the firm's optimal capital structure. The correct weights are those based on the firm's target capital structure, since this is the best estimate of how the firm will, on average, raise money in the future. Valuation of firm(s) as a going concern is the base for any merger and acquisition exercise. The determination of the right value of a business firm is crucial for the sustainable long-term success of the acquisition. There are various approaches and methodologies for valuation of a firm. Some of the common approaches to valuation are the discounted cash flow approach, the comparable firms approach and the adjusted book value approach. The discounted cash flow approach to valuation relates the value of the firm to the present value of the expected future cash flows of the firm. The comparable firms approach estimates the value of a firm in relation to the value of other similar firms based on various parameters like earnings, sales, book value, cash flows, etc. The adjusted book value approach to valuation involves estimation of the market value of the assets and liabilities of the firm as a going concern. Historically the comparable firms method and the adjusted book value method have been the more commonly used approaches to valuation of firms. However, in the recent years, there is a marked shift towards the application of the discounted cash flow method. The reasons for its increasing popularity and acceptance is its conceptual soundness and its strong endorsement by leading investment bankers and consultancy firms. Value and Pricing A postulate for sound investing is that an investor does not pay more for an asset than its worth. This statement may seem logical and obvious, but it is forgotten and rediscovered at sometime in every generation and every market. There are those who are disingenuous to argue that the value lies in the eyes of the beholder and that any price can be justified, if there are other investors willing to pay that price. This is patently absurd. Perceptions may be all that matters when the asset is a painting or a sculpture, but investors do not (and should not) buy assets or firms for aesthetic or emotional reasons. They buy them for the cash flows they expect to receive. Consequently, the perceptions of value have to be backed up by reality, which implies that the price paid for any asset should reflect the cash flow it is expected to generate. There are many areas in valuation on which there is room to disagree, including the actual estimates of the true value and the time taken for the prices to adjust to their true value. However, there is one point on which there can be no disagreement: pricing cannot be justified by merely using the argument mat there will be other buyers around willing to pay a higher price in the future. That is equivalent to playing a very expensive game of musical chairs in which, before playing, every investor has to answer the question "Where will I be when the music stops?" Source: Damodaran on Valuation: Security Analysis for Investment and Corporate Finance by Aswath Damodaran DISCOUNTED CASH FLOW APPROACH The discounted cash flow model relates the value of the firm to the present value of its expected future cash flows. The nature of the cash flows will depend upon the asset: dividends for an equity share, coupons and redemption value for bonds and the post-tax cash flows for a project. This approach is based on the time value 154 concept where the value of any asset is the present value of its expected future cash flows. The first step in the Discounted Cash Flow approach entails estimating the Free Cash Flow for the explicit forecast period. The free cash flow represents the cash flow available to all the suppliers of capital to the firm. These include the equity holders, the preference investors and the providers of debt to the firm. The free cash flow is used for the following purposes; • Interest payments (post-tax basis); • Equity and preference dividend; • Repayment of loans ana redemption/amortization of bonds; • Redemption/amortization of preference shares; • Buy-back of equity shares. The free cash flow of a firm is the sum of its free cash flow from operations and its non-operating cash flows. The free cash flow from operations is the difference between the gross cash flow of the firm and its gross investments. The Gross Cash Flow of the firm can be computed as follows: Earnings Before Interest and Taxes (EBIT) Less: Taxes on EBIT = Net Operating Profit Less Adjusted Taxes (NOPLAT**) Add: Depreciation Add: Non-Cash Charges Gross Cash Flow ** NOPLAT can also be computed as EBIT (1 - t) where t is the tax rate of the firm. The Gross Investment can be computed as follows: Increase in Net Working Capital Add: Capital Expenditure incurred Add: Increase in Other Assets Gross Investments Non-Operating Cash Flows represent the post-tax cash flows from items other than the regular operations of the firm. For e.g. profit realized on sale of fixed assets. The explicit forecast period of the firm also needs to be determined. One of the premises of this theory is that the firm is a going concern. The implication of this assumption is that cash flows in perpetuity need be discounted to value the firm. This is, however, impossible in practice. Hence the cash flows are explicitly computed for a finite period of time and the continuing value of the firm at the end of such period is computed. This finite period (say 7 years) for which the free cash flows are computed is called as the explicit forecast period. Normally the explicit forecast period is coterminous with the period during which the company enjoys competitive advantage. The firm is expected to stabilize and reach a steady state at the end of the explicit forecast period. This implies that the ROCE, reinvestment rate and the growth rate remain constant in perpetuity after the explicit forecast period, It is also important to obtain a historical perspective before forecasting the expected free cash flow of the firm. The principal drivers which affect the free cash flow are the Return on Capital Employed (ROCE) and the Reinvestment Rate. The historical analysis involves careful perusal of past financial statements, analysis of the historical ROCE and reinvestement rates and assessing the sustainability of these rates over the explicit forecast period. The second step in the DCF model involves computation of the cost of capital to the firm. The cost of capital is the rate to be used for discounting the free cash flows to their present values. The cost of capital is to be computed as the weighted average of the costs of all sources of capital. The weights assigned are based on the market value or each or the components of the capital. Weightages based on market value is considered to be superior to assigning weights based on book value. This is because book values represent the financial legacy rather than a current perspective. On the other hand, weightages based on market value are taken to represent the economic claims of the various providers of capital. Secondly the cost of capital is to be computed on post- tax terms. This is to ensure consistency in the approach, as the free cash flow is computed on post-tax basis. 155 The cost of capital is to be computed as follows: k o = k ev + k pv + M 1 -') v where, kQ is the weightage average cost of capital ke is the cost of equity capital k_ is the cost of preference capital kd is the cost of debt S is the market value of equity capital P is the market value of preference capital B is the market value of debt V is the sum of the market values of the equity capital, preference capital and the debt i.e. S + P + B t is the tax rate applicable to the firm. It is to be noted that non-interest bearing debt like sundry creditors and bills payable are to be excluded in the above computation. This is because the cost of extending credit would have been factored in by the seller in pricing of the goods/services. Hence the impact of the same would have been reflected in the free cash flows which would have been understated to that extent. The third step in the DCF model involves computing the continuing value of the firm. Continuing value is also referred to as the horizon value. The continuing value represents the value of the free cash flows beyond the explicit forecast period. In many cases, the continuing value may be dominant component of the value of the firm. Hence the valuer should be circumspect and realistic in computing the continuing value. There are a number of methods to compute the continuing value. The most common method is the Free Cash Flow method. The premise of this method is that the free cash flow will grow at a constant rate after the explicit forecast period. The continuing value of the firm may be computed as follows: where, CV is the continuing value of the firm at the end of the year n FCFn+1 is the expected free cash flow for the year n + 1 k is the weighted average cost of capital of the firm g is the expected perpetual growth rate of the free cash flow. In addition to the above method, there are a number of non-cash flow based methods. The non-cash flow based methods are the Book Value Method, Price Earnings Multiple (P/E) Method and the Replacement Cost Method. The Book Value Method values the firm at its book value at the end of the explicit forecast period. Some valuers use a variation of this method and values the firm as a multiple of its book value. The main drawback of this method is that it does not take into account the increase in the book value due to inflation. Another drawback is that the book values are influenced by the accounting policies. The Price Earnings Multiple Method involves valuing the firm based on its earnings of the first year after the explicit forecast period. The earnings are multiplied by an appropriate multiple (P/E ratio) to determine the continuing value. The advantage of this method is its familiarity as it is extensively used to value equity. The 156 main drawback is that this method uses earnings, which is vulnerable to distortion, due to the high degree of subjectivity involved in its computation. Secondly, the valuation process becomes inconsistent due to use of cash flows in valuing the firm in the explicit forecast period and the use of earnings thereafter. The replacement cost method determines the continuing value based on the replacement cost of its assets. The main drawback of this method is that only certain assets can be replaced. Some non-tangible factors like relationships with customers (e.g. Goldman Sachs relationship with their clients), reputation of the firm for its ethical practices (e.g. Infosys Technology), employee loyalty, etc. cannot be replaced. However, some of these aspects are the principal factors responsible for the success of a firm. Ignoring these factors as non-replaceable grossly understates the value of the firm. Secondly, in some instances, it may be simply uneconomical to replace some of its assets. In such an eventuality, the replacement cost exceeds the value of the firm as a going concern. The last step in the DCF model involves determination of the value of the firm. The free cash flow projections and the continuing value of the firm should be discounted by the cost of capital to arrive at the present value of the cash flows. The value of non-operating assets like investments should be added to it. The market value of all claims (bonds issued, loans, etc.) on the firm should be deducted to arrive at the ownership value of the firm. Valuation: A Science or An Art Valuing a company is neither an art nor a science but an odd combination of both. There is enough science that appraisers are not left to rely solely on experience but there is enough art that without experience and judgments, failure is assured. Illustration 7.1 Swagat Enterprises is engaged in the construction business. Its current financials are as follows: Rs. (in crore) Sales 100 Operating expenses 40 EBDIT 60 Depreciation 10 EBIT 50 Tax (@ 40%) 20 The current level of its net fixed assets is Rs.80 crore. The corresponding level of net current assets stands at Rs.l0 crore. The sales of the firm are expected to grow at the rate of 10% per year for the next 5 years. During the same period, the operating expenses are expected to increase at the rate of 8% per annum. Depreciation is to be charged @ 10% of the net fixed assets at the beginning of the year. To finance this expansion, Swagat Enterprises will be making the following investments: Year Investment in fixed assets (Rs. crore) 1 20 2 0 3 10 4 15 5 0 Throughout the five-year period, the net current assets will remain at 10% of the net fixed assets. All the investments will be made at the beginning of the respective years. 157 The tax rate will continue to be at 40%. The post-tax non-operating cash flows will be as follows: Year — Non-operating cash flows (Rs. crore) 1 10 3 5 4 20 The post-tax cost of debt is 8% for the firm. The cost of equity is 15%. The market value of debt is Rs.40 crore, and the market value of equity is Rs.ll0 crore. From the sixth year onwards, the free cash flow is expected to grow @ 10% per annum. Calculate the value of Swagat Enterprises. Solution Step 1 Calculating the Gross Cash Flow for the explicit forecast period Year 1 2 3 4 5 Sales 110 121 133 146 161 Operating Expenses 43 47 50 54 59 EBDIT 67 74 83 92 102 depreciation** 10 9 9 10 9 EBIT 57 65 74 82 94 Taxes 23 26 29 33 37 NOPLAT 34 39 44 49 56 Gross Cash Row 44 48 53 59 65 ** Depreciation is calculated as follows: Year 1 2 3 4 5 Net fixed assets at the end of previous year 80 90 81 82 87 Additions at the beginning of the year 20 0 10 15 0 Total 100 90 91 97 87 Depreciation for the year 10 9 9 10 9 Net fixed assets at the end of the year 90 81 82 87 78 Step 2 Calculating the gross investment a. Investment in Net Current Assets b. Year 1 2 3 4 5 Total Net Current Assets 10 9 9 10 9 Net current assets at the 10 10 9 9 10 end of previous year Investment in net current 0 -1 0 1 —1 assets Investment 20 0 10 15 0 Gross investment 20 —1 10 16 -1 158 Step 3 Calculating the Free Cash Flow Year 1 2 3 4 5 Gross cash flow 44 48 53 59 65 Gross investment 20 -1 10 16 -1 Free cash flow from 24 49 43 43 66 operations Non-operating cash flow 10 0 5 20 0 Free cash flow 34 49 48 63 66 Step 4 Ascertaining the cost of capital Cost of capital = (0.08 x 40/150) + (0.15 x 110/150) 13.13% Step 5 Determine the present value of the free cash flow Year Free cash flow PV factor Present value 1 34 0.8839 30.12 2 49 0.7813 38.45 3 48 0.6906 33.26 4 63 0.6104 38.75 5 66 0.5396 35.52 Total 176.10 Step 6 Calculating the discounted continuing value Value of the firm = Discounted free cash flows + Discounted continuing value = 176.10 + 2319 = Rs.2,495 cr Market value of debt = Rs.40 cr Value of equity = Rs.(2495 - 40) cr = Rs.2455 cr. Limitations of DCF Approach The DCF approach is the ideal model to be used when a firm has positive future cash flows, the expected cash flows can be reliably estimated and there exists a proxy for risk which is required in computation of discount rates. However, in a real life situation, the valuer faces some practical challenges. The limitations of the DCF approach become apparent in the following cases. 1. Asset Rich Firms: DCF valuation reflects the value of all the assets which produce cash flows. The firm may have some assets which do not produce any cash flows. For e.g. surplus land, unutilized floor space in factory buildings, staff quarters, etc. The value of such assets will not be reflected in the DCF valuation. The 159 same limitation also applies, to a lesser extent, to underutilized assets, as their values will be understated in the DCF model. 2. Firms in Distress: Firms in financial distress may have negative current and future cash flows. The present value of such firms will be a negative figure under the DCF method. Further such firms have a high probability of going into bankruptcy. This violates the basic premise of the DCF approach which views a firm as a going concern. 3. Mergers/Takeovers: A key driver in several merger/takeover transactions is the expected synergy between the two firms. The challenge involved in such a valuation exercise is understanding the nature and form of the synergy and estimating its value in financial terms to compute its impact on the expected cash flows. The second challenge involves estimating the effect of the resultant change in management (due to the merger or the takeover) on the discount rates due to the change in the risk profile of the firm. This limitation is more pronounced when the transaction involves a hostile takeover. 4. Cyclical Firms: The cash flows of cyclical firms tend to shadow the performance of the economy. The earnings and cash flows are high during the boom periods and are low during recessionary periods. The valuations can be misleading if the explicit forecast period does not cover the entire economic cycle. However this is an onerous task and the resulting valuation can be highly subjective depending on the valuer's assumptions about the timing and the duration of the phases of the economic cycle. 5. Firms with Product Options: Firms often have unutilized product options which do not generate any current cash flows. For e.g. for companies involved in oil exploration, winning the right to drill oil and gas in a particular region represents a product option. Similarly firms may also have unutilized intellectual property rights like patents and copyrights. If DCF model is applied for such valuations, the firm will be grossly undervalued. Some practitioners have overcome this limitation either by obtaining the market value of such options or by applying the option pricing model for its valuation. The resultant value of the option is added to the value obtained from DCF valuation to arrive at the true value of the firm. COMPARABLE FIRMS APPROACH This approach is also called as the relative approach. In this approach, the value of any firm is derived from the value of comparable firms, based on a set of common variables like earnings, sales, cash flows, book value, etc. The most common manifestation of the comparable approach is in the use of the industry average Price- Earnings multiple (P/E ratio) for valuation of equity. Another commonly used tool for valuing equity is the Price- Book Value multiple (P/BV ratio). The comparable firms model is essentially a top-down approach. The valuation process applying this approach is a four staged exercise. Analysis of the Firm The valuer is required to make an indepth analysis of the firm to get rich insights into the financial and operational aspects. The profitability of the firm may be analyzed by looking at the operating profit margins and the net profit margins. Further analysis may be made by analyzing the return on capital employed and return on net worth. The liquidity position may be analyzed from the current ratio and quick ratio. The interest coverage and the debt service coverage would provide pointers to the solvency position. The efficiency of the operations can be captured from ratios like inventory turnover, fixed assets turnover, debtors turnover, etc. The cash flows of the firm need to be carefully studied and a sensitivity analysis may be conducted. The capital structure of the firm also needs to be analyzed. The qualitative analysis includes assessing the position of the firm in the industry, market share, competitive advantage (if any) etc. For e.g. Reliance Industries plays a dominant role in the petrochemical industry in India and commands a valuation multiple than IPCL. The managerial evaluation is also important as the competence and integrity of the management have a greater bearing on the valuation. For e.g. one of the factors due to which Infosys Technologies commands high valuation is the market perception of its exemplary corporate governance. The ownership pattern plays its part as historically MNC firms have been given higher valuation vis-a-vis domestic firms as they are considered to be better managed. 160 Identification of Comparable Firms The next stage involves identification of comparable firms. This process begins with a thorough analysis of the industry in which the firm operates. The valuer is to carefully assess the general profile of the industry, competitive structure, demand-supply position, installed capacities, pricing system, availability of inputs, government policies and regulatory framework, long-term trends, etc. The next step involves identification of firms with comparable profile. The parameters used for identification of such firms include product profile, scale of operations, markets served, cost structures, geographical location, technology, etc. In practice, it is virtually impossible to find truly similar firms, which can match the subject firm on all or even most of the parameters. The identification process generally involves delineating a list of firms which bear some resemblance to the firm being valued. Once a universe of potentially comparable firms is identified, each of the firms is analyzed based on the predetermined parameters. From the universe identified as above three to five specific firms which bear similarity, as close as possible, to the firm being valued, are selected. Solution The valuation multiples of the comparable firms are as follows: Particulars Alpha Beta Gamma Avg. Price/Sales Ratio 1.50 1,25 1.60 1.45 Price/Earnings Ratio 10.00 8.33 9.60 9.31 Price/Book Value Ratio 3.00 1.66 2.40 2.35 Applying the above multiples, the value of Sigma is as follows: Particulars Multiple Parameter (Rs. in cr.) Value (Rs. in cr.) Price/Sales 1.45 100 145.00 Price/Earnings 9,31 15 139.65 Price/Book Value 2.35 60 141.00 The weightages to P/S ratio, P/E ratio and the P/BV ratio are 1, 2 and 1 respectively. Thus the weighted average value will be = Rs.141.32 cr. The value of Sigma Ltd., using the comparable firms approach, is Rs.141.32 cr. ADJUSTED BOOK VALUE APPROACH The adjusted book value approach to valuation involves estimation of the market value of the assets and liabilities of the firm as a going concern. It is a pointer to the liquidation value of the firm. It is, however, distinct from the conventional book value method. The conventional approach relies on the historical book value of the assets and liabilities as against the valuation of the assets and liabilities at their fair market value in this method. Valuation of Tangible Assets The approach begins with valuation of all the assets of the firm. Fixed assets constitute substantial portion of the asset side of the balance sheet in capital intensive companies. Land is valued at its current market price. Buildings are normally valued at replacement cost. However appropriate allowances are to be made for depreciation and deterioration in its conditions. Similarly plant & machinery, capital equipments, furniture, fixtures, etc. are to be valued at fixed costs net of depreciation and allowances for deterioration in conditions. An alternative method of valuing plant & machinery involves estimation of the prevailing market price of similar used (second-hand) machinery and adding the cost of transportation and erection. The other major block on the asset side of the balance sheet is current assets. The principal components of current assets are inventory, debtors and cash. The inventory is valued depending upon its nature; the raw materials are to be valued at the rates of the latest orders; the finished goods at the current realizable sale value after deducting provisions for 161 packing, transportation, selling costs, etc. The work-in-process can be valued either based on the cost i.e. cost of materials plus processing costs incurred or based on the sales price i.e. sale price of the finished product less cost incurred to convert the work-in-process into sales. Debtors are generally valued at their book value. However, allowances should be made for any doubtful debts. Valuation of cash (including balances with bank) does not need any great expertise. Miscellaneous current assets like income accrued but not due, prepaid expenses, deposits made etc. are to be taken at their book value. Non-operating assets like investments, surplus land, staff quarters, etc. are generally valued at their fair market value. Valuation of Intangible Assets The valuation of intangible assets like brands, goodwill, patents, trademarks & copyrights, distribution channel, etc. is a controversial area of valuation. Several major companies (consumer goods in particular) believe that brands are its most valuable assets. The idea of intangibles as financial assets emerged in the mid-eighties. As intangibles have significant financial value, their absence from the valuation distorts the true financial position of a company. Hence in order to ensure that the valuation of a company is reflective of its true intrinsic worth it has become necessary for companies to determine the values of their brands. In the late eighties, the Australian group. Goodman Fielder Wattie (GFW) mounted a hostile bid on a British company Ranks Hovis McDougall (RHM). RHM issued a defense document that mentioned that GFW bid significantly undervalued RHM's true worth, since it did not take into account the company's strong brands. It said "These valuable assets are not included in the balance sheet, but they have helped RHM build profits in the past and provide a sound base for future growth". RHM engaged the services of a professional consultancy firm to do a brand valuation. Viewing brands as assets, the consultants valued the business at 900 million Pounds, significantly higher than GFW bid of 600 million Pounds. Once they published that information, it was clear that GFW's bid undervalued the business and the bid finally drifted away. However, there is a large element of subjectivity in the process of valuation of intangibles. The two popular methods of valuing intangibles are given below. Earnings Valuation Method: This method of valuation is widely accepted in most markets around the world. The value of an intangible like any other asset is equal to the present value of the future earnings attributable to it. This is a two-staged process involving • determining the future earnings attributable to the intangible asset; • applying an appropriate multiplier to determine its present value. The main drawback of this approach is that the future projections of the earnings may be optimistic. Further the process of determining the multiplier is highly subjective. Due care has to be taken for the above factors, failing which the intangible asset may be overvalued. Unscrupulous companies may possibly overvalue the intangibles and use brand values as a tool for window dressing. Cost Method: This method involves stating the value of the intangible asset at its cost to the company. This is relatively easy when the intangible asset is acquired. The money paid to buy the brands can be directly stated. (For e.g. Coca Cola paid Rs.170 cr to acquire the soft drinks brands of Parle). It is more difficult to value the brand when the intangible asset has been developed in-house by the company. The methodology involves determining the cost incurred in developing the intangible asset. The process of identification of the the costs incurred is characterized by a great degree of subjectivity. This may have a significant impact on the final valuation. Valuation of Liabilities The valuation of liabilities is relatively simple. It must be noted that share capital, reserves and surpluses are not included in the valuation. Only liabilities owed to outsiders are to be considered. All long-term debt like loans, bonds, etc. are to be valued at their present value using the standard bond valuation model. This involves computing the present value of the debt servicing (both principal and interest payments) by applying an appropriate discount rate. Current liabilities include amount due to creditors, short-term borrowings, provision for taxes, accrued expenses, advance payment received, etc. Normally such current liabilities and provisions are taken at their book value. 162 Valuation of the Firm The ownership value of a firm is the difference between the value of the assets (both tangible and intangible) and the value of the liabilities. Normally no premium is added for control as assets and liabilities are taken at their economic values. On the other hand, a discount may be necessary to factor in the marketability element. The market for some of the assets may be illiquid or may fetch a slightly lesser price if the buyer does not perceive as much value of the asset to his business. Hence a discount factor may be applied. CONTEMPORARY DEVELOPMENTS IN VALUATION THEORIES A significant portion of the current research in the area of valuations is devoted to the application of option theory to value firms. This is leading to the emergence of a new model to value firms or businesses called as the contingent claims model. A contingent claim (option) is an asset that pays off under certain contingencies; if the value of the underlying variable exceeds a predetermined amount, then for a call option has a value and if it is less than the predetermined value the put option has a value. The contingent claims model is based on the premise that equity can be viewed as call option on the firm. The equity in a firm is a residual claim; the equity holders can lay their claims to the cash flows (in the form of dividends) of the firm only after all the claims of other stakeholders (creditors', debt providers, preference shareholders, etc.) have been satisfied. Similarly, if the firm is liquidated, the equity holders receive the entire balance portion after all the financial claims on the firm have been paid off. The principle of limited liability provides immunity to the equity holders if the value of the firm is less than the outstanding financial claims. In other words, the maximum loss to the equity holders cannot exceed the amount of their investment. Thus the pay-off to the equity holders in the event of liquidation is V - C if V > C or zero if V < C where, V is the value of the firm C represents all the claims on the firm. Thus an analogy can be drawn between equity and options wherein the equity shares are treated as call options on the value of the underlying firm, the value of the claims can be taken as the exercise price (strike price), the maturity of the claims measuring the life of the option and the original investment representing the option premium. The principle of limited liability eliminates the downside risk for the equity holders. The contingent claims model values the firm by valuing its equity using the option-pricing models. While the contingent claim model stands the test of conceptual soundness, the practical application of this model in the real world has not been very significant. Some of the issues which need to be further addressed before this model gets acceptability in the corporate world are as follows: • One of the basic assumption of the Black-Scholes Model is that the variance in the price of the underlying asset is known and remains constant over the life of the option. In case of the contingent claim model where the underlying variable is the value of the firm, it is impractical to determine the variance in the first place. Secondly, even if such variance were to be measured, it is unlikely that it will remain constant over extended periods. • Option pricing theory, as in both the Binomial Model and the Black-Scholes Model, is built on the premise that a replicating portfolio can be created using the underlying asset and riskless borrowing and lending. This is a reasonably defensible assumption when the underlying variable is a security, commodity or a currency. However, the business (not the equity share) which is being valued is not traded in the market and the probability of building a replicating portfolio appears remote. Hence no possibility of arbitrage exists, which is the basis of the option pricing models. • The Black-Scholes Model is built on the assumption that the underlying asset's price process is continuous. The validity of this assumption to the value of the firm is doubtful. Experts opine that a possible solution is to use an option pricing model that explicitly allows for price jumps (discrete instead of continuous price process). However, the inputs required for such models are again difficult to determine. Jump process models are based on poisson distribution and require inputs on the probability of the price jumps, the average magnitude and the variance. 163 VALUATION: SOME MISCONCEPTIONS 1. Valuation Models give an exact estimate of value: The appropriateness of the valuation depends upon the quality of the data, correctness of the assumptions and the application of the right valuation model. Most of the data pertaining to projected cash flows is futuristic and is thus characterized by uncertainty. This makes valuation an inexact and imprecise exercise. The valuation process gives us at best a value anchor. A value range may be determined based on the margin of error which in turn is a function of the degree of uncertainty of the cash flows. 2. Valuation is a totally objective exercise: The models used in valuation may be quantitative but the inputs leave plenty of room for subjective judgements. The opinions and the biases of the valuer"get reflected in the valuation. _The_ estimation of the_future cash flows depend -upon the aggressiveness or the conservatism of the assumptions made. Further there is also a certain degree of subjectivity in determination of discounting rates. It is generally observed that in case of takeovers the value of the target firm as estimated by their investment bankers is higher than the valuation estimates by the investment bankers of the predator company. 3. A well-done valuation is a timeless treasure: Any valuation exercise is time specific and is reflective of the information available to the valuer at that specific point of time. As time passes by, the flow of new information begins. The information may be firm specific, industry specific or pertain to the market as a whole. Thus the valuation done in the past becomes increasingly obsolete and the same needs to be updated to reflect the current information. 4. The value estimated is important; the process does not matter: The valuation exercise depends on the robustness of the valuation process. Hence the focus should not be exclusively on the outcome in the form of a definitive value figure. The valuation process is informative and provides valuable insights about the firm. The process reveals a great deal about the determinants of value and the user should make an effort to understand the valuation process. 5. The market is always wrong: The benchmark for comparison of a valuation exercise is the market valuation of the firm. When the value estimated is significantly different from the market valuation, there can be two conclusions: the valuer is right and the market has substantially undervalued/ overvalued the firm or that the market is right and the valuation is incorrect. It is observed that very often, the instantaneous conclusion drawn is that the market is wrong. In such cases it is prudent to give the benefit of doubt to the market as the collective wisdom of the market as a whole is generally superior to the judgement of the valuer. However, if the valuer is able to convincingly prove the wisdom of his valuation, only then the same may be accepted and not otherwise. DIVERSIFICATION STRATEGY All other things being constant, an ideal strategy is to move into a diversification program from a base or core of existing capabilities or organizational strengths. The firm should be clear on both its strengths and weaknesses and should clearly define the specific new capabilities it is seeking to obtain. If the firm does not possess a sufficient breadth of capability to use as a basis for moving into other areas, an alternative strategy may be employed. In recent years, the nature of the firms and the boundaries of industries have become much more dynamic and flexible. This has to be kept in mind even before the carryover of capabilities in pure conglomerate mergers. In this dynamic changing world managements must relate to missions, defined in terms of customer needs, wants, or problems to be solved. Another important dimension of the concept of industries is a range of capabilities. The technological capabilities include all processes from the basic research, product design and development to interrelated manufacturing methods and obtaining feedback from consumers. Managerial capabilities include competence in the generic management functions of planning, organizing, directing, and controlling as well as specific management functions of research, marketing, finance and personnel. 164 Characteristics of a Successful Diversification Strategy Some of the characteristics of a successful diversification strategy are: PLATFORM OF EXISTING CAPABILITIES Any diversification strategy should be built on the foundation of existing competencies. This facilitates entry into new markets. A company can have multiple capabilities, but a capability qualifies as a core competence if it fulfills the following criteria: • It should be applicable across all the product categories. • It should not be open to duplication by competitors. • It should result in significant value addition to the consumer. CHOICE OF NEW MARKETS The markets earmarked for expansion should be growth markets with low gestation periods. A small company cannot afford to operate in markets where the 'gestation period is high. The telecom sector, for instance, was opened up in the year 1994. The private operators in most circles are yet to make profits. On the other hand, the software boom saw many companies diversify into the Info Tech arena with substantial rewards. The new markets should also offer room for companies to operate in a niche. NEW CAPABILITIES Though the strategy is based on existing capabilities, companies should acquire new ones to augment the existing strengths. They could make an effort to acquire new technologies, distribution channels or adding marketing muscle. MANAGEMENT SKILLS AND LEADERSHIP Implementation of the strategy will require strong and aggressive management. The owner/manager may have to take swift, decisive measures during the diversification effort, These could be decisions related to investment or downsizing. These decisions may be risky and face resistance from employees. Strong and visionary leadership is required to ensure successful implementation. EMPLOYEE SKILLS AND PRODUCTIVITY A skilled and autonomous workforce is a must for the diversification strategy to succeed. Employees are more productive if given autonomy. LEAN AND TENACIOUS Companies that can maintain a lean management structure can avoid high overhead margins. The success of the diversification ultimately hinges upon the tenacity of the personnel to see it through. Diversifying to new markets can be a risky proposition. The risk can be minimized if companies can identify their strengths and evaluate market opportunities accordingly. The key for small companies is to identify markets where their capabilities can be profitably leveraged to create customer value. The changing environments and the new forms of competition have created new opportunities and threats for business firms. Firms must adjust to new forces of competition from all directions. They have been forced to adopt many forms of restructuring activity. M&As will be considered first, but it should be understood that they represent only one set of the many adjustment and restructuring responses. INTERNAL Vs. EXTERNAL GROWTH Internal growth and mergers are not mutually exclusive activities. They are mutually supportive and reinforcing. Successful growing firms use many forms of M&As and restructuring based on opportunities and limitations. The characteristics and competitive structure of an industry will influence the strategies employed. Growth and diversification can be achieved both internally and externally. Internal development is more advantageous for some activities and for some other external diversification is more beneficial. 165 The factors which support the external growth and diversification through mergers and acquisitions include the following: Faster achievement of goals and objectives through an external acquisition. Greater cost of building an organization internally, than the cost of an acquisition. Attainment of feasible market share with less risk, in shorter time and at lower cost. Inefficiently managed target. Tax advantages. Complementary capabilities. Internal development is favored when the above given advantages are minimal. When the firms which are available for acquisition do not provide attractive opportunities for achieving the goals that have been set, internal development is more feasible from an economic perspective. Box 1: Diversification and Growth Through Acquisitions GE Capital is the product of dozens of acquisitions that have been blended to form one of the world's largest financial services organizations. GE Capital was founded in 1933 as a subsidiary of the General Electric Company to provide consumers with credit to purchase GE appliances. Since then, the company has grown to become a major financial services conglomerate with 27 separate businesses and more than 50,000 employees worldwide. These businesses include private label credit card services to commercial real estate financing to rail car and aircraft leasing. More than half of these businesses have become part of GE Capital through acquisitions. The acquisitions come in different forms and shapes. Sometimes, the acquisition is a portfolio or asset purchase that adds volume to a particular business without adding people. Sometimes, it is consolidating acquisition in which a company is purchased and then consolidated into an existing GE Capital business like it happened when GE Capital Vendor Financial Services bought Chase Manhattan Bank's leasing business. Sometimes the acquisition moves into a new territory, generate an entirely new GE Capital business, as when GE Capital bought Travelers Corporation's business. Sometimes the acquisition is a hybrid, parts of which fit into one or more existing businesses while the other parts stand alone or become joint ventures. DIVERSIFICATION PLANNING, MERGERS AND THE CARRY OVER OF MANAGERIAL CAPABILITIES Growth through mergers and diversification represents a very good alternative to be taken into account in business planning. The external growth contributes to opportunities for effective alignment to the firm's changing environments. The primary reason for acquiring or merging with another business is to produce improved cash flow or to reduce the risk faster or at a lower cost than achieving the same goal internally. Thus, the goal of any acquisition is to create a strategic advantage by paying a price for the target that is lower than the total resources required for internal development of a similar strategic position. Another reason is the expectation on the part of the diversifying or acquiring firm that it has or will have excess capacity of general managerial capabilities in relation to its existing product market activities. Moreover, there is an expectation that in the process of interacting with the generic management activities, the diversifying firms will develop industry specific managerial experience and firm specific organization capital overtime. Four factors have contributed to the increased diversification by business firms: Advances in Managerial Technology Important changes in the management technology include issues like development in theory and practice of planning, increased role of management functions in the firm's operations, the development and use of formalized decision models, increased recognition of quality and continuity of the firm's management organization as an important economic variable etc. These factors have made it beneficial to spread these abilities over a greater number of activities. Conversely, these management capabilities are not evenly distributed throughout industries giving an opportunity for firms to extend their capabilities to other firms and to new areas in order to increase the returns on investments in both management and physical assets. Increased Technological Change The opportunities for diversification have increased along with the demands to change. The expertise of technology is spread unequally among various business firms and industries. The prospects of economic profits from the supply of advanced technological capabilities to industries and firms which need them provide an increased incentive to diversify. 166 Large Fixed Costs and Staff Services Fixed cost of business firms have increased due to the need to maintain an affective competitive position in the world economy and the resultant larger management capabilities. Investments in managerial organizations have always resulted in economies of scale rather than investment in physical assets. Hence, the economies derived from spreading the fixed costs for managerial staff functions over a wide range of activities have increased. Development of Equity Markets The trends in the equity markets have strengthened the influence of the above mentioned factors in encouraging diversification by external diversification. In the equity markets stock which had a potential for growth in earnings and dividends, were highly valued. Hence, growth stocks had higher P/E ratio. This increased interest in the growth stimulated mergers in various ways. The search for product markets with growth opportunities intensified. In a rapidly changing world, companies are facing unprecedented turmoil in global markets. Severe competition, rapid technological change, and rising stock market volatility have increased the burden on managers to deliver superior performance and value for their shareholders. In response to these pressures, an increasing number of companies around the world are dramatically restructuring their assets, operations, and contractual relationships with shareholders, creditors, and other financial stakeholders. Corporate restructuring has facilitated thousands of organizations to re-establish their competitive advantage and respond more quickly and effectively to new opportunities and unexpected challenges. Corporate restructuring has had an equally profound impact on the many more thousands of suppliers, customers, and competitors that do business with restructured firms. Generally, most of the corporate growth occurs by internal expansion, when a firm's existing divisions grow through normal capital budgeting activities, Neverthless, if the goals are easily achieved within the firm, it may mean that the goals are too small. Growth opportunities come in a variety of other forms and a great deal of energy and resources may be wasted if an entrepreneur does not wait long enough to identify the various dynamics which are already in place. The most remarkable examples of growth and often the largest increases in stock prices are a result of mergers and acquisitions. M&As offer tremendous opportunities for companies to grow and add value to shareholders wealth. M&As is a strategy for growth and expansion. M&As are expected to increase value and efficiency and thereby increase shareholders' value. M&As is a generic term used to represent different types of corporate restructuring exercises. FORMS OF CORPORATE RESTRUCTURING Business firms in their pursuit of growth, engage in a broad range of restructuring activities. Actions taken to expand or contract a firm's basic operations or fundamentally change its asset or financial structure are referred to as corporate restructuring activities. Corporate restructuring is a broad umbrella that covers many things. One of them is the merger or takeover. From the viewpoint of the buyer, M&A represent expansion and from the perspective of the seller it represents a change in ownership that may or may not be voluntary. In addition to mergers, takeovers, and contests for corporate control; there are other types of corporate restructuring like divestitures, rearrangements, and ownership reformulation. These corporate restructuring activities can be divided into two broad categories -operational and functional. Operational restructuring refers to outright or partial purchase or sale of companies or product lines or downsizing by closing unprofitable, and non-strategic facilities. Financial restructuring refers to the actions taken by the firm to change its total debt and equity structure. 167 An overview of all these restructuring activities, is shown in a summarized form in Table 1. The grouping is a bit random but indicates the direction of the emphasis in these various practices. Table 1: Forms of Restructuring Business Firms Expansion Mergers and Acquisitions Tender offers Asset acquisition Joint ventures Contraction Spin offs Split offs Divestitures Equity carve outs Assets sale Corporate Control Anti takeover defenses Share repurchases Exchange offers Proxy contests Changes in Ownership Structures Leveraged buyout Junk bonds Going private ESOPs and MLPs Each type of activity mentioned in the above Table is briefly explained below: Expansion Expansion is a form of restructuring, which results in an increase in the size of the firm. It can take place in the form of a merger, acquisition, tender offer, asset acquisition or a joint venture, MERGER Merger is defined as a combination of two or more companies into a single company. A merger can take place either as an amalgamation or absorption. Amalgamation This type of merger involves fusion of two or more companies. After the amalgamation, the two companies lose their individual identity and a new company comes into existence. A new firm that is hitherto, not in existence comes into being. This form is generally applied to combinations of firms of equal size. Example: The merger of Brooke Bond India Ltd with Lipton India Ltd resulted in the formation of a new company Brooke Bond Lipton India Ltd. Absorption This type of merger involves fusion of a small company with a large company. After the merger the smaller company ceases to exist. Example: The recent merger of Oriental Bank of Commerce with Global Trust Bank. After the merger, GTB ceased to exist while the Oriental Bank of Commerce expanded and continued. TENDER OFFER Tender offer involves making a public offer for acquiring the shares of the target company with a view to acquire management control in that company. Example: (1) Flextronics International giving an open market offer at Rs.548 for 20% of paid-up capital in Hughes Software Systems. (2) AstraZenca Pharmaceuticals AB, a Swedish firm, announced an open offer to acquire 8.4% stake in Astra Zenca Pharma India at a floor price of Rs.825 per share. ASSET ACQUISITION Asset acquisitions involve buying the assets of another company. These assets may be tangible assets like a manufacturing unit or intangible assets like brands. In such acquisitions, the acquirer company can limit its acquisitions to those parts of the firm that coincide with the acquirer's needs. Example: The acquisition of the cement division of Tata Steel by Laffarge of France. Laffarge acquired only the 1.7 million tonne cement plant and its related assets from Tata Steel. 168 The asset being purchased may also be intangible in nature. For example, Coca-Cola paid Rs. 170 crore to Parle to acquire its soft drinks brands like Thums Up, Limca, Gold Spot, etc. The business world has changed drastically. Markets, instruments, financing and relationships have transformed to become exceedingly complex. The economic environment has shifted dramatically and in order to prosper or even to survive in such an environment, the strategy formulation has become very important. It is no longer possible to take a simple, idealistic view of what should be done and how it should be done. The pursuit of growth and the need to access new markets are driving companies all over the world to undertake mergers, and acquisitions. This phenomenon is becoming part of the strategic planning of many corporate bodies seeking not only to exploit existing core competencies but also to build new ones for the future. While the motives or influences leading to mergers are multiple, varied and complex, the potential for concentration of economic power is inherent in the phenomenon of mergers. When two businesses combine their activities, the combination may take the form of acquisition (takeover) or a merger (amalgamation). The distinction between a merger and an acquisition is not very clear. The methods used for mergers are often the same as the methods used to make takeovers. However, theoretically there can be a subtle difference between the two, as can be interpreted from the following definitions: Acquisition or Takeover: The purchase of a controlling interest by a company in the voting share capita! of another company, usually by buying the majority of the voting shares is called an acquisition or a takeover. Idea Cellular acquiring Escotel is an example of an acquisition. Merger: A business combination that results in the creation of a new reporting entity formed from the combining parties, in which the shareholders of the combining entities come together in a partnership for the mutual sharing of the risks and the benefits of the combined entity, and in which no party to the combination obtains control over the other. An example of a merger is Daimler-Benz and Chrysler. The main reason for any business organization to combine is to increase the shareholder wealth. This increase usually comes from the effects of synergy. In this chapter we shall discuss in detail the various types of mergers and the process undergone by firms to accomplish a merger or an acquisition. TYPES OF MERGERS Merger or acquisition depends upon the purpose for which the target company is acquired. A company will seek to acquire the other company only when it has arrived at its own developmental plan to expand its operations after a thorough analysis of its own internal strength. It has to aim at a suitable combination where it could have opportunities to supplement its funds; secure additional financial facilities, eliminate competition and strengthen its market position. Based on the reason why firms combine, mergers can be divided into three categories: (i) Horizontal mergers (ii) Vertical mergers, and (iii) Conglomerate mergers. Horizontal Merger A horizontal merger involves a merger between two firms operating and competing in the same kind of business activity. The main purpose of such mergers is to obtain economies of scale of production. The economies of scale is obtained by the elimination of duplication of facilities and operations and broadening the product line, reduction in investment in working capital, elimination of competition in a product, reduction in advertising costs, increase in market share, exercise of better control on market, etc. Horizontal mergers result in decrease in the number of firms in an industry and hence such type of mergers make it easier for the industry members to join together for monopoly profits. Horizontal mergers also have a potential to create monopoly power on the part of the combined firm enabling it to engage in anticompetitive practices. Hence, in many countries, restrictive business practices legislation enforce strict regulations on the integration of competitors. Horizontal mergers of even small enterprises may create conditions triggering concentration of economic power and oligopoly. The alliance between Birla, AT&T and Tata (BATATA) in Idea Cellular Ltd., is an example of a horizontal merger. Vertical Mergers A vertical merger involves merger between firms that are in different stages of production or value chain. They are combination of companies that usually have buyer-seller relationships. A company involved in a vertical merger usually seeks to merge with another company or would like to takeover another company mainly to 169 expand its operations by backward or forward integration. The acquiring company through merger of another unit attempts to reduce inventories of raw material and finished goods, implements its production plans as per objectives and economizes on working capital investments. In other words, in vertical combination, the merging company would be either a supplier or a buyer using its product as an intermediary material for final production. Firms integrate vertically between various stages due to reasons like technological economies, elimination of transaction costs, improved planning for inventory and production, reconciliation of divergent interests of parties to a transaction, etc. Anticompetitive effects have also been observed as both the motivation and the result of these mergers. Examples: Nirma's bid for Gujarat Heavy Chemical (backward integration) or Hindalco bidding for Pennar Aluminium (forward integration). Conglomerate Mergers Conglomerate mergers involve merger between firms engaged in unrelated types of business activity. The basic purpose of such combination is utilization of financial resources. Such type of merger enhances the overall stability of the acquirer company and creates balance in the company's total portfolio of diverse products and production processes and thereby reduces the risk of instability in the firm's cash flows. Conglomerate mergers can be distinguished into three types: product extension mergers, geographic market extension mergers and pure conglomerate mergers. Product extension mergers are mergers between firms in related business activities and may also be called concentric mergers. These mergers broaden the product lines of the firms. Geographic market extension mergers involve a merger between two firms operating in two different geographic areas. Pure conglomerate mergers involve merger between two firms with unrelated business activities. They do not come under product extension or market extension mergers. Within the broader category of conglomerate mergers two types of conglomerate firms can be distinguished. Financial Conglomerates: Financial conglomerates provide a flow of funds to each segment of their operations, exercise control and are the final financial risk takers. They undertake strategic planning but do not participate in operating decisions. Managerial Conglomerates: Managerial conglomerates transmit the attributes of financial conglomerates still further. They not only assume financial responsibility and control, but also play a role in operating decisions and provide staff expertise and staff services to the operating entities. By providing managerial guidance and interactions on decisions, managerial conglomerates increase the potential for improving performance. THE MERGER AND ACQUISITION PROCESS The acquisition process can be divided into a planning stage and an implementation stage. The planning stage consists of the development of the business and the acquisition plans. The implementation stage consists of the search, screening, contacting the target, negotiation, integration and the evaluation activities. In short, the process of acquisition can be summarized in the following steps: i. Develop a strategic plan for the business (Business plan). ii. Develop an acquisition plan related to the strategic plan (Acquisition plan). iii. Search companies for acquisitions (Search). iv. Screen and prioritize potential companies (Screen). v. Initiate contact with the target (First contact). vi. Refine valuation, structure the deal, perform due diligence, and develop financing plan (Negotiation). vii. Develop plan for integrating the acquired business (Integration plan). viii. Obtain all the necessary approvals, resolve post-closing issues and implement closing (Closing). ix. Implement post-closing integration (Integration). x. Conduct the post-closing evaluation of acquisition (Evaluation). Developing the Business Plan As discussed earlier, a merger or an acquisition decision is a strategic choice. The acquisition strategy should fit the company's strategic goals of increasing the net cash flows and reduce risk. 170 A business plan communicates a mission or vision for the firm and a strategy for achieving that mission. A well- structured business plan consists of the following activities: i. Determining where to compete i.e., the industry or the market in which the firm desires to compete. ii. Determining how to compete. An external industry or the market analysis can be made to determine how the firm can most effectively compete in its chosen market(s). iii. Self-assessment of the firm by conducting an internal analysis of the firm's strengths and, weaknesses relative to the competition. iv. Defining the mission statement by summarizing where and how the firm has chosen to compete and the basic operating beliefs of the management. v. Setting objectives by developing quantitative measures of performance. vi. Selecting the strategy most likely to achieve the objectives within a reasonable time period subject to constraints identified in the self-assessment. The strategic planning process identifies the company's competitive position and sets objectives to exploit its relative strengths while minimizing the effects of its weaknesses. The firm's Mergers and Acquisitions strategy should complement this process, targeting only those industries and companies that improve the acquirer's strengths or lessen the weaknesses, Building the Acquisition Plan After a proper analysis of the various available options if it is determined that a merger or an acquisition process is appropriate to implement the business strategy then an acquisition plan is prepared. This plan focuses on the tactical rather than the strategic issues. The acquisition plan defines the key management objectives for the takeover, resource constraints, appropriate tactics for implementing the proposed transactions and the schedule or a time table for completing the acquisition. It furnishes a proper guidance to those responsible for successfully completing the transaction by providing valuable inputs to all the later phases of the acquisition process. MANAGEMENT OBJECTIVES Management objectives are both financial and non-financial. The financial objectives include a minimum rate of return or operating profit, revenue and cash flow targets to be achieved within a specified time period. Non- financial objectives address the motivations for making the acquisition that support the achievement of the financial returns predetermined in the business plan. RESOURCE ASSESSMENT The assessment of the resources involves the determination of the maximum amount of resources available to assign to the merger or acquisition. This information is useful in the selection of the right candidate for the merger or the acquisition. The resources available generally include the financial resources like the internal cash flows in excess of the normal operating requirements plus funds from equity and the debt markets. If the target is identified, resources should also include funds which the combined firm can raise by issuing equity or by increasing leverage. It is the management's perception about the likely risks that it would be exposed to by virtue of acquisition that determines the financial implications. These risks may be: Operating Risk It refers to the ability of the acquirer to manage the acquired company. The risk is higher in conglomerate mergers. The limited understanding of the business operations of the newly acquired firm may negatively impact the integration effort and the ongoing management of the combined companies. Financial Risk It refers to the acquirer's willingness and the ability to leverage a transaction as well as the willingness of shareholders to accept near-term earnings per share dilution. The acquiring company tries to maintain certain level of financial ratios such as the debt to equity and interest coverage ratio to retain a specific credit rating. 171 The incremental debt capacity of the firm can be estimated by comparing the relevant financial ratios to those of comparable firms in the industry. The difference represents the amount of money that the firm can borrow without making the current credit rating vulnerable. Overpayment Risk It refers to the possibility of dilution in the earnings per share or reduction in the growth of the firm because of paying more than the economic value of the acquired firm. TIME TABLE A time table or a schedule that recognizes all the key events that should take place in the acquisition process is the final component of a properly structured acquisition plan. It should be both realistic and aggressive to motivate all the participants in the process to work as fast as possible to achieve the management objectives established in the acquisition plan. The schedule should also include the names of the individuals who will be responsible for ensuring that the set objectives are achieved. The Search Process After the firm has developed a viable business plan that requires an acquisition to realize the firm's strategic direction and an acquisition plan the search for the right candidate for acquisition begins. The search for a potential acquisition candidate generally takes place in two stages. The first stage of the search process involves establishing a primary screening process. The primary criteria based on which the search process is based include factors like the industry, size of the transaction and the geographic location. The size of the transaction is best defined in terms of the maximum purchase price a firm is willing to pay. It can be expressed as the maximum purchase price to earnings, book, cash flow or revenue ratio or a maximum purchase price stated in terms of rupees. The second stage involves developing the search strategy. Such strategies generally involve using computerized database and directory services to identify the prospective candidates. Law, banking and accounting firms also form valuable sources from which information can be obtained. Investment banks, brokers, and leveraged buyout firms are also useful sources although they are likely to require an advisory fee. The Screening Process The screening process starts with the reduction of the initial list of potential candidates identified by using the primary criteria such as the size and the type of the industry. In addition to the primary criteria employed, secondary selection criteria include a specific market segment within the industry or a specific product line within the market segment. Other measures like the firm's profitability, degree of leverage and the market share are also used in the screening process. First Contact The contact phase of the process involves meeting the acquisition candidate and putting forward the proposal of acquisition. It could run through several distinctively identifiable phases that need a little more elaboration. ALTERNATIVE APPROACH STRATEGIES The approach employed for contacting the target depends on the size of the company and whether it is publicly or privately held. For small companies in which the buyer has no direct contacts, a letter expressing interest in a joint venture or marketing alliance is enough. Thorough preparation before the first contact is essential for that alone enables the acquirer to identify the company's strengths and weaknesses and be able to explain the benefit of the proposal to the client convincingly. A face to face meeting is then arranged when the target is willing to entertain the idea of an acquisition. Contact is made through an intermediary for a medium sized company. The intermediaries might include members of the acquirer's board of directors, accounting firm, lender or an investment banker. For a large sized company contact is made through an intermediary but it is important that the contact is made with the highest level of the management of the target firm. DISCUSSING VALUE Valuation of the target company is the most critical part of a deal. A conservative valuation can result in collapse of the deal while an aggressive valuation may create perpetual problems for the acquiring company. The commonly used valuation methods are: 172 i. Discounted Cash Flow Method: In this method, valuation represents the present value of the expected stream of future cash flow discounted for time and risk. This is the most valid methodology from the theoretical standpoint. However, it is very subjective due to the need to make several assumptions during the computations. ii. Comparable Companies Method: This method is based on the premise that companies in the same industry provide benchmark for valuation. In this method, the target company is valued vis-a-vis its competitors on several parameters. iii. Book Value Method: This method attempts to discover the worth of the target company based on its Net Asset Value. iv. Market Value Method: This method is used to value listed companies. The stock market quotations provide the basis to estimate the market capitalization of the company. EXPLANATION AND RATIONALE FOR GAINS TO SELL OFFS Some of the main reasons why firms are forced to divest are; efficiency gains and refocus, information effects, wealth transfers, and tax reasons. Efficiency Gains and Refocus While Mergers and Acquisitions lead to synergy, divestures can result in reverse synergy. A particular business may be more valuable to someone for generating cash flows and that someone will be paying a higher price for the business than its present value. Divestiture is also taken to enable a company to make certain strategic changes. The competitive advantage that a company has may change over time due to changing market conditions, and as a result, a company may have to divest a particular business. In some cases, the past diversification programs of a company may have lost value, making it necessary for the company to refocus its core competencies. A divestiture helps a company to refocus on its core competencies. Information Effects The information that a divestiture conveys to investors is another reason for divestiture. If the information given by management is not known to investors, the announcement of divestiture can be seen as a change in investment strategy or in operating efficiency. This may be taken in a positive sense and boost share price. However, if the divestiture announcement is perceived as the firms' attempt to dispose off a marketable subsidiary to deal with adversities in other businesses, it will send a wrong signal to investors. Whether the divestiture is seen as a good or a bad signal depends on the circumstances. Wealth Transfers Divestiture results in the transfer of wealth from debtholders to stockholders. This transfer takes place when a company divests a particular division and distributes the resulting proceeds of the sale among, stockholders. As a result of this transaction there is less likelihood of repayment and it will have lesser value. If the total value of the firm remains unchanged, its equity value is expected to rise. Tax Reasons As in the case of mergers, divestitures also provide a considerable tax advantage. When a company is losing money and is unable to use a tax-loss carry forward, it is better to divest wholly or in part to realize a tax benefit. When there is increased leverage due to restructuring, a firm can have a tax shield advantage due to interest payments being tax deductible. TYPES OF SELL OFFS Divestitures Definition A divestiture is the sale of portion of the firm to an outside party generally resulting in cash infusion to the parent. They are generally the least complex of the exit restructuring activities to understand. Most of the sell offs are simply divestitures. The most common form of divestiture involves sale of a division of the parent company to another firm. The process is a form of contraction for the selling company and a means of expansion for the purchasing corporation. 173 SPIN OFFS It is a transaction in which a company distributes to its own shareholders on a pro rata basis all of the shares it owns in a subsidiary. Hence a spin-off results in the creation of a new public company with the same proportional equity ownership as the parent company. Spin off has emerged as a popular form of corporate downsizing in the nineties. A new legal entity is created to takeover the operations of a particular division or unit of the company. The shares of the new unit are distributed on a pro rata basis among the existing shareholders. In other words, the shareholding in the new company at the time of spin-off will reflect the shareholding pattern of the parent company. The shares of the new company are listed and traded separately on the stock exchanges, thus providing an exit route for the investors. Spin-off does not result in cash inflow to the parent company. Spin-offs are often tax-free to the parent company and to the shareholders receiving stock in the spin-off. In addition, a spin-off can be an effective method for minimizing the execution risk of a divestiture, whether due to third-party negotiations or to market conditions. Spin-offs also have smaller underwriting discounts and fees than transactions such as carve-outs. Moreover, the shareholders of the parent company receive a direct benefit by obtaining the stock of the spun-off subsidiary, as opposed to the less direct benefits of the parent company receiving the proceeds of a negotiated sale. In the US spin-offs have become increasingly popular in the last decade, with firms seeking to divest a part of their businesses. Most of these spin-offs involve a pro rata distribution of shares in a wholly owned subsidiary to the shareholders of the firm, in the form of a dividend. After the distribution, both the parent and the subsidiary initially share the same shareholder base, even though the operations and management of the two entities are now separate and independent of each other. Another important feature of a spin-off that sets it apart from other types of corporate divestitures is that it does not provide the parent with any cash infusion. Recently, there has been a noticeable trend towards two-step spin off transactions, where parent firms first sell up to 20% of the shares in the subsidiary in an initial public offering, followed shortly by a distribution of the remaining shares to its shareholders. The 20% limit is usually observed in the first step in order to preserve the tax-free status of the transaction. Why firms choose to pursue a two-step spin-off instead of a 100% pure spin- off is unclear. Previous research generally focuses on pure spin-offs, so this question has yet to be addressed. A possible reason for a two-step spin-off is to avoid the dip in the stock price that the spun-off subsidiary usually experiences in the first few months following the distribution. This initial stock price decline is usually associated with the portfolio rebalancing activities of large institutional investors who may not wish to hold the shares of the subsidiary given away by the parent in a spin-off transaction. For example, the manager of an index fund may be required to sell the shares of the spun-off subsidiary if that subsidiary does not form part of the index. In a two-step spin-off, the minority carve-out enables the parent firm to create an orderly market for the new issue, so as to avoid flooding the market with a large number of shares, as in the case of a pure spin-off (Lament and Thaler, 2000). Also, since the carve-out takes the form of an IPO, investment banks are often committed to help support and market the new issue - a feature that is also conspicuously absent in a pure spin-off transaction. When the second step of the spin-off takes place, the market is then better positioned to support the portfolio rebalancing activities highlighted above. There is a wealth of research on the effects of spin-offs on both parent and subsidiary firms. Early research efforts focused mainly on the changes in parent company share prices at the time of the spin-off announcement. In a study of 6 major spin-offs in the 1970s, Kudla and Mclnish (1983) showed a positive market reaction in the parents' stock 15 to 40 weeks before the distribution took place - an indication that the market correctly predicted the spin-off well ahead of the actual event. This result has been supported by many other studies for periods that date back as early as 1963 to 1981. Cusatis, Miles and Woolridge (1993) were among the first researchers to focus on the performance of the subsidiary post-spin-off. They examined 815 spin-offs from 1965 to 1988 and found significantly positive abnormal returns for the spun-off subsidiary, the parent and the spin-off-parent combination for a period of up to three years after the spin-off announcement date. They also found that the abnormal returns were attributable to increased takeover activity, which was not folly anticipated by the market at the time of the spin-off announcement. Hence, they concluded that earlier event studies underestimated the value created by spin-offs. A 1997 study done by J P Morgan provided evidence that the positive stockholder wealth effects continued well into the 1990s. Also, it was found that smaller spin-offs (with an initial market capitalization of less than $200 million) significantly outperformed their larger counterparts. J P Morgan attributed this to underpricing by the market, which was in turn due to the lack of knowledge on the part of investors. 174 An interesting phenomenon reflected in the graphs showing the post-distribution stock returns of the spun-off subsidiary, but not investigated by J P Morgan, is the initial decline in returns experienced by the spin-offs in approximately the first 30 trading days after the distribution. Thereafter, the downward trend is reversed and returns become positive three months after the spin-off date. This pricing anomaly, however, had already been picked up by the press and documented by other researchers such as Brown and Brooke (1993) and Abarbanell, Bushee and Raedy (1998). Brown and Brooke reported price declines of approximately 4% in spun- off subsidiaries that coincided with substantial reductions in institutional holdings in these firms, and concluded that the sudden and substantial sell-off of subsidiary shares by institutional investors as part of their portfolio rebalancing activities explained the downward pressures on price and consequently returns. Likewise, Abarbanell et al. found empirical evidence supporting the initial decline in the stock returns of the spun-off subsidiary. In a study of 179 spin-offs between 1980 and 1996, they noted that the overall returns to subsidiaries were significantly negative within 10 trading days of the distribution date, and this was consistent with a decrease in mean level of institutional ownership. In fact, a negative abnormal return of- 4.12% was observed for a 35-day trading period (similar to the finding by Brown and Brooke) and it took another 25 trading days for this trend to completely reverse. However, Abarbanell et al. did not find any reliable evidence that led them to conclude that this decline was associated with institutional sell-offs. Tax Consideration Spin offs consist of multiple spin offs not taxable to shareholders. To avoid ordinary income taxes the parent and the subsidiary must have been engaged in business for 5 years prior to the spin-off. The subsidiary should be at least 80% owned by the parent. And parent has to distribute the shares in the subsidiary without a prearranged plan for these securities to be resold. Treatment of Warrants and Convertibles Securities When the parent company has issued the warrants and the securities the conversion ratio may have to be adjusted. The spin-off may cause the common stock in the parent company to be less valuable if the deal is structured for the gain through the distribution of the proceeds in the form of special dividend. Warrant and security holders may not participate in this gain. The stock price of the parent company may fall because it will be less likely that the price will rise high to enable the securities to be converted. If this is the case, the conversion prices may not need to be adjusted as part of the terms of the deal. Employee Stock Option Plans Employee's shares are held under an employee stock option plan. The number of the shares obtained also need to be adjusted after the spin-off. The adjustment is designed to leave the market value of the shares that could be obtained after the spin-off at the same level. The main goal is to maintain the market value of the shares that may be obtained through the conversion of the employee stock options. It has grown its popularity since 1992. Its growth was partly fueled by investors' preferences to release the internal values in the company's stock prices. Disadvantages of Spin-offs • There will be considerable selling pressure from institutions and index funds immediately after the spin-off. This will have a downward pressure on the stock price in the short-term. • As shares are distributed primarily to existing shareholders, spin-off lack liquidity. • From the disposition proceeds the parent does not get anything. • The parent company does not gain monetarily through the spin off. • A spin off is often perceived as a method for getting rid of a sub-par asset by the parent. • The new company formed by the spin off has to incur expenses for issuing new shares. • Servicing the shareholders will lead to duplication of the activities in parent and the spun off company. EQUITY CARVE-OUTS An Equity Carve-out (ECO) is a partial public offering of a wholly owned subsidiary. Unlike spin-offs, ECOs generate a capital infusion because the parent offers shares in the subsidiary to the public through an IPO, although it usually retains a controlling interest in the subsidiary. Like spin-offs, ECOs have become increasingly popular in the last several years. 175 An equity carve-out involves conversion of an existing division or unit into a wholly owned subsidiary. A part of the stake in this subsidiary is sold to outsiders. The parent company may or may not retain controlling stake in the new entity. The shares of the subsidiary are listed and traded separately on the stock exchange. Equity carve-outs result in a positive cash flow to the parent company. An equity carve-out is different from a spin-off because of the induction of outsiders as new shareholders in the firm. Secondly equity carve-outs require higher levels of disclosure and are more expensive to implement. The potential benefits of equity carve-out include: "Pure play" Investment Opportunity: Pure plays have been in much demand by investors in recent years. An ECO, especially for a subsidiary that is not involved in the parent's primary business or industry, increases the subsidiary's visibility as well as analyst and investor awareness. This enhances its overall value. Investors also like ECO pure plays because separating the parent and subsidiary minimizes cross-subsidies and other potentially inefficient uses of capital. Management Scorecard and Rewards: Management is evaluated on a daily basis through the company's stock price. This immediate, visible scorecard can boost performance by spurring managers to make timely strategic decisions and concentrate on the factors that contribute to better shareholder value. Correspondingly, managers are also more likely to be rewarded for improved results. Capital Market Access: An ECO typically improves access to capital markets for both the parent and the subsidiary. Process of Equity Carve-out A typical carve-out scenario in the US begins with the parent publicly announcing its intention to offer securities in a subsidiary or division through an ECO. Since an ECO is a type of IPO, companies must file an S-l registration statement with the SEC. Registration requires three years of audited income statements, two years of audited balance sheets, and five years of selected historic financial data. The ensuing process — including the preparation of financial and registration statements, SEC review, responses, and amendments, and offering marketing — normally takes up to six months. Once the SEC reviews and declares it effective, the parent can sell the offering, either listing the spin-off on an exchange or providing for trading over the counter. Either the parent or the carve-out (or both) can receive the IPO proceeds. If the subsidiary sells the shares, the IPO represents a primary offering. Over 70 percent of the companies in the researchers' sample reported handling the ECO in this manner. If the parent sells the shares (known as secondary shares), it must recognize the difference between the IPO proceeds and its basis as a gain or loss for tax purposes. If the subsidiary sells the shares in the IPO, neither the parent nor the carve-out incurs a tax liability. When the ECO sells the shares, it often uses some of the proceeds to repay loans to the parent or pay a special dividend. A relatively small number of ECOs are handled as joint offerings of the parent and subsidiary. A study has found that 50 percent of the ECOs used for the proceedings of primary offerings to repay loans to the parent, 30 percent to be retained, and 20 percent pay to creditors. In secondary offerings, 50 percent of the parents ECOs retain the proceeds, while 50 percent pay to creditors. The research indicates that the initial stock market reaction to an ECO announcement is more favorable if the subsidiary retains the funds. After the IPO, all transactions between the parent and the subsidiary must be conducted on an arm's-length basis and disclosed in the registration statement. The parent typically continues to perform certain corporate services, such as investor relations, legal and tax services, human resources, data processing, and banking services, on a contractual basis. Characteristics of ECO candidate Strong potential ECO candidates have some or all of the following characteristics. Strong Growth Prospects: If the subsidiary is in an industry with better growth prospects than the parent, it will likely sell at a higher price/earnings multiple once it has been partially carved out of the parent. Independent Borrowing Capacity: A subsidiary that has achieved the size, asset base, earnings and growth potential, and identity of an independent company will be able to generate additional financing sources and borrowing capacity after the carve-out. 176 Unique Corporate Culture: Subsidiaries whose corporate culture differs from that of the parent may be good ECO candidates because the carve-out can offer management the freedom to run the company as an independent entity. Companies that require entrepreneurial cultures for success can especially benefit from this transaction. Special Industry Characteristics: Subsidiaries with unusual characteristics are often better suited to decentralized management decision-making, which may allow management to respond more quickly to changes in technology, competition, and regulation. Management Performance, Retention, and Rewards: Subsidiaries that compete in industries where management retention is an issue and targeted reward systems are required can benefit from an ECO. After the Equity Carve-Out While analyzing a sample of ECOs, researchers found important increases in sales, operating income before depreciation, total assets, and capital expenditures. However, they believe these improvements owe less to newly gained efficiencies than to the carve-out's growth after going public. This is because the relative growth rates were not positive or statistically significant. Note that ECOs, like spin-offs, are subject to a great deal of takeover activity. In the sample, 50% of the ECOs were acquired within three years. An analysis of returns for these companies suggests that ECOs that are taken over perform better than average, while those that are not perform worse than average. Nonetheless, even the latter outperform, on average, in other types of firms. Overall, it is clear that ECOs earn significantly positive abnormal stock returns for up to three years after the carve-out. Parents, on the other hand, earn negative stock returns. As with spin-offs, these higher-than-normal stock returns are associated with better operating performance and corporate restructuring activity. As a restructuring device, ECOs clearly seem to lead to better operating performance (on average) and greater increases in shareholder value. In a study of equity carve-outs by J P Morgan, it was found that carve-out firms in which the parent firm announced that a spin-off would follow at a later date, outperformed the market by 11% for a period of 18 months after the initial public offering, while carve-out firms without spin-off announcements under performed the market by 3%. Equity carve outs involve the sale of an equity interest in a subsidiary to outsiders. This sale may not necessarily leave the parent in control of the subsidiary. Post carve-out, the partially divested subsidiary is operated and managed as a separate firm. Disadvantages of Equity Carve-Outs The biggest disadvantage of carve-outs is the scope for conflict between the two companies as operation level conflict occurs because of the creation of a new group of financial stakeholders by the mangers of the carved- out company. The requirements of these stakeholders differ from those of the original stakeholders. This conflict can hinder the performance of both firms. The stock performance of a company that has carved out 70 to 100 percent is better than that of a company that has carved-out less than 70 percent. This indicates that lack of separation between the two entities prevents the carved-out entity from reaching its potential. Split-Off In a split-off, a new company is created to takeover the operations of an existing division or unit. A portion of the shares of the parent company are exchanged for the shares of the new company. In other words, a section of the shareholders will be allotted shares in the new company by redeeming their existing shares. The logic of split-off is that the equity base of the parent company should be reduced reflecting the downsizing of the firm. Hence the shareholding of the new entity does not reflect the shareholding of the parent firm. Just .as in spin- off, a split-off does not result in any cash inflow to the parent company. Split-Up Split-up results in the complete break up of a company into two or more new companies. All the division or units are converted into separate companies and the parent firm ceases to exist. The shares of the new companies are distributed among the existing shareholders of the firm. The term "split-up" is defined as the division of a company into two or more publicly traded comparatively substantial entities through one or more transactions. 177 Chapter 8 Financial Engineering ACTIVITY BASED COSTING Applying overhead costs to each product or service based on the extent to which that product or service causes overhead cost to be incurred is the primary objective of accounting for overhead costs. In many production processes, overhead is applied to products using a single predetermined overhead rate based on a single activity measure. With Activity-Based Costing (ABC), multiple activities are identified in the production process that are associated with costs. The events within these activities that cause work (costs) are called cost drivers. Examples of overhead cost drivers are machine set-ups, material-handling operations, and the number of steps in a manufacturing process. Examples of cost drivers in non-manufacturing organizations are hospital beds occupied, the number of take-offs and landing for an airline, and the number of rooms occupied in a hotel. The cost drivers are used to apply overhead to products and services when using ABC. The following five steps are used to apply costs to products under an ABC system. 1. Choose appropriate activities 2. Trace costs to activities 3. Determine cost drivers for each activity 4. Estimate the application rate for each cost driver 5. Apply costs to products. These steps are discussed in more detail below. Choose Appropriate Activities The first step of ABC is to choose the activities that result in incurring of overhead costs. These activities do not necessarily coincide with existing departments but rather represent a group of transactions that support the production process. Typical activities used in ABC are designing, ordering, scheduling, moving materials, controlling inventory, and controlling quality. Each of these activities is composed of transactions that result in costs. More than one cost pool can be established for each activity. A cost pool is an account to record the costs of an activity with a specific cost driver. Trace Costs to Activities Once the activities have been chosen, costs must be traced to the cost pools for different activities. To facilitate this tracing, cost drivers are chosen to act as vehicles for distributing costs. These cost drivers are often called resource drivers. A predetermined rate is estimated for each resource driver. Consumption of the resource driver in combination with the predetermined rate determines the distribution of the resource costs to the activities. Determine Cost Drivers for Activities Cost drivers for activities are sometimes called activity drivers. Activity drivers represent the event that causes costs within an activity. For example, activity drivers for the purchasing activity include negotiations with vendors, ordering materials, scheduling their arrival, and perhaps inspection. Each of these activity drivers represents costly procedures that are performed in the purchasing activity. An activity driver is chosen for each cost pool. If two cost pools use the same cost driver, then the cost pools could be combined for product-costing purposes. Cooper has developed several criteria for choosing activity drivers. First, the data on the cost driver must be easy to obtain. Second, the consumption of the activity implied by the activity driver should be highly correlated with the actual consumption of the activity. The third criterion to consider is the behavioral effects induced by the choice of the activity driver. Activity drivers determine the application of costs, which in turn can affect individual performance measures. The judicious use of more activity drivers increase the accuracy of product costs. Ostrenga concludes that there is a preferred sequence for accurate product costs. 178 Direct costs are the most accurate in applying costs to products. The application of overhead costs through cost drivers is the next most accurate process. Any remaining overhead costs must be allocated in a somewhat arbitrary manner, which is less accurate. Estimate Application Rates for each Activity Driver An application rate must be estimated for each activity driver. A predetermined rate is estimated by dividing the cost pool by the estimated level of activity of the activity driver. Alternatively, an actual rate is determined by dividing the actual costs of the cost pool by the actual level of activity of the activity driver. Standard costs, could also be used to calculate a predetermined rate. Applying Costs to Products The application of costs to products is calculated by multiplying the application rate times the usage of the activity driver in manufacturing a product or providing a service. Examples of Activity Based Costing Alpha Motors Inc. produces electric motors. The company makes a standard electric-starter motor for a major auto manufacturer and also produces electric motors that are specially ordered. The company has four essential activities: design, ordering, machinery, and marketing. Alpha Motors incurs the following costs during the month of January: Traditional cost accounting would apply the overhead costs based on a single measure of activity. If direct labor was used, then the overhead rate would be Rs.60,00,000/(Rs. 10,00,000 + Rs.2,00,000), or 500% of direct labor. Hence: Overhead to standard motors ~ 500% of Rs.10,00,000 of direct labor Standard Motors Special Order Motors Direct labor Rs.10,00,000 Rs.2,00,000 Direct materials 30,00,000 10,00,000 Overhead: Indirect labor Rs.35,00,000 Depreciation of building 2,00,000 Depreciation of equipment 10,00,000 Maintenance 3,00,000 Utilities 10,00,000 60,00,000 =Rs.50,00,000 Overhead to special-order motors = 500% of Rs.2,00,000 of direct labor = Rs.10,00,000 With ABC, activities are chosen and the overhead costs are distributed to cost pools within these activities through resource drivers. The costs of activities are then applied to products through activity drivers. Alpha Motors performs the following activities: designing, ordering, machining, and marketing. Each activity has one cost pool. The overhead costs are distributed to the cost pools of the activities using the following resource drivers: Overhead Account Resource Driver Indirect labor Labor hours Depreciation of building Area of building Depreciation of equipment Machine time Maintenance Area of building Utilities Amps used 179 The usages of the resource drivers by activity are: Designing Ordering Machining Marketing Totals Labor hours 1,00,000 20,000 1,00,000 1,30,000 3,50,000 Sq. ft. of building 50,000 30,000 1,00,000 20,000 20,00,000 Machine time 0 0 10,00,000 0 10,00,000 Amps 2,00,000 1,00,000 16,00,000 1,00,000 20,00,000 The resource driver application rates are calculated by dividing overhead costs by total resource driver usage: Overhead Account Resource Driver Cost of Overhead Total Driver Usage Application Rate Indirect labor - Labour hours Rs. 3,50,000 Rs. 10/Labor 35,00,000 labour-hours hour Depreciation of Area of 2,00,000 2,00,000 sp.ft. Re. 1/sq.ft. Building building Depreciation of Machine 10,00,000 50,000 hrs. Rs. 20/hr. Machinery time Maintenance Area of 3,00,000 2,00,000 sq.ft. Rs.l.SO/sq.ft building Utilities Amps used 10,00,000 20,00,000 amps 0.50/amps By multiplying the application rate times the resource usage of each activity, overhead costs can be allocated to the different activities. For example, the cost of the indirect labor allocated to the designing activity is Rs.l0/labor hour i.e. Rs. 10,00,000. Designing Rs. Ordering Rs. Machining Rs. Marketing Rs. Totals Rs. Indirect labor 10,00,000 2,00,000 10,00,000 13,00,000 35,00,000 Depreciation of building 50,000 30,000 1,00,000 20,000 2,00,000 Depreciation of equipment 10,00,000 10,00,000 Maintenance 75,000 45,000 1,50,000 30,000 3,00,000 Utilities 1,00,000 50,000 8,00,000 50,000 10,00,000 Totals 12,25,000 3,25,000 30,50,000 14,00,000 60,00,000 Once the overhead costs have been distributed to the activity cost pools, activity drivers must be chosen to apply the costs to the products. Suppose the following activity drivers are chosen: Activity Activity Driver Designing Design changes Ordering Number of orders Machining Machine time Marketing Number of contracts with customer Alpha Motors uses actual costs and activity levels to determine the application rates shown below: Activity Driver Costs of Activity Total Driver Usage Application Rate Design changes Rs.12,25,000 12,250 changes Rs.l00/change Number of orders 3,25,000 6,500 orders Rs.50/orders Machine time 30,50,000 152.5 hours Rs.2000/hours Number of contracts 14,00,000 7,000 contracts Rs.200/contract The application rates are then multiplied by the cost driver usage for each product to determine-the costs applied. The ABC method applied a much higher amount of the overhead cost to the special-order electric motors than when all overhead was applied by direct-labor basis. The reason for the greater overhead application to the special-order electric motors is the greater usage of the activities that enhance the manufacturing of the electric 180 motors during their production. Use of direct-labor hours to allocate overhead does not recognize the extra overhead requirements of the special-order electric motors. Misapplication of overhead could lead to inappropriate product line decisions. The greater the diversity of requirements of products on over head-related services and other overhead costs, the greater the need for an ABC system. Other Benefits of Activity Based Costing ABC is" valuable for planning, because the establishment of an ABC system requires a careful study of the total manufacturing or service process of an organization. ABC highlights the causes of costs. An analysis of these causes can identify activities that do not add to the value of the product. These activities include moving materials and accounting for transactions. Although these activities cannot be completely eliminated, they may be reduced. A recognition of how various activities affect costs can lead to modifications in the planning of factory layouts and increased efforts in the design process stage to reduce future manufacturing costs. An analysis of activities can also lead to better performance measurement. Workers on the line often understand activities better than costs and can be evaluated accordingly. At higher management levels, the activities can be aggregated to be in line with responsibility centers. Managers would be responsible for the costs of the activities associated with their responsibility centers. Weaknesses of Activity Based Costing First, ABC is based on historical costs. For planning decisions, future costs are generally the relevant costs. Second, ABC does not partition variable and fixed costs. For many short run decisions, it is important to identify variable costs. Third, ABC is only as accurate as the quality of the cost drivers. The distribution and application of costs becomes an arbitrary allocation process when the cost drivers are not associated with the factors that are causing costs. And finally, ABC tends to be more expensive than the more traditional methods of applying costs to products. Organizational Base Costing – It is a traditional costing that considers the cost of a product to be its direct costs for materials and labor, plus some allocated portion of manufacturing overhead. In OBC, overhead rates are allocated to products using a plant-wide or departmental overhead rates, i.e. cost assignment follows the organization chart. Product Costing Continuum Organizational-Based Costing (OBC) Activity-Based Costing (ABC)* Plant-Wide Departmental Two-Stage Models Multiple Stage Models Overhead Overhead Rate Methods *Also varies in number of cost drivers at each level Deciding the number of cost drivers • To decide on the number of cost drivers, the following factors can be considered: – Purpose of the system • The objectives of the system will determine how many cost drivers are needed • The greater the number of cost drivers, the greater will be the cost of designing and maintaining the system – Resources availability • Cost benefit analysis can be applied, companies should always ask the question as to whether the incremental benefit is justifiable in terms of the incremental cost incurred. The ultimate question is whether the company can afford the best system available given its requirements. – Company complexity • Product as the cost object: – Number of production processes – Total indirect costs – Product diversity • Customer as the cost object: – Number of distribution channels – Steps in distribution system – Variety in items – Customer diversity 181 ECONOMIC VALUE ADDED (EVA) Economic Value Added or EVA is the economic profit generated after the cost of invested capital. EVA incorporates the opportunity cost of invested capital that is not realized by traditional accounting measures. Numerous studies have shown EVA to have a higher correlation to stock valuation than accounting based measures. EVA = Net Operating Profit after Tax - (Invested Capital x Cost of Capital) There are two steps required to convert GAAP net income to EVA. First, calculate net operating profit after tax (NOPAT) by adjusting net income. Common adjustments include extraordinary gains and losses, securities gains and losses, provision expenses and preferred stock dividends. Second, calculate invested capital and apply cost of capital. Invested capital includes book value of common and preferred equity, after-tax allowance for loan losses, and certain adjustments for cumulative non-operating gains and losses. Cost of capital equals the minimum required rate of return for investors {e.g. 15%). Whenever EVA is positive, shareholders have received a total economic return on their investment in excess of their required rate of return. . CASH FLOW RETURNS ON INVESTMENT (CFROI) CFROI is defined as the return on investment expected over the average life of the firm's existing assets. CFROI is nothing but another form of IRR measure. The key difference between the IRR and CFROI is that cash flows and investment are stated in constant monetary units in CFROI which overcome deficiencies of the traditional return on investment methods. LEVERAGE- Leverage in the general sense means influence of power i.e., utilizing the existing resources to attain something else. Leverage in terms of financial analysis is the influence which an independent financial variable has over a dependent/related financial variable. When leverage is measured between two financial variables it explains how the dependent variable responds to a particular change in the independent variable. To explain further, let X be an independent financial variable and Y its dependent variable, then the leverage which Y has with X can be assessed by the percentage change in Y to a percentage change in X. where LY/LX measure of the leverage which dependent Y has with independent X AX change in X AY change in Y A X/X - percentage change in X AY/Y percentage change in Y Measures of Leverage To better understand the importance of leverage in financial analysis, it is imperative to understand the three measures of leverage. • Operating Leverage • Financial Leverage • Combined/ Total Leverage. These three measures of leverage depend to a large extent on the various income statement items and the relationship that exists between them. Given below is the Income Statement of XYZ Company Ltd. and the relationship that exits between the various items of the statement: Income Statement of XYZ Company Ltd. Item Amount (Rs.) Total Revenue 25,00,000 Less: Variable Expenses (V) 10,00,000 Fixed Expenses (F) 9,00,000 Earnings Before Interest & Tax (EBIT) 6,00,000 Less; Interest on Debt (I) 75,000 Profit Before Tax (PBT) 5,25,000 Less:Tax @ 50% (T) 2,62,500 182 Profit After Tax (PAT) 2,62,500 Less: Preference dividend (Dp) 50,000 Equity Earnings 2,12,500 Total Revenue = Quantity Sold (Q) x Selling Price (S) Hence, EBIT = QxS-QxV-F = Q(S-V)-F ...(i) EPS = r(EBIT-I)(l-T)-DJ/N ...(ii) ...(iii) where N = No. of Equity Shareholders The above three equations [(i), (ii) and (iii)] which establish the relationship between the various items of the Income Statement form the base for the measurement of the different leverages. OPERATING LEVERAGE Operating leverage examines the effect of the change in the quantity produced on the EBIT of the company and is measured by calculating the Degree of Operating Leverage (DOL). DOL = Percentage change in EBJT/Percentage change in Output From Eq(i) EBIT = Q(S - V) - F Substituting for EBIT, we get DOL = [Q(S-V)]/[Q(S-V)-F] ....(iv) Illustration 8.1 Calculate the DOL for XYZ Company Ltd. given the following additional information: Quantity produced 5,000 Variable cost per unit Rs,200 Selling price per unit Rs.500 Fixed asset Rs.9,00,000 DOL of XYZ Company Ltd. = [5,000(500 - 200)]/[5,000(500 - 200) - 9,00,000] = 2.50 Application and Utility of the Operating Leverage It is important to know how the operating leverage is measured, but equally essential is to understand its application and utility in financial analysis. To understand the application of DOL one has to understand the behavior of DOL visa-vis the changes in the output by calculating the DOL at the various levels of Q. Following are the different DOL for the various levels of Q for XYZ Company Ltd.: Quantity Produced Degree of Operating Leverage 1000 -0.5 2000 -2.0 3000 00 4000 4.0 5000 2.5 When the value of Q is 3000 the EBIT of the company is zero and this is the operating break-even point. Thus, 183 at operating break-even point, where the EBIT is zero, the quantity produced can be calculated as follows: Q = F/(S - V) For XYZ Company Ltd.: Q - 9,00,0007(500 - 200) = 3,000 After measuring the DOL for a particular company at varying levels of output the following observations can be made: • Each level of output has a distinct DOL. • DOL is undefined at the operating break-even point. • If Q is less than the operating break-even point, then DOL will be negative (which does not imply that an increase in Q leads to a decrease in EBIT). • If Q is greater than the operating break-even point, then the DOL will be positive. However, the DOL will start to decline as the level of output increases and will reach a limit of 1. IMPLICATIONS Determining Behavior of EBIT DOL helps in ascertaining change in operating income for a given change in output (quantity produced and sold). If the DOL of a firm is say, 2, then a 10% increase in the level of output will increase operating income by 20%. A large DOL indicates that small fluctuations in the level of output will produce large fluctuations in the level of operating income. In Table 8.1, two firms with different cost structures are compared. Table 8.1 Cost and Profit Schedules for Bell Metal Works and Fibre Glass Ltd. Bell Metal Works Fibre Glass Limited Units Produced & Sold Sales Total Operating Cost EBIT Units Produced & Sold Sales Total Operating Cost EBIT Q PQ Q PQ (In Rupees) (In Rupees} 10.000 1,00,000 1,60,000 (60,000) 10,000 1,00,000 2,40,000 (1,40,000) 20,000 2.00,000 2,30,000 (30,000) 20,000 2,00,000 2,90,000 (90,000) 30,000 3,00,000 3,00,000 0 30,000 3,00,000 3,40,000 (40,000) 40,000 4,00,000 3,70,000' 30,000 40.000 4,00,000 3,90,000 10,000 50,000 5,00.000 4,40,000 60,000 50,000 5,00,000 4,40,000 60,000 60,000 6,00,000 5,10,000 90,000 60,000 6,00,000 4,90,000 .1,10,000 70,000 7,00,000 5,80,000 1,20,000 70.000 7,00,000 5,40,000 1,60,000 80,000 8,00,000 6,50,000 1,50,000 80,000 8,00,000 5,90,000 2,10,000 Unit Selling Price (P) = Rs.10 Unit Selling Price (P) = Rs.10 . Operating Fixed Costs (F) = Rs.90,000 Operating Fixed Costs (F) = Rs.1. 90,000 Unit Variable Operating Cost (V) = Rs.7 Unit Variable Operating Cost (V) = Rs,5 EBIT Break-even Point = 30,000 units EBIT Break-even Point = 38,000 units From table 8.1, we can see that Bell Metal Works has lower fixed costs and higher variable cost per unit when compared to Fibre Glass Limited. The selling price per unit (P) of both firms is the same, viz., Rs.10. An interesting point we notice is that at an output of 50,000 units both firms have the same profit i.e., Rs.60,000. However, as sales fluctuate, the EBIT of Bell Metal Works fluctuates for less than the EBIT of Fibre Glass Limited. This brings us to the conclusion that the DOL of Fibre Glass Limited is greater than the DOL of Bell Metal Works. Let us compute the DOL of these two firms at an output of 50,000 units. For Bell Metal Works: DOL = [50,000 (10 - 7)] / [50,000 (10 - 7) - 90,000] = 2.5 For Fibre Glass Limited: DOL = [50,000 (10 - 5)] / [50,000(10 - 5) - 1,90,000] 184 = 4.17 The figures prove our conclusion to be right. • Measurement of Business Risk: We know that the greater the DOL, the more sensitive is EBIT to a given change in unit sales, i.e. the greater is the risk of exceptional losses if sales become depressed. DOL is therefore a measure of the firm's business risk. Business risk refers to the uncertainty or variability of the firm's EBIT. So, every thing else being equal, a higher DOL means higher business risk and vice-versa. • Production Planning: DOL is also important in production planning. For instance, the firm may have the opportunity to change its cost structure by introducing labor-saving machinery, thereby reducing variable labor overhead while increasing the fixed costs, Such a situation will increase DOL. Any method of production which increases DOL is justified only if it is highly probable that sales will be high so that the firm can enjoy the increased earnings of increased DOL. FINANCIAL LEVERAGE While operating leverage measures the change in the EB1T of a company to a particular change in the output, the financial leverage measures the effect of the change in EBIT on the EPS of the company. Financial leverage also refers to the mix of debt and equity in the capital structure of the company. The measure of financial leverage is the Degree of Financial Leverage (DFL) and it can be calculated as follows: DFL = (percentage change in EPS)/ (percentage change in EBIT) DFL = (AEPS/EPS)/(AEBTT/EBIT) Substituting Eq (ii) for EPS we get, Taking the example of XYZ Company Ltd., which has an EBIT of Rs.6,00,000 at 5,000 level of production, the capital structure of the company is as follows: Capital Structure Amount (Rs.) Authorized Issued and Paid-up Capital 500000 Equity Shares @ Rs. 10 each 50,00,000 15% Debentures 5,00,000 10% Preference Shares 5000 Preference Shares @ Rs.100 5,00,000 Total 60,00,000 Let us now calculate the DFL of XYZ Company Ltd. Earnings Before Interest and Tax (ERIT) = Rs.6,00,000 Interest on Long-term Debt (I) = Rs.75,000 Preference Dividend (Dp) = Rs.50,000 Corporate Tax (T) = 50% 6,00,000 DFL 50,000 6,00,000-75,000 1-0.5 Application and Utility of the Financial Leverage Financial leverage when measured for various levels of EBIT will aid in understanding the behavior of DFL and also explain its utility in financial decision making. Consider the case of XYZ Company Ltd. to measure DFL for varying levels of EBIT. EBIT (Rs.) DFL 50,000 -0.40 185 1,00,000 -1.33 1,75,000 00 6,00,000 1.41 7,00,000 1.33 7,50,000 1.30 The DFL at EBIT level of 175000 is undefined and this point is the Financial Break-even Point. It can be defined as: EBIT = I + Dp/(l-T) The following observations can also be made from studying the behavior of DFL. • Each level of EBIT has a distinct DFL. • DFL is undefined at the financial Break-even Point. • DFL will be negative when the EBTT level goes below the Financial Break-even Point • DFL will be positive for all values of EBIT that are above the Financial Break-even Point. This will however start to decline as EBIT increases and will reach a limit of 1. By assessing the DFL one can understand the impact of a change in EBLT on the EPS of the company. In addition to this it also helps in assessing the financial risk of the firm, Impact of Financial Leverage on Investor's Rate of Return Let us see with the help of a very simple example, how financial leverage affects return on equity. A company needs a capital of Rs. 10,000 to operate. This money may be brought in by the shareholders of the company. Alternatively, a part of this money may also be brought in through debt financing. If the management raises Rs. 10,000 from shareholders, the company is not financially leveraged and would have the following balance sheet. The use of debt in the company's capital structure has caused the net profit to decline from Rs. 1,500 to Rs. 1,000. But has the return on owner's capital declined? Return on Equity now works out to 30%, as. the owners have invested only Rs.3,333 now which earned them Rs.1,000. What were the factors which contributed to this additional return? We can trace out two sources of this additional return: • though the company has to pay interest at 15% on borrowed capital, the company's operations have been able to generate more than 15% which is being transferred to the owners. • the reduction in PBT has brought about a reduction in the amount of tax paid, as interest is a tax deductible expense, to the extent of interest (1 - tax rate) i.e., Rs.500. The greater the tax rate, the more is the tax shield available to a company which is financially leveraged. As was seen in the above example, a company may increase the return on equity by the use of debt i.e., the use of financial leverage. By increasing the proportion of debt in the pattern of financing i.e., by increasing the debt-equity ratio, the company should be able to increase the return on equity. Financial Leverage and Risk If increased financial leverage leads to increased return on equity, why do companies not resort to ever increasing amounts of debt financing? Why do financial and other term lending institutions insist on norms for Debt-Equity Ratio? The answer is that as the company becomes more financially leveraged, it becomes riskier, i.e., increased use of debt financing will lead to increased financial risk which leads to: • Increased fluctuations in the return on equity. • Increase in the interest rate on debts, Increased Fluctuations in Returns In the previous example, let us assume that sales decline by 10% (from Rs. 10,000 to Rs.9,000), expenses remaining the same, What happens to return on equity? The income statements for the financially unleveraged and leveraged firms will appear as follows: Unleveraged Firm (zero Debt) Leveraged Finn (Debt-Equity Ratio 2 : 1) 186 Sales 9,000 9,000 Expenses 7,000 7,000 EBIT 2,000 2,000 Interest Charges - 1,000 (6667x0.15) PBT Tax @5Q% 2,000 1,000 1,000 500 Net Profit 1,000 500 Net Profit at Sales of Rs, 10,000 1,500 1000 ROE at Sales of Rs. 10,000 15% 30% ROE at Sales of Rs.9,000 10% 15% We see that a 10% decline in sales produces substantial declines in earnings and the rates of return on owner's equity in both cases. But the decline is greater for the financially leveraged firm than for the financially unleveraged firm. Why is this so? The reason can be traced to the fact that once a firm borrows capital, interest payments become obligatory and hence fixed in nature. The same interest payment which was the cause for increase in owner's equity when sales were Rs. 10,000 is now the cause for its more than proportional decline with a decline in sales. Hence, the greater the use of financial leverage, the greater the potential fluctuation in return on equity. INCREASE IN INTEREST RATES Firms that are highly financially leveraged are perceived by lenders of debt as risky. Creditors may refuse to lend to a highly leveraged firm or may do so only at higher rates of interest or more stringent loan conditions. As the interest rate increases, the return on equity decreases. However, even though the rate of return diminishes, it might still exceed the rate of return obtained when no debt was used, in which case financial leverage would still be favorable. IMPLICATIONS Let us again refer to our earlier example. In the first situation, the company was unleveraged, in the second situation the debt-equity ratio was 2:1. The balance sheet and income statements are reproduced below; Balance Sheets Unleveraged Leveraged Liabilities Assets [Liabilities Assets Equity Capital 10,000 Cash 10,000 Equity Capital Debt Debt 3,333 Cash 10,000 6,667 10,000 10,000 10,000 10,000 Income Statements Unleveraged Leveraged Sales 10,000 10,000 Expenses 7,000 7,000 EBIT 3,000 3,000 Interest - 1,000 PBT 3,000 2,000 Tax @ 50% 1,500 1,000 Net Profit 1,500 1,000 The Degree of Financial Leverage (DFL) in each case is calculated as: 187 What do these figures imply? They imply that if EBIT is changed by 1%, EPS will also change by 1%, the company uses no debt. However, EPS changes by 1,5% when it uses debt in the ratio of 2:1 (66.67% of total capital). This is proof of what we have stated earlier: The greater the leverage, the wider are fluctuations in the return on equity and the greater is the financial risk the company is exposed to. Through an EBIT-EPS analysis, we can evaluate various financing plans or degrees of financial leverage with respect to their effect on EPS. TOTAL LEVERAGE A combination of the operating and financial leverages is the total or combined leverage. Thus, the degree of total leverage (DTL) is the measure of the output and EPS of the company. DTL is the product of DOL and DFL and can be calculated as follows; DTL = % change in EPS / % change in output = (AEPS/EPS)/(AQ/Q) DTL = DOL x DFL = {[Q(S-V)]/[Q(S-V)-F]}X {[Q(S - V) - F]/Q(S - V) - F - I - [Dp/1 - T)]} Calculating the DTL for XYZ Co. Ltd. given the following information: Equity Earnings = Rs.1,62,500 Quantity Produced (Q) 5000 Units Variable Cost per unit (V) = Rs.200 Selling Price per unit (S) = Rs.500 Number of Equity Shareholders (N) 5,00,000 Fixed Expenses (F) = Rs.9,00,000 Interest (I) = Rs.75,000 Preference Dividend (Dp) Rs.50,000 Corporate Tax (T) = 50% = 3.53 DTL = DOL x DFL - 2.5x1.41 -3.53 Thus, when the output is 5,000 units, a one percent change in Q will result in 3.5% change in EPS. Applications and Utility of Total Leverage 188 Before understanding what application the total leverage has in the financial analysis of a company, let us make a few more observations by studying its behavior. Let us calculate the overall break-even point and the DTL for the various levels of Q, given the following information: F = Rs.8,00,000 I = Rs.80,000 Dp = Rs.60,000 S = Rs. 1,000 V = Rs.600 The overall break-even point is that level of output at which the DTL will be undefined and EPS is equal to zero. This level of output can be calculated as follows: = [8,00,000 + 80,000 + 60,0007(1- 0.5)]/ (1,000 - 600) = 2,500. Thus, the overall break-even point is at 2500 units. Calculating DTL for various levels of output with the given information: Q DTL 1000 -0.67 2000 -4.00 2500 QO 3000 6.00 5000 2.00 The following observations can be made from the above calculations: • There is a unique DTL for every level of output. • At the overall break-even point of output the DTL is undefined. • If the level of output is less than the overall break-even point, then the DTL will be negative. • If the level of output is greater than the overall break-even point, then the DTL will be positive, DTL decreases as Q increases and reaches a limit of 1. Further, the DTL has the following applications in analyzing the financial performance of a company: 1. Measures changes in EPS: DTL measures the changes in EPS to a percentage change in Q. Thus, the percentage change in EPS can be easily assessed as the product of DTL and the percentage change in Q. For example, if DTL for Q of 3000 units is 6 and there is a 10% increase in Q, the affect on EPS is 60%. Percentage change in EPS = DTL (Q = 3,000) x Percent change in Q = 6x10% = 60% 2. Measures Total Risk: DTL measures the total risk of the company since it is a measure of both operating risk and total risk. Thus, by measuring total risk, it measures the variability of EPS for a given error in forecasting Q. APPRAISAL CRITERIA Having defined the costs and the benefits associated with a project, we are now ready to examine whether the project is financially desirable or not. A number of criteria have been evolved for evaluating the financial desirability of a project. These criteria can be classified as follows: Figure 8.2 189 Payback Period The payback period measures the length of time required to recover the initial outlay in the project. For example, if a project with a life of 5 years involves an initial outlay of Rs.20 lakh and is expected to generate a constant annual inflow of Rs.8 lakh, the payback period of the project = 20/8 = 2.5 years. On the other hand if the project is expected to generate annual inflows of, say Rs.4 lakh, Rs.6 lakh, Rs.10 lakh, Rs.12 lakh and Rs.14 lakh over the 5 year period the payback period will be equal to 3 years because the sum of the cash inflows over the first three years is equal to the initial outlay. In order to use the payback period as a decision rule for accepting or rejecting the projects, the firm has to decide upon an appropriate cut-off period. Projects with payback periods less than or equal to the cut-off period will be accepted and others will be rejected. The payback period is a widely used investment appraisal criterion for the following reasons: • It is simple in both concept and application; • It helps in weeding out risky projects by favoring only those projects which generate substantial inflows in earlier years. The payback period criterion however suffers from the following serious shortcomings: It fails to consider the time value of money, the importance of which has already been discussed at length. • The cut-off period is chosen rather arbitrarily and applied uniformly for evaluating projects regardless of their life spans. Consequently the firm may accept too many short-lived projects and too few long-lived ones. • Since the application of the payback criterion leads to discrimination against projects which generate substantial cash inflows in later years, the criterion cannot be considered as a measure of profitability. To incorporate the time value of money in the calculation of payback period some firms compute what is called the "discounted payback period". In other words, these firms discount the cash flows before they compute the payback period. For instance if a project involves an initial outlay of Rs.10 lakh, and is expected to generate a net annual inflow of Rs.4 lakh for the next 4 years, the discounted pay back will be that value of 'n' for which 4xPVIFA(12,n)-10 ......(1) Assuming the cost of funds to be 12 percent. Equation (1) can be re-written as PVIFA(12, n) = 2.5 From PVIFA Tables, we find that PV1FA (32,3) = 2.402 PVIFA (12,4) = 3.037 Therefore, 'n' lies between 3 and 4 years and is approximately equal to 3.15 years. We find the discounted pay back period is longer than the undiscounted pay back period which will be 2.5 years in this case. Evaluating the discounted pay back period as an appraisal criterion, we find it to be a whisker better than the 190 undiscounted pay back period. It considers the time value of money and thereby does not give an equal weight to all flows before the cut-off date. But it still suffers from the other shortcomings of the pay back period. This criterion also depends on the choice of an arbitrary cut-off date and ignores all cash flows after that date. In practice, companies do not give much importance to the payback period as an appraisal criteria. Accounting Rate of Return Trie accounting rate of return or the book rate of return is typically defined as follows: Accounting Rate of Return (ARR) = Average Profit After Tax/Average book value of the investment. To use it as an appraisal criterion, the ARR of a project is compared with the ARR of the firm as a whole or against some external yard-stick like the average rate of return for the industry as a whole. To illustrate the computation of ARR consider a project with the following data: (Amount in Rs.) Year 0 1 2 3 Investment Sales Revenue (90000) 120000 100000 80000 Operating expenses (excluding depreciation) 60000 50000 40000 depreciation 30000 30000 30000 Annual Income 30000 20000 10000 The firm will accept the project if its target average rate of return is lower than 44 percent. As an investment appraisal criterion, ARR has the following merits: • Like payback criterion, ARR is simple both in concept and application. It appeals to businessmen who find the concept of rate of return familiar and easy to work with rather than absolute quantities. • It considers the returns over the entire life of the project and therefore serves as a measure of profitability (unlike the payback period which is only a measure of capital recovery). This criterion, however, suffers from several serious defects. First, this criterion ignores the time value of money. Put differently, it gives no allowance for the fact that immediate receipts are more valuable than the distant flows and results giving too much weight to the more distant flows. Second, the ARR depends on accounting income and not on the cash flows. Since cash flows and accounting income are often different and investment appraisal emphasizes cash flows, a profitability measure based on accounting income cannot be used as a reliable investment appraisal criterion. Finally, the firm using ARR as an appraisal criterion must decide on a yard-stick for judging a project and this decision is often arbitrary. Often firms use their current book-return as the yard-stick for comparison. In such cases if the current book return of a firm tends to be unusually high or low, then the firm can end up rejecting good projects or accepting bad projects. Net Present Value (NPV) We have already discussed the concept of present value and the method of computing the present value in the chapter on time value of money. The net present value is equal to the present value of future cash flows and any immediate cash outflow. In the case of a project, the immediate cash flow will be investment (cash outflow) and the net present value will be therefore equal to the present value of future cash inflows minus the initial investment. The following illustration illustrates this point. Illustration 8.2 191 Consider the project described in illustration 8.3. Compute the net present value of the project, if the cost of funds to the firm is 12 percent. Solution The net cash flows of the project and their present values are as follows: Year 1 2 3 4 Net cash flow (Rs.) 5100 5100 5100 7100 PVIF@k-12% 0.893 0.797 0.712 0.636 Present value (Rs.) 4554 4065 3631 4516 Net present value - (-12,500) + (4,554 + 4,065 + 3,631 f 4,516) = Rs. (-12,500+ 16,766) = Rs.4,266 The decision rule based on the NPV criterion is obvious. A project will be accepted if its NPV is positive and rejected if its NPV is negative. Rarely in real life situations, we encounter a project with NPV exactly equal to zero. If it happens, theoretically speaking, the decision-maker is supposed to be either indifferent in accepting or rejecting the project. But in practice, NPV in the neighborhood of zero, calls for a close review of the projections made in respect of such parameters that are critical to the viability of the project because even minor adverse variations can mar the viability of such marginally viable projects. The NPV is a conceptually sound criterion of investment appraisal because it takes into account the time value of money and considers the cash flow stream in its entirety. Since net present value represents the contribution to the wealth of the shareholders, maximizing NPV is congruent with the objective of investment decision making viz., maximization of shareholders' wealth. The only problem in applying this criterion appears to be the difficulty in comprehending the concept per se. Most non-financial executives and businessmen find 'Return on Capital Employed' or 'Average Rate of Return' easy to interpret compared to absolute values like the NPV. Benefit-Cost Ratio (BCR) The benefit-cost ratio (or the Profitability Index) is defined as follows: where BCR = Benefit Cost Ratio PV = Present Value of Future Cash Flows and = Initial Investment A variant of the benefit-cost ratio is the net benefit-cost ratio (NBCR) which is defined as: The BCR and NBCR for the project described in illustration 18.4 will be: BCR -16,766/12,500 =1.34 NBCR = 4,266/12,500 = 0.34 The decision-rules based on the BCR (or alternatively the NBCR) criterion will be as follows: 192 If Decision Rule BCR > 1 (NBCR > 0) Accept the project BCR < 1 (NBCR < 0) Reject the project Since the BCR measures the present value per rupee of outlay, it is considered to be a useful criterion for ranking a set of projects in the order of decreasingly efficient use of capital. But there are two serious limitations inhibiting the use of this criterion. First, it provides no means for aggregating several smaller projects into a package that can be compared with a large project. Second, when the investment outlay is spread over more than one period, this criterion cannot be used. The following illustration illustrates the first limitation. Illustration 8.3 Zeta Limited is considering 4 projects - A, B, C, and D with the following characteristics: Initial Investment Annual Net Cash (Year 0) Flow (Years 1 to 5) A (20) 7.5 B (4.5) 1 S 1.3 C (7) 2.5 D (8) 3.5 The funds available for investment are limited to Rs.20 lakh and the cost of funds to the firm is 14 percent. Rank the 4 projects in terms of the NPV and BCR criteria. Which project(s) will you recommend given the limited supply of funds? Solution The NPVs of the 4 projects are: Project NPV(Rs, in lakh) Rank A 7.5xPVIFA(I4,5) -20 =(7.5x3.433) -20 = 5.75 I B (1,5x3.433) -4.5 = 0,65 IV C (2,5x3.433)- 7 = 1.58 III D (3,5x3.433)- 8 -4.02 II The BCR of the 4 projects are: Project BCR Rank A 25.75/20 = 1.27 II B 5.15/4.5 = 1.14 IV C 8.58/7 = 1.23 III D 12.02/8 = 1.50 I Based on the NPV and BCR criteria, all 4 projects are acceptable because NPV is positive and BCR is greater than one for each project. But all 4 projects cannot be taken by the firm because of the limited availability of funds. Either Zeta has to accept project A or a package consisting of projects, B, C and D but not both. The decision will depend upon which option maximizes the shareholders' wealth. In this sort of a decision-making situation, the BCR becomes inapplicable because there is no way by which we can aggregate the BCRs of projects B, C and D. On the other hand NPVs of projects B, C, and D can be aggregated and compared with the NPV of project A to arrive at a decision. NPV (B + C + D) = NPV (B) + NPV (C) + NPV (D) =0.65 + 1.58 + 4.02-6.25 which is more than NPV (A). Therefore the package comprising projects B, C and D must be accepted. Internal Rate of Return 193 The internal rate of return is that rate of interest at which the net present value of a project is equal to zero, or in other words, it is the rate which equates the present value of the cash inflows to the present value of the cash outflows. While under NPV method the rate of discounting is known (the firm's cost of capital), under IRR this rate which makes NPV zero has to be found out. To illustrate this concept, let us consider the following illustration. Illustration 8.4 A project has the following pattern of cash flows: Year Cash flow (Rs. in lakh) 0 (10) 1 5 2 5 3 3.08 4 1.20 What is the IRR of this project? Solution To determine the IRR, we have to compute the NPV of the project for different rales of interest until we find that rale of interest at which the NPV of the project is equal to zero or sufficiently close to zero. To reduce the number of iterations involved in this trial and error process, we can use the following short-cut procedure: Step 1 Find the average annual net cash flow based on the given future net cash flows. In our illustration, the average annual net cash flow will be equal to: (5 + 5 + 3.08 + 1.20)74 = 3.57 Step 2 Divide the initial outlay by the average annual net cash flow i.e., 10/3.57 = 2.801 Step 3 From the PVIFA table find that interest rate at which the present value of an annuity of Re.l will be nearly equal to 2.801 in 4 years i.e., the duration of the project. In our case, this rate of interest will be equal to 15%. We use 15% as the initial value for starting the trial and error process and keep trying at successively higher rates of interest until we get an interest rate at which the NPV is marginally above zero and an interest rate at which the NPV is marginally below zero. Now we know that IRR. lies between the two rates of interest and using a linear approximation, we can determine the approximate value of the IRR. In the case of our project, the NPV at r - 15% will be equal to: -10 + (5 x 0.870) + (5 x 0.756) + (3.08x0.658)+ (1.2x0.572) -0.84 NPV at r - 16% will be equal to: -10 + (5 x 0.862) + (5 x 0.743) + (3.08 x 0.641) + (1.2x0.552)-0.66 NPV at r = 18% will be equal to: -10 + (5+9/ x 0.848) + (5 x 0.719) + (3.08 x 0.609) + (1.20 x 0.516) -0.33 NPV at r - 20% will be equal to: -10 + (5 x 0,833) + (5 x 0.694) + (3.08 x 0.579) '+(1.20 x 0.482)-0 We find that at r - 20%, the NPV is zero and therefore the IRR of the project is 20%. To use IRR as an appraisal criterion, we require information on the cost of capital or funds employed in the project. If we define IRR as 'r' and cost of funds employed as 'k', then the decision rule based on IRR will be: Accept the project if 'r 1 is greater than k and reject the project if r is less than k. (If r = k, it is a matter of indifference). 194 IRR is a popular method of investment appraisal and has a number of merits like: • It takes into account the time value of money. • It considers the cash flow stream over the entire investment horizon. • Like ARR, it makes sense to businessmen who prefer to think in terms of rate of return on capital employed. This criterion however suffers from the following limitations: IRR is uniquely defined only for a project whose cash flow pattern is characterized by cash outflow(s) followed by cash inflows (such projects are called simple investments). If the cash flow stream has one or more cash outflows interspersed with cash inflows, there can be multiple internal rates of return. This point can be clarified with the help of the following table no; 8.1 where four projects with different patterns of cash flows are given: Table: 8.1 (Rs. in lakh) Project Cash Flow Stream (Rs.) Year 0 Year 1 Year 2 Year3 Year 4 A -20 5 10 15 15 B -10 -10 15 15 15 C -10 5 -10 20 20 D -10 15 10 -5 20 • Projects A and B are simple investments and therefore will have unique IKK values. But projects C and D can have multiple internal rates of return because their cash inflows and outflows are interspersed. For such projects, IRR cannot be a meaningful criterion of appraisal. • The IRR criterion can be misleading when the decision-maker has to choose between mutually exclusive projects that differ significantly in terms of outlays. In spite of these defects, IRR is still the best criterion today to appraise a project financially. Financial Institutions insist that projects having substantial outlay specially in the medium and large scale sectors must show the computation of IRR in the Detailed Project Report, which they appraise before sanctioning financial assistance. Annual Capital Charge This appraisal criterion is used for evaluating mutually exclusive projects or alternatives which provide similar service but have differing patterns of costs and often unequal life spans, e.g., choosing between fork-lift transportation and conveyor-belt transportation. The steps involved in computing the annual capital charge are as follows: Step 1 Determine the present value of the initial investment and operating costs using the cost of capital (k) as the discount rate. Step 2 Divide the present value by PVIFA (k,n) where n represents the life span of the project. The quotient is defined as the annual capital charge or the equivalent annual cost. Once the annual capital charge for the various alternatives are defined, the alternative which has the minimum annual capital charge is selected. Illustration 8.5 195 Hindustan Forge Limited is evaluating two alternative systems: A and B, for internal transportation. While the two systems serve the same purpose, system A has a life of 7 years and system B has a life of 5 years. The initial outlay and operating costs (in Rs.) associated with these systems are: Year A B 0 10,00,000 8,00,000 1 1,00,000 75,000 2 1,25,000 1,00,000 3 1,50,000 1,20,000 4 1,75,000 1,40,000 5 2,00,000 1,00,000 6 2,25,000 7 2,00,000 Calculate the annual capital charge associated with these two systems, if the cost of capital is 12 percent. (You can assume that the net salvage values of the two systems at the end of their economic lives will be zero.) Solution Present value of costs associated with system A - Rs.10,00,000 + (1,00,000 x 0.893) + (1,25,000 x 0.797) (1,50,000 x 0.712) + (1,75,000 x 0.636) + (2,00,000 x 0.567) + (2,25,000 x 0.507) + (2,00,000 x 0.452) = Rs.17,24,900 Annual capital charge associated with system A Present value of costs associated with system B = Rs.8,00,000 + (75,000 x 0.893) + (1,00,000 x 0.797) + (1,20,000 x 0.712) + (1,40,000 x 0.636) + (1,00,000 x 0.567) = Rs.l 1,77,855 Annual capital charge associated with system B = Rs.3,26,728 Since the annual capital charge associated with system B is lower than that of system A, system B is preferred to system A. A wide variety of measures are used in practice for appraising investments. But whatever method is used, the appraisal must be carried out in explicit, well-defined, preferably standardized terms and should be based on sound economic logic. 196 Chapter 9 Financial Ethics Business Ethics and Social Responsibility Is the goal of maximizing stock prices consistent or inconsistent with high standards of ethical behavior and social responsibility? It is most definitely consistent. Many socially responsible firms have created enormous value for their owners, and many unethical firms now are bankrupt. Business Ethics The word ethics is defined in Webster's dictionary as "standards of conduct or moral behavior." Business ethics can be thought of as a company's attitude and conduct to-1 ward its employees, customers, community, and stockholders. High standards of ethical behavior demand that a firm treat each party that it deals with in a fair and honest manner. A firm's commitment to business ethics can be measured by the tendency of the firm and its employees to adhere to laws and regulations relating to such factors as ! product safety and quality, fair employment practices, fair marketing and selling practices, the use of confidential information for personal gain, community involvement, bribery, and illegal payments to obtain business. There are many instances of firms engaging in unethical behavior. For example, in recent years the employees of several prominent Wall Street investment banking houses have been sentenced to prison for illegally using insider information on pro-posed mergers for their own personal gain, and E. E Hutton, a large brokerage firm, lost its independence through a forced merger after it was convicted of cheating its banks out of millions of dollars in a check kiting scheme. Drexel Burnham Lambert, once the most profitable investment banking firm, went bankrupt, and its "junk bond king," Michael Milken, who had earned $550 million in just one year, was sentenced to ten years in prison plus charged a huge fine for securities-law violations. Another investment bank, Salomon Brothers, was implicated in a Treasury bond scandal that resulted in the firing of its chairman and other top officers. These cases received a lot of notoriety, and they made people wonder about the ethics of business in general. However, the results of a recent study indicate that the executives of most major firms in the United States do try to maintain high ethical standards in all of their business dealings. Furthermore, there is a positive correlation between ethics and long-run profitability. For example, Chase Bank suggested that ethical behavior has increased its profitability because such behavior helped it (1) avoid fines and legal expenses, (2) build public trust, (3) attract business from customers who appreciate and support its policies, (4) attract and keep employees of the highest caliber, and (5) support the economic viability of the communities in which it operates. Most firms today have in place strong codes of ethical behavior, and they also conduct training programs designed to ensure that employees understand the correct behavior in different business situations. However, it is imperative that top management—the chairman, president, and vice-presidents—be openly committed to ethical behavior, and that they communicate this commitment through their own personal actions as well as through company policies, directives, and punishment/reward systems. When conflicts arise between profits and ethics, sometimes the ethical considerations are so strong that they clearly dominate. However, in many cases the choice between ethics and profits is not clear cut. For example, suppose Norfolk Southern's managers know that its trains are polluting the air along its routes, but the amount of pollution is within, legal limits and preventive actions would be costly. Axe the managers ethically bound to reduce pollution? Similarly, suppose a medical products company's own research indicates that one of its new products may cause problems. However, the evidence is relatively weak, other evidence regarding benefits to patients is strong, and independent government tests show no adverse effects. Should the company make the potential problem known to the public? If it does release the negative (but questionable) information, this will hurt sales and profits, and possibly keep some patients who would benefit from the new product from using it. There are no obvious answers to questions such as these, but companies must deal with them on a regular basis, and a failure to handle the situation properly can lead to huge product liability suits and even to bankruptcy. Social Responsibility Another issue that deserves consideration is social responsibility: Should businesses operate strictly in their stockholders' best interests, or are firms also responsible for the welfare of their employees, customers, and the communities in which they operate? Certainly firms have an ethical responsibility to provide a safe working environment, to avoid polluting the air or water, and to produce safe products. However, socially responsible 197 actions have costs, and not ail businesses would voluntarily incur all such costs. If some firms act in a socially responsible manner while others do not, then the socially responsible firms will be at a disadvantage in attracting capital. To illustrate, suppose all firms in a given industry have close to "normal" profits and rates of return on investment, that is, close to the average for all firms and just sufficient to attract capital. If one company attempts to exercise social responsibility, it will have to raise prices to cover the added costs. If other firms in its industry do not follow suit their costs and prices will be lower. The socially responsible firm will not be able to compete, and it will be forced to abandon its efforts. Thus, any voluntary socially re sponsible acts that raise costs will be difficult, if not impossible, in industries that are subject to keen competition. What about oligopolistic firms with profits above normal levels—cannot such firms devote resources to social projects? Undoubtedly they can, and many large, sue cessful firms do engage in community projects, employee benefit programs, and the like to a greater degree than would appear to be called for by pure profit or weal™ maximization goals. 4 Furthermore, many such firms contribute large sums to chari-ties. Still, publicly owned firms are constrained by capital market forces. RATIO ANALYSIS Ratios are well-known and most widely used tools of financial analysis. A ratio gives the mathematical relationship between one variable and another. Though the computation of a ratio involves only a simple arithmetic operation, its interpretation is a difficult exercise. The analysis of a ratio can disclose relationships as well as bases of comparison that reveal conditions and trends that cannot be detected by going through the individual components of the ratio. The usefulness of ratios ultimately depends on their intelligent and skillful interpretation. Ratios are used by different people for various purposes. Ratio analysis mainly helps in valuing the firm in quantitative terms. If two groups of people are interested in the valuation of the firm and they are creditors and shareholders, creditors are again divided into short-term creditors and long-term creditors. Short-term creditors hold obligations that will soon mature and they are concerned with the firm's ability to pay its bills promptly. In the short run, the amount of liquid assets determines the ability to clear off current liabilities. These persons are interested in liquidity. Long-term creditors hold bonds or mortgages against the firm and are interested in current payments of interest and eventual repayment of principal. The firm must be sufficiently liquid in the short-term and have adequate profits for the long-term. These persons examine liquidity and profitability. In addition to liquidity and profitability, the owners of the firm (shareholders) are concerned about the policies of the firm that affect the market price of the firm's stock. Without liquidity, the firm cannot pay cash dividends. Without profits, the firm would not be able to declare dividends. With poor policies, the common stock would trade at low prices in the market. Considering the above category of users financial ratios fall into three groups: • Liquidity ratios • Profitability or efficiency ratios • Ownership ratios Earnings ratio Dividend ratios - Leverage ratios • Capital structure ratios • Coverage ratios LIQUIDITY RATIOS Liquidity implies a firm's ability to pay its debts in the short run. This ability can be measured by the use of liquidity ratios. Short-term liquidity involves the relationship between current assets and current liabilities. If a firm has sufficient net working capital (excess of current assets over current liabilities) it is assumed to have enough liquidity. The current ratio and the quick ratio are the two ratios, which directly measure liquidity. The ratios like receivables turnover ratios and inventory turnover ratios indirectly measure the liquidity. Current Ratio The liquidity ratio is denned as; s Liabilitie Current Assets Current 198 Current assets include cash, marketable securities, debtors, inventories, loans and advances, and pre-paid expenses. Current liabilities include loans and advances taken, trade creditors, accrued expenses, and provisions. From the balance sheet data given in table 6.1 for the year 5, the current ratio for the year 5 can be calculated as: Current ratio = 4.24 32.36 23.10 1.85 49.85 46.30 + + + + = 121.1 36.6 As the current ratio measures the ability of the enterprise to meet its current obligations, a current ratio of 3.31: 1 implies that the firm has current assets which are 3.31 times the current liabilities. A current ratio of 3.31 is considered to be healthy by normal standards which is 2:1. In the operating cycle of the firm current assets are converted into cash to provide funds for the payment of current liabilities. So higher the current ratio, higher the short-term liquidity. But in interpreting the current ratio care should be taken in looking into the composition of current assets. A firm which has a large amount of cash and accounts receivable is more liquid than a firm with a high amount of inventories in its current assets, though both the firms may have the same current ratio. To overcome this a more stringent form of liquidity ratio referred to as quick ratio can be calculated. Quick Ratio Quick-test (also known as acid-test ratio) is defined as: Quick Assets Current Liabilities Current Assets - Inventotries Current Liabilities The quick ratio is a more stringent measure of liquidity because inventories, which are least liquid of current assets, are excluded from the ratio. Inventories have to go through a two-step process of first being sold and converted into receivables and secondly collected. The quick test is so named because it gives the abilities of the firm to pay its liabilities without relying on the sale and recovery of its inventories. Quick ratio of Rainbow-chem Industries for the year 5 is calculated as: From the above figures, we can infer that as the proportion of inventories in total current assets is 3S.23%, and the liquidity ratio of the firm decreased from 3.31 to 2.04. Though there is no standard with which the ratio can be compared, normally ratios are compared with the industry figures in the absence of predetermined standards. In the above case, the quick ratio for the industry (dyes and pigments) is 2.26. As the quick ratio is below the industry average, we can conclude that the liquidity position is below average though the current ratio gives a different picture. Limitations of the Current and Quick Ratios The current ratio is a static or stock concept of what resources are available at a given moment in time to meet the obligations at that moment. The ratio has limitations in the following aspects: 1. Measuring and predicting the future fund flows. 2. Measuring the adequacy of future fund inflows in relation to outflows. The existing pool of net funds does not have a logical or causative relationship to the future funds that will flow through it. Yet it is the future flows that are the subject of our greatest interest in the assessment of liquidity. These flows depend importantly on elements not included in the ratio, such as sales, cash costs and expenses, profits, and changes in business conditions. This concept will be clear when the study of funds flow analysis is done. 199 Bank Finance to Working Capital Gap Ratio Where working capital gap is equal to current assets less current liabilities other than bank borrowings. This ratio shows us the degree of the firm's reliance on short-term bank finance for financing the working capital gap. Turnover Ratios Receivables turnover ratios and inventory turnover ratios measure the liquidity of a firm in an indirect way. Here the measure of liquidity is concerned with the speed with which inventory is converted into sales and accounts receivables converted into cash. The turnover ratios give the speed of conversion of current assets (liquidity) into cash as shown above, Two ratios are used to measure the liquidity of a firm's account receivables. They are: a. Accounts receivable turnover ratio b. Average collection period Accounts Receivable Turnover Ratio The average accounts receivable is obtained by adding the beginning receivables of the period and the ending receivable, and dividing the sum by two. The sales figure in the numerator is only credit sales, because firm cash sales don't give any receivables. As the publicly available information on the firm, may not disclose the credit sales details, the analyst in the external environment has to assume that cash sales are insignificant. Normally the receivables ratios are useful for internal analysis. Higher the receivables turnover ratio, greater the liquidity of the firm. However, care should be taken to see that to project higher receivables turnover ratio, the firm does follow a strict credit policy. The accounts receivables position of the Rainbow-chem Industries for two years is as follows: Sundry debtors more than 6 months Year 5 Year 4 04.19 01.31 Other debtors 45.66 35.99 Prov. for doubtful debts. Total Debtors 00.00 00.00 49.85 37.30 Average accounts receivables (49.85 + 37.30)72 43.58 Average receivables turnover 261/43.58 5.99(6Approx.) Turnover ratio gives, how many times on an average the receivables are generated and collected during the year. In our case, the average receivables turnover ratios of 6 indicates that on an average receivables are revolved 6 times during the year. When we compare this with the industry of 5.16 times, we can say that the firm's liquidity of accounts receivables is on average 16.28% more than the industry. Average Collection Period One can get a sense of the speed of collections from receivables turnover ratio and it is valuable for comparison purposes, but we cannot directly compare it with the terms of trade usually given by the firm. For example, the firm may be having a policy of giving certain percent of discount if the debtor pays in certain period of time. Such comparison is best made by converting the turnover into days of sales tied up in 200 receivables. The ratio that gives the above comparison is average collection period, which is defined as the number of days it takes to collect accounts receivable. It can be obtained by dividing 360 by the average receivables turnover ratio calculated above. That is, For Rainbow-chem Industries, assuming that there is only one sundry debtor the average collection period is equal to 60 days (360/6). If the firm is having a credit policy of giving substantial discounts if the receivables are collected within 30 days, the debtor will not be able to avail the discounts. If we compare the above with the industry figure (i.e. 360/5.16 = 69.76 days), the firm is having above average collection period. Evaluation Accounts receivable turnover rates or collection periods can be compared to industry averages or to the credit terms granted by the firm to find out whether customers are paying on time. If the terms, for example say the average collection period is 30 days and the realized average collection period is 60 days, it could reflect the following: 1. Collection job is poor. 2. In spite of careful collection efforts difficulty in obtaining prompt payments. 3. Customers facing financial problems. The first conclusion requires remedial managerial action, while the second and third conclusions convey the quality and liquidity of the accounts receivables. Inventory Turnover The liquidity of a firm's inventory may be calculated by dividing the cost of goods sold by the firm's inventory. The inventory turnover, or stock turnover, measures how fast the inventory is moving through the firm and generating sales. Inventory turnover can be defined as: Higher the ratio, greater the efficiency of inventory management. The importance of inventory turnover can also be looked from a different point of view i.e. it helps the analyst measure the adequacy of goods available to sell in comparison to the actual sales orders. In this regard, the presence of inventory involves two risks: 1. Running out of stock due to low inventory (high turnover) which may indicate future shortages. 2. Excessive carrying charges, because of high inventory (low turnover). One has to manage carefully between running out of goods to sell and investing in excessive inventory otherwise it will result in either a high or low ratio, which may be an indication of poor management. The analyst should keep in mind that high and low turnovers are relative in nature. The current turnover must be compared to previous periods or to some industry norms before it is designated as high, low, or normal. The nature of the business should also be considered in analyzing the appropriateness of the size and turnover of the inventory. For example, a manufacturing firm which has to import its key raw materials is justified in keeping high inventory of raw materials if it finds out that its base currency has been depreciating against the exporting country's currency consistently. In this case, high inventory is kept if the cost of imported raw materials because of depreciation is more than the cost of storage. In the case of Rainbow-chem Industries the inventory turnover could be calculated as follows. First for getting the cost of goods sold, we have to add all the expenses in the profit and loss account including depreciation charges and excluding interest expenses. Average inventory can be obtained by adding the closing inventory (Year 5) and the opening inventory (Year 4) and dividing them by two. 201 The average industry inventory turnover is 4.3. A meaningful conclusion about the inventory turnover can be arrived after studying its composition, its change over the years and comparing the turnover trends with the industry. Table 9.1 Trend Analysis of Inventory Composition Inventory composition Year 5 Year 4 Year 3 Year 2 Year 1 Raw materials 13.99 (30.22) 12.28 (30.34) 6.18(17.73) 11.28(31.75) 13.83 (33.57) Work-in-progress 14.42 (31.14) 14.87 (36.73) 12.37(35.47) 12.22(34.39) 12.79(31.04) Finished goods Total 17.89 (38.64) 13.33(32.93) 1632 (46,80) 12.03 (33.86) 14.58 (35.39) 46,30 (100) 40.48 (100) 34.87 (100) 35.53 (100) 41.2(100) Table 9.2 Inventory turnover ratio Year 5 Year 4 Year 3 Year 2 Rainbow-chem Industries Ltd. 5.63 5.25 4.69 3.10 Dyes & Pgrrt. Industry 4.31 4.40 4.28 3.87 Table 9.3 Growth Rates Items Year 5 Year 4 Year 3 Sales (Rainbow-chera) 21.72 18.26 16.52 Inventory (Rainbow-chem) 14.37 16.08 -9.80 Sales (Industry) 21.42 12.63 17.42 Inventory (Industry) 23.65 7.67 6.14 Table 9.3 Overall Liquidity Position Ratios Definition Rainbow-chem Ltd. Dyes & Pigm Ind. Liquidity or Current Ratio Current Assets 3.31 3.53 Current Liabilities Quick Ratio Current Assets - Inventory 2,04 2.26 Current Liabilities Accounts Receivable Turnover Ratio Net Credit Sales 5.99 5.16 Average Accounts Receviable Average Collection Period 360 60 70 Accounts Receivables /Turnover Inventory Turnover Cost of Goods Sold 5,63 4.31 Average Inventory From the above table, it can be noticed that the Rainbow-chem's current and quick ratios are just below the average industry figures, and receivables turnover ratios are above the industry averages to an extent. Inventory turnover is in a better position compared to the industry which is concluded in the overall analysis of inventory turnover in the respective section. In conclusion, the liquidity position of the Rainbow-chem Industries Ltd. can be said to be above average. 202 PROFITABILITY OR EFFICIENCY RATIOS These measure the efficiency of the firm's activities and its ability to generate profits. There are two types of profitability ratios. 1. Profits in Relation to Sales: It is important from the profit standpoint that the firm be able to generate adequate profit on each unit of sales. If sales lack a sufficient margin of profit, it is difficult for the firm to cover its fixed charges on debt and to earn a profit for shareholders. Two popular ratios in this category are gross profit margin ratio, and net profit margin ratio. 2. Pro/its in Relation to Assets: It is also important that profit be compared to the capital invested by owners and creditors. If the firm cannot produce a satisfactory profit on its asset base, it might be misusing its assets. They are also referred to as rate of return ratios and some of them are asset turnover ratio, earning power and return on equity. Gross Profit Margin Ratio The gross profit margin ratio (GPM) is defined as: where net sales = Sales - Excise duty This ratio shows the profits relative to sales after the direct production costs are deducted. It may be used as an indicator of the efficiency of the production operation and the relation between production costs and selling price. GPM for Rainbow-chem Industries is calculated as: GPM for industry is 10.60% which is less than GPM of Rainbow-chem Industries. Net Profit Margin Ratio The net profit margin ratio is defined as: This ratio shows the earnings left for shareholders (both equity and preference) as a percentage of net sales. It measures the overall efficiency of production, administration, selling, financing, pricing, and tax management. Jointly considered, the gross and net profit margin ratios provide the analyst available tool to identify the sources of business efficiency/inefficiency. - 6.92% NPM for industry = 6.39% In comparison with the industry net profit, margin ratio is just above the average percentage figure. Had this been below the industry average, it would have indicated some mismanagement in the areas excluding production (as GPM is in line with the industry). Specific area could have been investigated by taking all the aspects and analyzing respectively. Asset Turnover It highlights the amount of assets that the firm used to generate its total sales. The ability to generate a large volume of sales on a small asset base is an important part of the firm's profit picture. Idle or improperly used assets increase the firm's need tor costly financing and the expenses for maintenance and upkeep. By achieving a high asset turnover, a firm reduces costs and increases the eventual profit to its owners. Asset turnover ratio is defined as: 203 Average assets is calculated by adding the opening stock of assets (previous year's closing stock of assets) and closing stock of assets of the present year. Asset turnover for Rainbow-chem Industry asset turnover is 1.15. An asset turnover ratio of 1.49 indicates the firm with an asset base of 1 unit could produce 1.49 units of sales. This is a healthy both in absolute terms and also in comparison with the industry as the turnover of the industry is only 1.15. Earning Power Earning power is a measure of operating profitability and it is defined as: The earning power is a measure of the operating business performance which is not effected by interest charges and tax payments. As it does not consider the effects of financial structure and tax rate it is well suited for inter-firm comparisons. Rambow-chem s earning power = 26 . 175 82 . 30 1758 - 17.58 % Inter-firm comparisons earning power percentages Company Year 5 Earning power Rainbow-chem Industries 17.58% Atul Products 13.76% Indian Dyestuff 16.18% Mardia Chem 17.34% Sudarshan Chem 13,33% Industry (dyes & pigm (large)) 16.29% From the table, we can conclude that Rainbow-chem tops the industry with a percentage of 17.58%, whereas the average is only 16.29%. Rainbow-chem is operationally very efficient in comparison to all the players in the industry. Return on Equity The return on equity (ROE) is an important profit indicator to shareholders of the firm. It is calculated by the formula: Net income denotes profit after tax (PAT) and average equity is obtained by taking the average equities of year 5 and year 4. The return on equity measures the profitability of equity funds invested in the firm. It is regarded as a very important measure because it reflects the productivity of capital employed in the firm. It is influenced by several factors: earning power, debt-equity ratio, average cost of debt funds, and tax rate. Return on equity for the industry is 13.18%. The firm s healthiness in this respect also can be easily seen from 204 the differences in returns of equity. Rainbow-chem is giving 20.68% return to the equity holders, whereas the industry is giving only 13.18%.'Thus, we can conclude that Rainbow-chem has employed it resources productively. Overall Profitability (Efficiency) Analysis Rainbow-chem's profitability ratios are summarized in the following table against the industry. Ratios Rainbow-chem Ltd. Dyes & Pigm Ind. Gross Profit Margin 22.69% 10.60% Net Profit Margin 6.92% 6.39% Asset Turnover 1 ,49% 1.25% Return on Equity 20.68% 13.80% Earning Power 17.58% 34.12% As mentioned in the beginning of this section, profitability is analyzed in two respects. That is in relation to sales and in relation to assets. The above table conveys that, Rainbow-chem Industries is able to generate profits in relation to sales on an average scale, but in respect of efficient application of assets it performs well above the average. This indicates that some remedial measures have to be taken from the sales' point of view. OWNERSHIP RATIOS Ownership ratios will help the stockholder to analyze his present and future investment in a firm. Stockholders (owners) are interested to know how the value of their holdings are affected by certain variables. Ownership ratios compare the investment value with factors such as debt, earnings, dividends and the stock's market price. By understanding the liquidity and profitability ratios, one can gain insights into the soundness of the firm's business activities, whereas by analyzing the ownership ratios, the analyst is able to assess the likely future value of the market. Ownership ratios are divided into three main groups. They are; 1. Earnings Ratios 2. Leverage Ratios - Capital Structure Ratios - Coverage Ratios 3. Dividend Ratios. 1. Earnings Ratios The earnings ratios are earnings per share (EPS), price-earnings ratio (P/E ratio), and capitalization ratio. From earnings ratios we can get information on earnings of the firm and their effect on price of common stock. In the following paragraphs we will discuss the above ratios in detail. EARNINGS PER SHARE (EPS) Shareholders are concerned about the earnings of the firm in two ways. One is availability of funds with the firm to pay their dividends and the other to expand their interest in the firm with the retained earnings. These earnings are expressed on a per share basis which is in short called EPS, EPS is calculated by dividing the net income by the number of shares outstanding. Mathematically, it is calculated as follows: Earning per share (EPS) A cross-sectional and year-to-year analysis (will be discussed in later sections in detail) can be very informative to the analyst. As an example let us take two firms Atul Products and Rainbow-chem Industries in the Dyes & Pigm. (large) industries. Assuming the market price of each stock as Rs.50 per share, the earnings trend for the two firms is as follows: Firm Year 5 Year 4 Year 3 Year 2 Year 1 Atul Products (EPS) 5.97 8.18 5,15 7.96 12.16 205 Rainbow-chem (EPS) 13.68 12.81 8.98 6.70 5.24 From the above table, it can be easily understood that the Rainbow-chem Industries began at a low EPS of Rs.5.24 per share but steadily progressed and nearly tripled its EPS in 5 years. Whereas, Atul Products started at a high EPS of Rs.12.16 per share but in 5 years declined up to Rs.5.97 per share. The trends of the two earnings streams appear to forecast a brighter future for Rainbow-chem Industries than for Atul Products. If we go further into the reasons behind this performance of Atul Products, we can find that over the years, the share capital of Atul products has increased without proportionate increase in the net income. We will get an even more clear picture if we compare all the players in the industry. PRICE-EARNINGS RATIO The price-earnings ratio (also P/E multiple) is calculated by taking the market price of the stock and dividing it by earnings per share. This ratio gives the relationship between the market price of the stock and its earnings by revealing how earnings affect the market price of the firm's stock. If a stock has a low P/E multiple, for example 3/1, it may be considered as an undervalued stock. If the ratio is 80/1, it may be viewed as overvalued. It is the most popular financial ratio in the stock market for secondary market investors. The P/E ratio method is useful as long as the firm is a viable business entity, and its real value is reflected in its profits. The P/E multiples for Rainbow-chem Industries is calculated as follows: Table 9.4 Year5 Year 4 Year 3 Year 2 Year 1 Share price 425 450 130 240 80 EPS 13.68 12.81 8.98 6.70 5.24 P/E 31.06 35.12 14.47 35.82 15.26 The main use of P/E ratio is it helps to determine the expected market value of a stock. For example, one firm A may be having a P/E of 5/1 and another firm B of 9/1. If we assume the average industry P/E and EPS as 7/1, Rs.3 respectively and earning per shares of both the firms as Rs.3, we will get the following results. Market value of industry =7x3=21 Market value of firm A =5x3 = 15 Market value of firm B =9x3=27 THE CAPITALIZATION RATE The P/E ratio also may be used to calculate the rate of return investors expect before they purchase a stock. The reciprocal of the P/E ratio, i.e. (market price/EPS) gives this return. For example, if a stock has Rs.12 EPS and sells for Rs.100, the marketplace expects a return of 12/100, i.e. 12 percent. This is called the stock's capitalization rate. A 12 percent capitalization implies that the firm is required to earn 12 percent on the common stock value. If the investors require less than 12% return they will pay more for the stock and capitalization rate would drop. Capitalization rate Year 5 Year 4 Year 3 Year 2 Year 1 0.032 0.028 0.069 0.0279 0.0655 For Rainbow-chem Industries, rates are very low because of very high prices in comparison to earning per shares. 2. Leverage Ratios 206 When we extend the analysis to the long-term solvency of a firm we have two types of leverage ratios. They are structural ratios and coverage ratios. Structural ratios are based on the proportions of debt and equity in the capital structure of the firm, whereas coverage ratios are derived from the relationships between debt servicing commitments and sources of funds for meeting these obligations. CAPITAL STRUCTURE RATIOS Various capital structure ratios are: Debt-equity ratio. Debt-assets ratio. Debt-equity Ratio The debt-equity ratio which indicates the relative contributions of creditors and owners can be defined as: Equity Debt Depending on the type of the business and the patterns of cash flows the components in debt to equity ratio will vary. Normally the debt component includes all liabilities including current. And the equity component consists of net worth and preference capital. It includes only the preference shares not redeemable in one year. The ratio of long-term debt (total debt-current liabilities) to equity could also be used, but what is important is that consistency is followed when comparisons are made. For Rainbow-chem Industries the debt-equity ratio is In the above case the debt-equity ratio stood as 1.33, which implies that the debt portion is more than equity. The debt-equity ratio of the dyes & pigments industry on average is 1.424. In the manufacturing industry a debt- equity ratio of 1.5:1 is considered to be healthy. By normal standards and also the industry's the debt-equity ratio is within the limits. In the heavy engineering industries, petroleum industries, infrastructure industries like railways, airways the ratio may even go more than 3:1 as the capital outlays required are in very huge sums. In general, the lower the debt-equity ratio, the higher the degree of protection felt by the lenders. One of the limitations of the above ratio is that the computation of the ratios is based on book value, as it is sometimes useful to calculate these ratios using market values. At the time of mergers and acquisitions or rehabilitation operations the valuation of the equity and debt will be affected by the basis of computation. For example, a sick company whose equity is initially valued at book values may be a healthy one if its assets are valued at market prices if it has large land property in its books. The debt-equity ratio indicates the relative proportions of capital contribution by creditors and shareholders. It is used as a screening device in the financial analysis. While analyzing the financial condition of a firm, when the debt-equity ratio is less than 0.50, the analyst can go to other critical areas of analysis. But an analysis reveals that debt is a significant amount in the total capitalization if further investigation is undertaken which will throw light on firm's financial condition, results of operations and future prospects. This way, analysis of debt-equity ratio has a very important position in the financial analysis of any firm. Debt-Asset Ratio The above ratio measures the extent to which borrowed funds support the firm's assets. It is defined as: The composition of debt portion is same as in the debt-equity ratio. The denominator in the ratio is total of all assets as indicated in the balance sheet. The type of assets an organization employs in its operations should determine to some extent the sources of funds used to finance them. It is usually held that fixed and other long-term assets should not be financed by means of short-term loans. In fact, the most appropriate source of funds for investment in such kind of assets is equity capital, though financially very sound organization may go for debt finance. Rainbow-chem's debt-asset ratio for the year 5 is: 207 = 0.57 A debt-asset ratio of 0.57 implies that 57% of the total assets are financed from debt sources. When we compare this with the industry average debt-asset ratio of (0.69), we find that the firm is having a lower leverage compared to the industry. There are two major uses of capital structure ratios: 1. To Measure Financial Risk: One measure of the degree of risk resulting from debt financing is provided by these ratios. If the firm has been increasing the percentage of debt in its capital structure over a period of time, this may indicate an increase in risk for its long-term finance providers. As the debt content increases most of firm's income will go for servicing the debt and net income will be reduced. This will affect the long- term earnings prospects of the company as less funds are reemployed because of increased debt servicing burden. 2. To Identify Sources of Funds: The firm finances all its requirements either from debt or equity sources. Depending on the risk of different types the amount of requirements from each source is shown by these ratios. 3. To Forecast Borrowing Prospects: If the firm is considering expansion and needs to raise additional money, the capital structure ratios offer an indication of whether debt funds could be used. If the ratios are too high, the firm may not be able to borrow, Ratios Coverage ratios give the relationship between the financial charges of a firm and its ability to service them. Important coverage ratios are interest coverage ratio, fixed charges coverage ratio and debt-service coverage ratio. Funds available to meet an obligation Amount of that obligation COVERAGE RATIOS Interest Coveragerage Ratio One measure of a firm's ability to handle financial burdens is the interest coverage ratio, also referred to as the times interest-coverage ratio. This ratio tells us how many times the firm can cover or meet the interest payments associated with debt. For Rainbow-chem Industries it is equal to The greater the interest coverage ratio, the higher the ability of the firm to pay its interest expense. An interest coverage ratio of 4 means that the firm's earnings before interest and taxes are four times greater than its interest payments. FIXED CHARGES COVERAGE RATIO Interest coverage ratio considers the coverage of interest of pure debt only. Fixed charges coverage ratio measures debt servicing ability comprehensively because it considers all the interest, principal repayment obligations, lease payments and preference dividends. This ratio shows how many times the pre-tax operating income covers all fixed financing charges. It is defined as: 208 Fixed charges that are not tax deductible must be tax adjusted. This is done by increasing them by an amount equivalent to the sum that would be required to obtain an after-tax income sufficient to cover such fixed charges. In the above ratio, preference-stock dividend requirement is one example of such non-tax deductible fixed charges. To get the gross amount of preference dividends, it has to be divided by the factor (1 - tax rate). For Rainbow-chem Industries the fixed charges coverage ratio is calculated for the year 5 as follows: For Rainbow-chem there are no lease rental payments and preference dividend payments. The loan repayment has been assumed to be Rs.7.37 crore. The fixed charges coverage ratio of 1.92 indicates that its pre-tax operating income is 1.92 times all fixed financial obligations, DEBT SERVICE COVERAGE RATIO Normally used by term-lending financial institutions in India, the debt service coverage ratio, which is a post-tax coverage is defined as: For Rainbow-chem Industries the debt service coverage ratio for the year 1995-96 is: A DSCR of 1.89 indicates the firm has post-tax earnings which are 1.89 times the total obligations (interest and loan repayment) in the particular year to the financial institution. 3. Dividend Ratios The common stockholder is very much concerned about the firm's policy regarding the payment of cash dividends. If the firm is not paying enough dividends the stock may not be attractive to those who are interested in current income from their investment in the company. If the firm is paying excessive dividends, it may not be retaining adequate funds to finance future growth. So depending on the shareholder's aspirations a firm must formulate its dividend policy in a balanced way. The firm must be liquid and profitable to pay consistent and adequate dividends. Without profits, the firm will not have sufficient resources to give dividends, without liquidity the firm cannot get cash to pay the dividends. In the above respects, two dividend ratios are important. They are dividend pay-out ratio and dividend yield ratio. 3. DIVIDEND PAY-OUT RATIO This is the ratio of dividend per share (DPS) to earnings per share (EPS). It indicates what percentage of total earnings are paid to shareholders. The percentage of the earnings that is not paid out (1 - dividend pay-out) is retained for the firm's future needs. There is no guideline as to what percentage of earnings should be declared as dividends and it varies according to firm's fund requirements to support its operations. If the firm is in need of funds, then it may cut the dividends in relation to earnings and on the other hand if the firm finds that it lacks opportunities to use the firms generated, it might increase the dividends. But in both the cases, consistency of dividend payment is important to the shareholders. DIVIDEND YIELD This is the ratio of dividends per share (DPS) to market price of the share. 209 This ratio gives current return on his investment. This is mainly of interest to the investors who are desirous of getting income from dividends. No dividend yield exists for firms which do not declare dividends. Financial Ethics Ethical conduct lies at the core of all businesses. Cases of wrong doing in business are not confined to particular industries and occur almost across the board. However, companies are entrusted with an extraordinary responsibility: managing other people's money. This basic fiduciary duty required is that the financial managers on behalf of the company serve the interests of the clients not as a by-product, but as an end in itself. And, the satisfaction of their self-interest is obtained as a by-product of a proper discharge of that responsibility. Ethical codes of conduct come into picture where regulations end. Because regulations are often specific to events and activities, gaps exist. Ethics fill in the gaps where a specific regulation may not exist. In other words, ethical behavior seeks to achieve compliance, not just to the letter of law, but also to the spirit of law. This is particularly important for those activities that fall under the "grey areas" of regulations. While regulations might aim at avoiding any actual unscrupulous activity or conflicts of interests, ethical conduct ensures avoidance of even apparent or perceived conflicts of interests. For the managers, being perceived as trustworthy is essential because transactions involve the exchange of significant volumes of assets, often without a face-to-face meeting or the traditional handshake. Investors base their trust on a firm's reputation for financial performance and ethical soundness. When an firm's ethical stance comes into question, or its commitment to the honest conduct of business is in doubt, trust is extremely difficult to rebuild, damaging the firm's reputation and ability to compete. To be engaged in questionable financial dealings is not merely a breach of ethics and the law it is poor business. And it will surely imperil many client relationships, and along with them the future profitability of the firm. The high-voltage, high-velocity financial environment that has emerged in the recent years as a result of globalization, convergence, consolidation, and e-business applications not only poses a particular threat to investment banks that manage ethics as a strategic element rather than a core business principle but also challenge even the most ethically vigilant and conservative firms. Managers thus need to be ever more diligent to balance their entrepreneurial impulses with their fiduciary responsibilities and adhere to strong standards of professionalism that require that the interest of clients be placed ahead of self-interest at all times. CONCEPT OF ETHICS Business ethics can he defined as an attempt to ascertain the responsibilities and ethical obligations of the business professionals. It is based on broad principles of integrity and fairness and focuses in issues that a company or an individual can actually influence. Some of these include honesty in financial transactions, respect for company property, avoidance of conflicts of interest, honoring of contractual obligations, and respect for the law. The focus here is on the individuals rather than on the issues, and the primary question deals with how individuals conduct themselves in fulfilling these ethical requirements. Being ethical would broadly include trying to be a good corporate citizen, trying as an organization to adhere to certain ethical values like honesty, integrity, fairness, responsible citizenship and accountability, and trying to do the right thing. While being ethical may in simple words imply choosing the good over the bad, the right over the wrong and the fair over the unfair in an increasingly competitive business where the choice is not always the simple one between what is right and what is wrong. It is more often between what is right and what is less right - in other words between shades of grey. The key challenge therefore lies in making ethics a core value and making values, not rules, the driver of a company's culture. MANAGERIAL ETHICS The ethical dilemma faced by the management centers on the continual conflict, or on the continual potential of that conflict, that exists between the economic and social performance of an organization. The economic function demands that the firms have to operate profitably in order to survive over the long-term while the social function stresses the obligations of the firm towards its employees, customers, clients, stockholders and the general public. The management confronts an ethical dilemma when the improvements in economic performance namely, the increase in profits or decrease in costs - can be made only at the expense of one or more of the groups to 210 whom the firm has some form of obligation. The question for the management therefore lies in finding a balance between social performance and economic performance when faced by an ethical dilemma. Managerial decisions have extended consequences impacting both the organization and the customers. Managers confront many ethical dilemmas while making the decisions because many of the times someone to whom the firm has some form of obligation is going to be hurt or harmed in some manner, while the company is going to profit. Managers face ethical dilemmas while taking decisions on aspects like downsizing, marketing policies, or mergers and acquisitions. DOWNSIZING One of the most common ethical dilemmas faced by the management is layoffs or downsizing in the event of a market downturn or increasing competitive pressures. Sluggish pace of activities in the capital markets that include decline in both equity and debt markets, decline in the stock prices prompt the investment banks to layoffs in different business segments. For say, as the wave of consolidation, mergers and acquisitions sweeps through the financial services industry downsizing in order to avoid duplication of efforts has become a common practice. Similarly shutting down a business segment that has not been profitable also leads to job cuts. The employees who are forced to leave their jobs feel betrayed and the organization and its leadership may be thought to be impatient, premature and lacking integrity. The surviving employees will often share perceptions about ethics of this decision with those who are being forced to leave. They also feel tremendous pressure when asked to do more work or learn new tasks. The management must therefore demonstrate empathy for all of those affected by this decision. While being fired is always traumatic, companies can cause extra pain to employees by bumbling their way through the process. The management must try to soften the blow as much as possible. When companies are forced to downsize because of economic considerations, it is crucial to keep in mind the human impact. By granting generous packages to the fired employees, or helping the employees find new jobs firms can reduce the emotional impact of the downsizing. MARKETING STRATEGIES Marketing strategies is another area where the increasing competitive pressures prompt the corporations to engage in activities at the expense of consumer education about their products and services in order to generate sales. While most of the commercial advertising is regulated there continue to be instances where the corporations stretch the truth, engage in subtle forms of deception, or make claims about their services that are exaggerations or worse. Instances of such practices have been seen in the online brokerage industry where the advertising practices and the advertising content of the online brokers could color the expectations of the online investors. Types of Management Ethics Archie B. Carroll, an eminent researcher in the field of corporate social responsibility, broadly divided the managements into three types: (i) Moral management (ii) Amoral management (iii) Immoral management. Moral management strives to follow ethical principles and precepts. Even while fighting it tough for business success, it never sacrifices the sense of fairness, justice and ethics. It does attach due weight to profits and financial results, but within the purview of legal and moral compliance. Amoral management is a middle path between moral and immoral. Basically, it does not have a stance on issues relating, to morality or ethical considerations, nor do they seem to bother about them does it. When the management is intentionally amoral, it thinks that general ethical standards are not applicable to business. Therefore, it excludes ethical issues from the decision-making process. It does care about the letter of law, if not the spirit of it. An amoral management intervenes in the matters when the actions of the employees lead to external pressures. Immoral management is synonymous with the "unethical practices" in business. Such a management not only ignores ethical consideration in business operations, but also actively opposes ethical behavior. It supports extreme pragmatism and displays short-term tendencies. ROLE OF LAW IN ETHICS It is generally agreed that law cannot substitute either ethical standards or corporate governance. However, law can support the cause by specifying the basic minimum standards to be followed. Over and above the compliance, strictly confined to the letter of the law, it is left to the firm to follow judicious and ethical practices. In this context, it is worthy to note the following: "The law states minimum standards of conduct. But it does not and cannot embody the whole duty of man, and mere compliance with the law does not necessarily make a good citizen or a good company." 211 Given the limitations of law in enforcing high ethical standards, it still attempts to legally govern a few aspects of business and corporate functioning. The following are the areas that can be subjected to the purview of law with effective supervision: i. Disclosure practices ii. Transparency of operations iii. Maintaining confidentiality of client information The company law in any country can also govern the conduct and behavior of the management and accountability, to the others within and outside the company. Regulations pertaining to conduct of meetings address the issue of management participation and also pave the way for shareholder activism. The limit on the maximum number of directorships attempts to define a span of attention and devotion for an individual. Misrepresentations in prospectuses are dealt with under both civil and criminal laws. TRANSPARENCY OF OPERATIONS There is a major difference in terms of transparency of operations, between corporates and partnership firms. This aspect is peculiar due to their historical adherence to the partnership form of business organization. Visionary and ethical managements resorted to corporatization as a means of communicating their commitment to greater transparency, responsibility and accountability. Investment banks also allowed the market to value them. The evolution of technology has provided greater access to information to the companies. Information technology has enabled the exchanges to broadcast the trade and quotation information to all the market participants. This allows all the market participants to have equal access to the same market information and removes the disparity of information between the clients and brokers to a certain extent. The compensation policies in the industry are peculiar and highly subjected to multiple counting of transaction value that can be credited to each employee. It is important to design a compensation determination policy that would instill a sense of confidence and fair play among the employees. Ethical practices mean "justice should not only be done, but also seem to be done." ENFORCING ETHICS Companies face the daunting task of promoting ethical behavior among all the employees and ethics programs seek to promote awareness of legal and ethical concerns and to encourage ethical behavior among the employees. The key challenge for every financial managers lies in making ethics the core value and making values, not rules the drivers of a company's culture. This is because in a purely rule-driven culture, people may conclude, "what is not forbidden, is permitted" which is a dangerous assumption. Tools for Ethical Management Though there can be no hard and fast rules on the tools that would bring in ethical business practices, there can be a set of guidelines acting as general tools and techniques to create an ethical climate. According to Theodore Parcell and James Weber, the management can incorporate ethical practices techniques in three steps: establish appropriate company policy or code of ethical conduct, appoint a formal ethical committee and, impart education on ethics during management development programs. The tools for enforcing ethics seek to promote awareness of legal and ethical concerns and to encourage ethical behavior among employees at work. The tools include: 1. Top management commitment: Managers can prove their commitment and dedication to work by employing the other tools that would inject a sense of ethics in the staff. 2. Code of Ethics: This is a formal document that states an organization's primary values and the ethical rules it expects employees to follow. 3. Ethics Committees: Codifying the ethical practices would alone not suffice if it is not supplemented by an exclusive body for monitoring and steering the operations. An ethics committee needs to be constituted with both the internal and external directors. This way, the firm can try to institutionalize ethical behavior. The role of the committee becomes significant when the firm faces situations of dilemma regarding policy matters. The ethics committee organizes regular meetings to discuss ethical issues, communicate the code to all members of the organization, identifies possible violations of the code, enforces the code, rewards ethical behavior and punishes those who violate corporate ethics, reviews and update the code of ethics and reports activities of the committee to me board of directors. 212 4. Ethics Audits: This involves scrutiny and assessment of activities and their conformance with the predetermined ethical guidelines. Audits attempt to identify and correct any deviations from the standards set. 5. Ethics Training: The goal of ethics training is to encourage ethical behavior. This can be conducted both during the induction of the employee as well as during the periodic employee/management development programs. 6. Ethics Hotline: Ethics Hotline enables employees to deviate from the normal chain of command and reach the top management with their observations, experiences, problems and opinions, relating to the ethical validity of any of the firm's activity. For example, a country head may resort to unethical practices by manipulating the equities market (underlying) to suit the derivatives operations of the firm. An employee who comes to know of it can contact the region-head or the global corporate headquarters and complain about the matter. Such a whistle-blower might even go public with the information, if he perceives that no remedial action might be available inside the firm. The hotline helps in gathering the information from the whistle-blower, thereby controlling the damage that adverse publicity can cause to the firm. While a commitment to ethics is among the most valuable assets a firm can possess, it is also among the most difficult of assets to acquire and maintain, as well as among the easiest to lose. Even a company with a long tradition of being committed to ethics has no assurance that it will remain so committed. This requires the managers to develop a strong ethical culture that imbibes and reflects the values, attitudes and beliefs, which have the single greatest influence on how the investment bank works'. The future growth and success of any company depends on its commitment to these values, attitudes and beliefs and its ability to instill them in its employees. 213 One power that shareholders possess is the right to remove the directors from office. But shareholders have to take the initiative to do this, and in many companies, the shareholders lack the energy and organization to take such a step. Even so, directors will want the company’s report and accounts, and the proposed final dividend, to meet with shareholders’ approval at the AGM. Another reason why managers might do their best to improve the financial performance of their company is that managers’ pay is often related to the size or profitability of the company. Managers in very big companies, or in very profitable companies, will normally expect to earn higher salaries than managers in smaller or less successful companies. Perhaps the most effective method is one of long-term share option schemes to ensure that shareholder and manager objectives coincide. Management audits can also be employed to monitor the actions of managers. Creditors commonly write restrictive covenants into loan agreements to protect the safety of their funds. These arrangements involve time and money both in initial set-up, and subsequent monitoring, these being referred to as agency costs. Stakeholder Groups and Strategy The actions of stakeholder groups in pursuit of their various goals can exert influence on strategy. The greater the power of the stakeholder, the greater the influence will be. Each stakeholder group possesses different expectations about what it wants, and the expectations of the various groups’ conflicts with each other. Each group, however, tends to influence strategic decision-making. The relationship between management and shareholders is sometimes referred to as an agency relationship, in which the managers act as agents for the shareholders, using delegated powers to run the affairs of the company in the shareholders’ best interests. Primary Reasons for Conflicts of Interest Maximization of Shareholder Wealth Although most of the financial management theory is developed keeping in mind the assumed objective of maximizing shareholder wealth, it is, at the same time, important to note that in reality, companies may be working toward other objectives. The other parties that share interests in the organization (e.g., employees, the community at large, creditors, customers, etc.) have objectives that differ to those of the shareholders. As the objectives of these other parties might conflict with those of the shareholders, it will be impossible to maximize shareholder wealth and satisfy the objectives of other parties at the same time. In such situations, the firm faces multiple, conflicting objectives, and satisfying of the interested parties’ objectives becomes the only practical approach for management. If this strategy is adopted, then the firm seeks to earn a satisfactory return for its shareholders while at the same time (for example) is able to pay reasonable wages to its workforce. Goal Congruence Goal congruence is the term which describes the situation when the goals of different interest groups coincide. A way of helping to achieve goal congruence between shareholders and managers is by the introduction of carefully designed remuneration packages for managers which would motivate managers to take decisions which were consistent with the objectives of the shareholders. Agency theory sees employees of businesses, including managers, as individuals, each with his or her own objectives. Within a department of a business, there are departmental objectives. If achieving these various objectives also leads to the achievement of the objectives of the organization as a whole, there is said to be goal congruence. Achieving Goal Congruence Goal congruence can be achieved, and at the same time, the ‘agency problem’ can be dealt with, providing managers with incentives which are related to profits or share price, or other factors such as: a. Pay or bonuses related to the size of profits termed as profit-related pay. b. Rewarding managers with shares, e.g.: when a private company ‘goes public’ and managers are invited to subscribe for shares in the company at an attractive offer price. c. Rewarding managers with share options. In a share option scheme, selected employees are given a number of share options, each of which gives the right (after a certain date) to subscribe for shares in the company at a fixed price. The value of an option will increase if the company is successful and its share price goes up. For example, an employee might be given 10,000 options to subscribe for shares in the company at a price of Rs.30,000 (by buying Rs.50,000 worth shares for Rs.20,000). Such measures might encourage management in the adoption of “creative accounting” methods which will distort the reported performance of the company in the service of the managers’ own ends. However, creative accounting methods such as off-balance sheet finance present a temptation to management at all times given that they allow a more favorable picture of the state of the company to be presented than otherwise, to shareholders, potential investors, potential lenders and others. An alternative approach is to attempt to monitor 2 managers’ behavior, for example, by establishing ‘Management audit’ procedures, to introduce additional reporting requirements, or to seek assurance from managers that shareholders’ interests will be foremost in their priorities. External Constraints and Financial Strategy Economic Influences Aggregate Demand and Inflation A growth in aggregate demand can have either or both of the following consequences. a. An increased production by the firms. b. Inability on the part of the firms to produce more to meet the demand, due to limitations, resulting in the increase in the price. The impact of the rate of price inflation in the economy has the following affects: a. Costs of production and selling prices b. Interest rates c. Foreign exchange rates d. Demand in the economy (high rates of inflation seem to put a brake on real economic growth). Let us now try to understand each of the above factors in detail. Interest Rates Interest rates exert the following economic influences. a. Interest rates in a country influence the foreign exchange value of the country’s currency. b. Interest rates act as a guide to the return that a company’s shareholders might want, and changes in market interest rates will affect share prices. A positive real rate of interest enhances an investor’s real wealth to the income he earns from his investments. However, when interest rates go up or down, perhaps due to a rise or fall in the rate of inflation, there will also be a potential capital loss or gain for the investor. In other words, the market value of interest-bearing securities will alter. Market values will fall when interest rates go up and vice versa. Interest Rates and Share Prices When interest rates change, the return expected by investors from shares also tends to change. For example, if interest rates fall from 14 percent to 12 percent on government securities, and from 15 percent to 13 percent on company debentures, the return expected from shares (dividends and capital growth) would also fall. This is because shares and debt are alternative ways of investing money. If interest rates fall, shares become more attractive to buy. As demand for shares increases, their prices too rise, and so the dividend return gained from them falls in percentage terms. Interest Rates are Important for Financial Decisions by Companies Interest rate is important for financial decisions by companies. The incidence of the interest rates can have the following effects. a. When interest rates are low, it might be beneficial: i. To borrow more, preferably at a fixed rate of interest, and so increase the company’s gearing, ii. To borrow for long periods rather than for short periods, iii. To pay back loans which incur a high interest rate, if it is within the company’s power to do so, and take out new loans at a lower interest rate. b. When interest rates are higher: i. A company might decide to reduce the amount of its debt finance, and to substitute equity finance, such as retained earnings, ii. A company which has a large surplus of cash and liquid funds to invest might switch some of its short-term investments out of equities and into interest bearing securities, iii. A company might opt to raise new finance by borrowing short-term funds and debt at a variable interest rate (for example on overdraft) rather than long-term funds at fixed rates of interest, in the hope that interest rates will soon come down again. 3 Interest Rates and New Capital Investments When interest rates go up, consequently the cost of finance to a company also goes up; the minimum return that a company will require on its own new capital investments also goes up. A company’s management is supposed to give close consideration, when interest rates are high, keeping investments in assets, particularly unwanted or inefficient fixed assets, stocks and debtors, down to a minimum. This activity of the company is done in order to reduce the company’s need to borrow. At the same time, the management also needs to bear in mind the deflationary effect of high interest rates that deters spending by raising the cost of borrowing. Financial Planning and Strategic Planning Financial Planning The management function of planning requires the development, definition and evaluation of the following: a. The organization’s objectives, b. Alternative strategies for achievement of these objectives. The objectives of business activity are invariably concerned with money, as the universal measure of the ability to command resources. Thus, financial awareness probes into all business activities. Nevertheless, finance cannot be managed in isolation from other functions of the business and, therefore, financial planning will be undertaken within the framework of a plan for the whole organization, i.e., a corporate plan. The Relationship between Short-term and Long-term Financial Planning The process of financial planning must begin at the strategic level, where the corporate strengths and weaknesses are reviewed and long-term objectives are identified. It is to be kept in mind that business review should enable a forecast to be made of future changes in sales, profitability and capital employed. When this forecast is compared with the results desired by the corporate objectives, a gap may be identified which must be made good by developing new strategies. Senior management must negotiate with middle management, until a single strategic plan for the whole company is agreed. From this strategic plan, tactical plans must be drawn up (e.g., pricing policies, personnel requirements, and production methods) and a medium-term plan established. This medium-term plan can be broken down into a series of short-term financial plans at a later point of time. Potential Conflicts between Short-term and Long-term Objectives Companies are often accused of favoring short-term profitability at the expense of long-term prosperity. For example, an investment in the latest technology in production machinery might be postponed because of fear of increasing the depreciation charge, although longer-term profitability will be improved by the investment. Types of Long-term Strategy The different types of long-term strategies can be better understood with the help of the following flow chart. Long-term strategies Survival Growth By acquisition Internal 4 • Enable the owner-manager to retain personal control over operations. by paying out dividends larger than current earnings. • Risk which an organization can afford to take. or as one component of. 5 . • Maintain an acceptable quality of life. but a corrective strategy can also be used in conjunction with. his return can rise since the capital invested also falls. A company might pursue a non-growth strategy if it saw its non-economic objectives as more important than its economic objectives. In particular. A considerable amount of management time should be devoted to consider the actions needed to correct its overall strategic structure to achieve the optimum. • Lack of enough additional staff with sufficient expertize and loyalty. The negative growth strategy consists of an orderly. This involves seeking a balance between its overall strategic structures to achieve the optimum. In general. Risk-reducing Contingency Strategies A company faces risk because of its lack of knowledge of the future. it should be remembered that although it is desirable to reduce risk. • Pressure from public opinion. In the event of failure it would be left in an extremely vulnerable position and could even face winding up. and while the shareholder’s dividend may eventually decline. While on the subject of risk. and there is a net fall in assets employed. If the company simply runs down. planned withdrawal from less profitable areas. there could even be negative growth.Survival Strategies Non-growth Strategies A non-growth strategy refers to that strategy where there is no growth in earnings. high return involves higher risk and a company which is in a strong position might be prepared to take a higher risk in the hope of achieving a high return. risk is inevitably involved in any business. so that shareholders are effectively receiving a refund of their capital investment. it will increase its overall return on investment. a growth strategy. where forecasts of the outcome in n years’ time takes into account not only the likely return but also the risk involved. • Risk which an organization cannot afford to take. A negative growth strategy can be adopted in pursuit of an objective to increase the percentage return to the shareholders – if the company pulls out of the least profitable areas of its operations first. his return will also fall. Thus although there is no overall growth (or negative growth occurs) the company will shift its product market position. this risk should be minimized as above. The primary reasons for adopting a non-growth strategy may include. This does not necessarily mean no turnover. and • Diseconomies of scale of the particular production set-up. In certain cases. Sometimes a company is forced to take a risk because it knows that its competitors are going to act and if it does not follow it could be seriously left behind. although the total investment will be less. • Risk which is inevitable in the nature of the business. • Risk which an organization cannot afford not to take. Corrective Strategies A non-growth strategy certainly does not mean that the company can afford to be complacent. A company cannot afford to commit penny (and perhaps an overdraft as well) to a risky project. In fact there are different ways of looking at risk. the company will aim to correct any weaknesses which it has discovered during its appraisal. For this reason the term corrective strategy is also used. A non-growth strategy is bound to be a corrective strategy. The extent of the risk it faces can be revealed by the use of performance-risk gap analysis. This involves seeking a balance between different areas of operations and also seeking the optimum organization structure for efficient operation. employ its resources in different fields and continue to search for new opportunities. Chapter 2 Conceptual Framework The capital structure is the basic concept that should be designed with the aim of maximizing the market valuation of the firm in the long run. The important determinants in designing capital structure are: 1. 2. 3. 4. 5. 6. 7. 8. 9. Type of Asset Financed: Ideally short-term liabilities should be used to create short-term assets and long-term liabilities for long-term assets. Otherwise a mismatch develops between the time to extinguish the liability and the asset generation of returns. This mismatch may introduce elements of risks like interest rate movements and market receptivity at the time of refinancing. Nature of the Industry: A firm generally relies more on long-term debt and equity if its capital intensity is high. All short-term assets need not be financed by short-term debt. In a non-seasonal and noncyclical business, investments in current assets assume the characteristics of fixed assets and hence need to be financed by long-term liabilities. If the business is seasonal in nature, the funding needs at seasonal peaks may be financed by short-term debt. The risk of financial leverage increases for businesses subject to large cyclical variations. These businesses need capital structures that can buffer the risks associated with such swings. Degree of Competition: A business characterized by intense competition and low entry barriers faces greater risk of earnings fluctuations. The risks of fluctuating earnings can be partially hedged by placing more weightage for equity financing. Reductions in the levels of competition and higher entry barriers decrease the volatility of the earnings stream and present an opportunity to safely and profitably increase the financial leverage. Obsolescence: The key factors that lead to technological obsolescence should be identified and properly assessed. Obsolescence can occur in products, manufacturing processes, material components and even marketing. Financial maneuverability is at a premium during times of crisis triggered by ' obsolescence. Excessive leverage can limit the firm's ability to respond to such crisis. If the chances of obsolescence are high, the capital structure should be built conservatively. Product Life Cycle: At the venture stage, the risks are high. Therefore equity, being risk capital per se, is usually the primary source of finance. The venture cannot assume additional risks associated with financial leverage. During the growth stage, the risk of failure decreases and the emphasis shifts to financing growth. Rapid growth generally signals significant investment needs and requires huge sums of capital to fuel growth. This may entail large doses of debt and periodic induction of additional equity capital. As growth slows, seasonality and cyclicality become more apparent, As the business reaches maturity stage, leverage is likely to decline as cash flows accelerate. Financial Policy: Designing an optimum capital structure should be done in response to overall financial policy of the firm. The management may have evolved certain financial policies like maximum debt-equity ratio, predetermined dividend pay-out, minimum debt service coverage level, etc, Designing of capital structure will become subservient to such constraints and the solution provided may be suboptimal. Past and Current Capital Structure: The proposed capital structure is often determined by past events. Prior financing decisions, acquisitions, investment decisions, etc. create conditions which may be difficult to change in the short run. However, in the medium- to long-term, capital structure can be changed by issuing or retiring debt, issuing equity, equity buy-backs (when permitted), securitization, altering dividend policies, changing asset turnover, etc. Corporate Control: Firms which are vulnerable to takeover are averse to further issuance of equity as it can result in the dilution of the ownership stake. Such firms place an excessive reliance on debt and retained earnings. Firms with 'strong' management (having controlling stake) are unlikely to have reservations over further issue of equity. Credit Rating: The market assigns a great deal of weightage to the credit rating of a firm. Hence obtaining and maintaining a target rating has become imperative for most firms. Rating agencies maintain constant watch to identify any signs of deterioration in the creditworthiness of the company. The market reacts negatively to any downgrading of the rating of a firm. This may result in a denial of access to capital either due to the provision of any law/regulations (companies below a certain rating cannot issue CPs) or by the market forces (investors may not subscribe to debt with low ratings). The possibility of downgrading of rating due to the increase in leverage should be factored in while making capital structure decisions. ROI-ROE Analysis The relationship between the Return on Investment (total capital employed) and the return on equity (net worth) at different levels of financial leverage needs to be analyzed. 6 The relation between ROI and ROE is as follows: ROE = {ROI + (ROI - kd) D/E) (I -1). Where, ROE is the return on equity ROI is the return on investment kd D E t is the cost of debt (pre-tax) is the debt component in the total capital is the equity component in the total capital is the tax rate The ROE of an unlevered firm (or a firm with a lower leverage) is higher than the ROE of a levered firm (or a firm with a higher leverage) when the ROI is lower than the cost of debt. Conversely, the ROE of a levered firm is higher than the ROE of an unlevered firm (or a firm with lower leverage) when the ROI is higher than the cost of debt. The ROE will remain constant irrespective of the levels of leverage if the ROI is equal to the cost of debt. Beta and Theta are identical firms except for their capital structure. Particulars Debt Equity Total Investment Tax Rate Cost of Debt Beta 1000 1000 40% Theta 500 500 1000 40% 10% We shall examine the impact on ROE of both the firms if the ROI is 5%, 10% and 20%. Particulars ROI EBIT Interest PBT Tax PAT ROE Beta 10% 100 0 100 40 60 6% Theta 10% 100 50 50 20 30 6% 5% 50 0 50 20 30 3% 20% 200 0 200 80 120 12% 5% 50 50 0 0 0 0% 20% 200 50 150 60 90 18% It can be observed that firm Beta is better off (generates a higher ROE) when the ROI at 5% is less than the cost of debt at 10%. On the other hand, firm Theta is better off when the ROI at 20% is higher than the cost of debt at 10%. When the ROI is equal to the cost of capital, both the firms generate an identical ROE of 6%. DU PONT ANALYSIS It is important to examine a firm's rate of return on assets (ROA) in terms of profit margin and asset turnover. The profit margin measures the profit earned per Rupee of gross revenue but does not consider the amount of assets used to generate the revenue margin ratio. Return on assets = Net pro fit/sales Average assets/sal es 7 = Net profit margin x Average asset turnover When analyzing a change in return on assets, the analyst could look into the above equation to see changes in its components: net profit margin and total assets turnover. Figure 2.1 Du point Analysis A firm's rate of return on firm equity (ROE) is related to ROA through the interest-expense to-average-asset ratio and a leverage ratio - the asset-to-equity ratio, often termed the equity multiplier. Thus, the impact of ROE of changes in leverage as well as changes can be determined in firm operations and efficiency. Du point analysis is an excellent method to determine the strengths and weaknesses of a firm. A low or declining ROE is a signal that there may be a weakness. However, using Du pont analysis, source of the weakness can be determined. Asset, management, expense control, production efficiency or marketing could be the potential weaknesses within the firm. Expressing the individual components rather than interpreting ROE itself, may identify these weaknesses more readily. ECONOMIC VALUE ADDED (EVA) Economic Value Added or EVA is the economic profit generated after the cost of invested capital. EVA incorporates the opportunity cost of invested capital that is not realized by traditional accounting measures. Numerous studies have shown EVA to have a higher correlation to stock valuation than accounting based measures. EVA = Net Operating Profit after Tax - (Invested Capital x Cost of Capital) There are two steps required to convert GAAP net income to EVA. First, calculate net operating profit after tax (NOPAT) by adjusting net income. Common adjustments include extraordinary gains and losses, securities gains and losses, provision expenses and preferred stock dividends. Second, calculate invested capital and apply cost of capital. Invested capital includes book value of common and preferred equity, after-tax allowance for loan losses, and certain adjustments for cumulative non-operating gains and losses. Cost of capital equals the minimum required rate of return for investors (e.g. 15%). Whenever EVA is positive, shareholders have received a total economic return on their investment in excess of their required rate of return. . CASH FLOW RETURNS ON INVESTMENT (CFROI) CFROI is defined as the return on investment expected over the average life of the firm's existing assets. CFROI is nothing but another form of IRR measure. The key difference between the IRR and CFROI is that cash flows and investment are stated in constant monetary units in CFROI which overcome deficiencies of the traditional return on investment methods. Model for Maximizing Shareholder Value The following section discusses a few models for maximizing shareholders' wealth. Management focused on maximizing shareholders' wealth is referred to as value-based management. The models being discussed are • • • Marakon model Alcar model McKinsey model. 8 MARAKON MODEL The Marakon model was developed by Marakon Associates, a management consulting firm known for its work in the field of value-based management. According to this model, a firm's value is measured by the ratio of its market value to the book value. An increase in this ratio depicts an increase in the value of the firm, and a reduction reflects a reduction in the firm's value. The model further states that a firm can maximize its value by following these four steps: • • • Understand the financial factors that determine the firm's value Understand the strategic forces that affect the value of the firm Formulate strategies that lead to a higher value for the firm Create internal structures to counter the divergence between the shareholders1 goals and the management's goals. • Financial Factors The first step in this model is to identify the financial factors that affect the value of the firm. The model states that a firm's market value to book value ratio, and hence, its value depends on three factors - return on equity, cost of equity, and growth rate. This conclusion is drawn indirectly from the constant growth dividend discount model. Let P0 D1 k g r B b M be the current market price of the firm's share be the dividend per share after one year be the cost of equity be the growth rate in earnings and dividends be the return on equity be the current book value per share be the dividend pay-out ratio. The constant growth dividend discount model says that P0 = D1 k −g Further, D0 – B x r x b Substituting the value of Dj in the dividend discount model, we get Bxrxb P0 = Bxr xb k −g Dividing both sides of the equation by B, we get P0 r xb = B k −g Further, we know that g = r (1- b) 9 Figure 2. These include • • • • • Level of entry barriers Level of exit barriers Degree of direct competition Degree of indirect competition Number of suppliers Kinds of regulations Customers' influence. and a high growth rate in order to create value tor its shareholders. The following figure illustrates the effect of the strategic factors on the firm's value. we get P0 r xb M = = B B k −g Thus.2 Strategic Determinants of Value Creation Market economics refers to the forces that affect the prospects of the industry as a whole. The firm's competitive position in the industry determines its relative rate of growth and its relative spread. It can be observed from the formula that 1. The two important strategic factors that affect a firm's value are market economics and competitive position. When the return on equity is higher than the cost of equity. the higher a firm's growth rate. • • 10 . Hence. rxb=r-g Replacing the value of r x b in the equation. its cost of equity and its growth rate. The market economics determines the trend of the growth rate and the spread between the return on equity and cost of equity for (he industry as a whole.or. This is supported by the other theories of valuation of equity. a firm should have a positive spread between the return on equity and the cost of equity. a firm's market value to book value ratio can be derived from its return on equity. the higher its market value to book value ratio. A firm's market value will be higher than its book value only if its return on equity is higher than its cost of equity. 2. Strategic Forces The financial factors that affect a firm's value are in turn affected by some strategic forces. participation strategy and competitive strategy. The strategy on the preferred markets is followed by the competitive strategy. rather than being disjointed. A low economic cost may result from a number of factors like • • • • • • Access to cheaper sources of finance Access to cheaper raw material State-of-the-art technology resulting in better quality control Better management Strong dealer network Exceptional labor relations. and forego the higher market share.Competitive Position refers to a firm's relative position within the industry. by increasing the price of the product or the market share) and the means of creating an economic cost advantage. These may include • • • • The management's compensation being linked to the company's performance Corporate governance mechanisms that specify responsibilities and holds managers accountable for their decisions Resource allocation among projects guided by the specific requirements of the projects rather than the past allocations and capital rationing A mechanism for making sure that the various projects undertaken form part of a strategy. A firm needs internal structures which can control this tendency of the management. For achieving this objective two kinds of strategies are required . discrete projects Plans being made in accordance with the long-term goals and target performance being fixed in accordance with these plans. A firm's relative position is affected by its ability to produce differentiated products and its economic cost position. thus achieving the maximum possible growth and creating value. this strategy outlines the market areas (in terms of the geographical areas. Thus. to create value for its shareholders. has to either operate in an area where the market economies are favorable. A company. Economic costs include operating costs and the cost of capital employed. the high-end market or the low-end market.e. the ability to produce differentiated products improves a firm's relative position vis-a-vis its competitors. which specifies the plan of action required for achieving and maintaining a competitive advantage in those markets. the method for utilizing the differentiation so created (i. rather than the level of achievable targets determining the plans. or can command a higher price for its product than its competitors. At the level of a business unit. it needs to develop strategies that would help it utilize its strengths and underplay its weaknesses. It includes deciding the way of achieving product differentiation. The other factor that helps a firm enjoy a strategic advantage over its competitors is a low per unit economic cost. The strategy that specifies the broad product areas or businesses in which a firm is to be involved is referred to as its participation strategy. Strategies Once a company has identified its potential growth prospects and analyzed its strengths and weaknesses. It may either increase its market share by pricing it competitively. The firm can benefit from a differentiated product in two ways. Internal Structures The separation of ownership and management in the traditional manner results in the management bearing all the risks associated with value-adding decisions. A product can be referred to as a differentiated product when the consumers perceive its quality to be better than the competitive products and are ready to pay a premium for the same. without their enjoying any of the benefits. Performance targets should 11 . the level of quality and differentiation to be offered) to be entered. This often results in the management taking sub-optimal decisions. or has to produce those products in which it can enjoy a highly competitive position. Value growth duration refers to the time period for which a strategy is expected to result in a higher than normal growth rate for the firm. there are seven 'value drivers' that affect a firm's value. the cost of capital. The following figure represents the Alcar approach. According to the model.e. uses the discounted cash flow analysis to identify value adding strategies. According to this model. a strategy should be implemented if it generates additional value for a firm.3 Calculate the value of the firm's equity without the strategy The present value of the expected cash flows of the firm is calculated using the cost of capital. The cash flows should take the firm's normal growth rate and its effect on operating flows and additional investment in fixed assets and working capital into consideration. The last term. The cost of capital would be the weighted average cost of the various sources of finance.. ALCAR MODEL The Alcar model. developed by the Alcar Group Inc. Non-fulfillment of such promises affects the future performance. The first six factors affect the value of the strategy for the firm by determining the cash flows generated by a strategy. i. with their market values as the weights. For ascertaining the value generating capability of a strategy. rather than being the base for the plans. when achieved. The value of the equity is arrived at by deducting the market value of the firm's debt from its present value. taking into consideration the growth rate 12 . Target performance. affects the value of the strategy by determining the present value of these cash flows. the value of the firm's equity without the strategy is compared to the value of the firm's equity if the strategy is implemented. Figure 2. Calculate the value of the firm if the strategy is implemented The firm's cash flows are calculated over the value growth duration. should be rewarded with promised incentives.be a function of the plans. The following steps are undertaken for making the comparison. The strategy is implemented if the latter is higher than the former. a company into management education and software development. These are • • • • • • • The growth rate of sales Operating profit margin Income tax rate Incremental investment in working capital Incremental investment in fixed assets Value growth duration Cost of capital. The three main levels at which the key value drivers need to be identified are • The generic level: At this level. etc. it should prevail over all other objectives. achieving consumer satisfaction. the key steps in maximizing the value of a firm are as follows: • • • • • • • Identification of value maximization as the supreme goal Identification of the value drivers Development of strategy Setting of targets Deciding upon the action plans Setting up the performance measurement system Implementation. For example. For example. developed by leading management consultants McKinsey & Company. the key value drivers may be achieving the optimum product mix. These may be the level of capacity utilization. which are consistent with the goal of value maximization. etc. maximizing market share. but in case of a conflict. the variables that reflect the achievement or non-achievement of the value maximization objective most directly are identified. The grass roots level: At the grass roots level. and places emphasis on these value drivers in all the areas. The post-strategy cost of capital may be different from the pre-strategy cost of capital due to the financing pattern of the additional funds requirement. value-based management is "an approach to management whereby the company's overall aspirations. These cash flows are discounted using the post-strategy cost of capital. The post-strategy market value of debt is then deducted from the value of the firm to arrive at the post-strategy value of equity. Value Maximization . for the sales department. degree of innovation in products may be identified as the value driver for the design department.e. A strategy should be accepted if it generates a positive value. in the various management processes. or due to a higher cost of raising finance. cost of managing inventory. The other goals that a firm may have are generally consistent with the goal of value maximization. It is necessary to identify these variables for value-based management. i. Identification of the Value Drivers The important factors that affect the value of a business are referred to as key value drivers. The first step in maximizing the value of a firm is to make it the most important goal for the organization. It focuses on the identification of key value drivers at various levels of the organization. MCKINSEY MODEL The McKinsey model. The strategies should be aimed at and give 13 . According to Copeland. analytical techniques. and lead to the achievement of the same. These may be the return on capital employed or operating margin or the net profit margin. The value of the strategy is given by the difference between the post-strategy value and the pre-strategy value of the firm's equity. The value drivers need to be identified at various levels of an organization. and management processes are all aligned to help the company maximize its value by focusing management decision-making on the key drivers of value". as at the end of the value growth duration. etc. so that the personnel at all levels can ensure that their performance is in accordance with the overall objective. in performance measurement. The residual value is the value of the steady perpetual cash flows generated by the strategy.generated by the strategy and the required additional investments in fixed assets and current assets. The department level: At this level. is a comprehensive approach to value-based management. the variables that reflect the performance at the operational level are identified. It is generally reflected in maximized discounted cash flows. The other objectives of a firm mentioned above may act as value drivers at some level of the organization. Roller and Murrin. The PV of the residual value of the strategy is added to the present value of these cash flows to arrive at the value of the firm. etc. in setting up of targets. • • Development of Strategy The next step is to develop strategies at all levels of the organization.The Supreme Goal A firm may have many conflicting goals like maximization of PAT. maximization of market share. According to this model. etc. the variables that guide the department towards achieving the overall objective are identified. A performance measurement system should be linked to the achievement of targets and should reflect the characteristics of each individual department. At this stage. there is a need to specify the particular actions that are required to be undertaken to achieve the targets in a manner that is consistent with the strategy. Similarly. Hence. Setting up the Performance Measurement System The future performance of personnel is affected by the way their performance is measured. Deciding upon the Action Plans Once the strategy is in place and the targets have been determined. to a large extent. it is essential to set up a precise and unambiguous performance measurement system. the detailed action plans are laid out. Setting of Targets Development of strategies is followed by setting up of specific short-term and long-term targets. the targets for the various levels of the organization should be in tune. They should be set both for financial as well as non-financial variables. These should be specified in terms of the desirable level of key value drivers. The short-term targets should be in tune with the long-term targets. 14 .directions for the achievement of the desired level of the key value drivers. Piece Work Cards form the basis of preparation of the Payroll or Wages Sheet. To prevent fraud in payment of wages. Use of wrong rate of pay in the payroll. Inclusion of ghost or dummy workers in the payroll. Clock Cards form the basis of preparation of Payroll On the other hand. Employees' Slate Insurance. (b) The departmental labour rate can be calculated for each department. 15 2. etc. not entitled or due. 5. a number of steps should be taken. etc. It is desirable that separate Payroll or Wages Sheet is prepared for each cost centre or department. Prevention of fraud in wage payment: One of the problems associated with wage payment is the possibility of fraud perpetuated by workers.Chapter 3 Strategic Wage Management Preparation and Payment of Wages and Accounting PREPARATION AND PAYMENT OF WAGES When wages are paid on the basis of time. under the Payment of Wages Act. 3. Attendance time should be reconciled with time booked and lost time. The following types of frauds are more commonly seen: 1. viz. Inclusion of wrong hours when payment is done on the basis of time or overstatement of work done when payment is made on the basis of results. bonus. Co-operative Society dues. some of the authorized heads of deductions are: 1. The cashier then makes arrangement for paying out wages. 4. When the Wages Sheets are completed. For instance. These are: 1. This will serve three purposes. All payments should be made only on proper identification. 2. 3.. From the gross wages certain deductions are made to ascertain the net amount payable to the workers. 5. etc. Payment of wages in a factory is to be made preferably at the same time and in all the departments/sections in the presence of the departmental/sectional heads. 6. This will help in detecting attendance of a dummy worker fraudulently marked in the time card. Provident Fund. or overstatement of the amount due. 4. Inclusion of overtime. they are passed to the cashier for payment. Deliberate absenteeism on the date of wage payment to claim fraudulent payment later. (a) The volume of work can be spread over. 6. 1963. and (c) The actual wages of a department can be compared with the budgeted wages so as to pin down responsibility. . Income-tax. Omission to make authorized deductions (partially or fully). when payments are made on the basis of results. House Rent and supply of other amenities and services. Advance taken by workers. 2. Idle Time. Unavoidable idle facilities is the difference between maximum capacity and budgeted or standard capacity expected. 7. Tax E. Idle facilities may be unavoidable and avoidable. Control A/c Admn. it is necessary to make use of a Wages Analysis Book. Control A/c A/c Deduction Accounts Income P. ACCOUNTING FOR WAGES An analysis of the wages to the main control accounts is essential for accounting purposes. The exact amount of wages should be drawn from the bank and each individual should be paid his exact amount. 4. Further. Avoidable idle facilities is the difference between budgeted or standard capacity expected and the aggregate of actual time booked and the idle time. Actual hours worked should not exceed that authorized. Progress O.S. and Selling and Distribution Overhead Control Account. it should be recounted by another individual. For this purpose.F.H. Distribution Amount Control O. Factory Overhead Control Account. The rate of wages (time or piece basis) should be verified from relevant schedule of wage rates. Administration Overhead Control Account. It is not possible to work a machine all the available time. 8. extending them to Work-in-Progress Control Account. Idle Facilities It is the availability of facilities of plant and machinery and others which are not being utilized. 16 . Unclaimed wages should be paid on particular dates under strict supervision. scrap and defective production should be made only on proper authorization. 5. or in paying out the wages.I. From Figure 3. payment for idle time. Wages Analysis Book Dept Total Work-in. all calculations of payroll should be verified by another clerk. Selling and Net O. For instance.Fy. Outstation workers should be paid by the staff from Head or Main Cash office. etc. those who check the Clock Cards should not be concerned with the preparation of the payroll and those who do that work should not be concerned with making up the pay. and. Before handing over the pay packet. Similarly.3. All payments in this respect should be made after proper scrutiny of the reason for not drawing wages on the payment day. Payment for incentives should be made only on the basis of a certificate issued and initialled by the inspector. The documents necessary for compiling these extensions are: (1) (2) (3) (4) Payroll Job Cards Idle time Cards Wages Analysis Sheet Treatment of Idle Facilities.K. 6. There should be proper authorization in advance for overtime work. Any change in the rate should be incorporated in the schedule only when it is approved by a responsible officer. Certain necessary safeguards within the wages section are to be taken. The deduction accounts relate to credit side for use in an integral system of accounts.H. Others Wages Analysis Book The above analysis is necessary for accounting. The payroll should be signed by the individuals on preparation and verification.9 it will be seen that provision is made for entering the wages by departments. administration. Amount Hrs. While accounting for wages in the Cost Ledger.. (For details of accounting procedure see Chapter 7 on Cost Control Accounts.800 possible hours 40 20 30 17 ... selling and distribution.. Wages Analysis Sheet Week Ending.) Illustration 3..1 Accounting of Labour Cost in a diagram... The total shown in the summary column must agree with the direct wages on the Payroll. 13 Amount Clock No... of working weeks in a year Anticipated working hours: Actual hours worked: Idle time (hours): Waiting for instructions Waiting for materials Machine breakdown 48 hours per week 50 80% of maximum 1. 15 No. Ledger FolioCost Job 10 11 13 15 16 No. Summary Amount Hrs. 10 Job No.. No. 16 Clock No.. as the case may be) on some equitable basis. it is important to segregate the cost into direct and indirect—the direct labour cost being charged to prime cost while indirect labour being included in product cost as overhead (production...No . Total Wages Analysis Sheet.. Amount Job No. This type of analysts is done with the help of Job Card and Idle time Cards. Hrs. Job No. Figure 3. Hrs. Amount Hrs...Clock Clock No..1 Machine capacity: No. Amount Job No.. 1 1 Job No.Clock Hrs.The total will be posted to Work-in -Progress Account and Factory Overhead Control Account via Wages Analysis Book. e. machinery and other facilities while the latter with idleness of labour.920 (i) Unavoidable idle facilities (2.e. This is represented by the difference between the time as per the attendance records and the time booked to the various jobs or work orders. 30 hours hours hours hours The main point of distinction between idle facilities and idle time is that the former is related with idleness of plant. (b) Cost for normal but uncontrollable idle time: Such a cost may be merged with wages of the 18 . Administrative Causes which arise out of administrative decisions. they should be included in the departmental overhead.g. Economic Causes.920) 480 (ii) Avoidable idle facilities: Standard capacity expected 1.g.1.400 Budgeted or standard capacity expected for the period (2. In other words. Therefore..400 . The labour cost of operator may be excluded on the assumption that the operator has worked with another machine during the hours the machine was available for work. in order to analyze the cost by causes.400 x 80%) = 1. etc. i. idle time due to many of the productive causes is subject to control internally. The various causes that lead workers to sit idle may be grouped under three broad heads: I. The cost of idle facilities for reasons such as trade depression. The treatment of idle time in costs is as follows: (a) Cost for normal and controllable idle time: The costs should be segregated under separate standing order numbers and charged to Factory Overhead. Idle Time Idle lime may be defined as the time during which no production is obtained although wages are paid for that period. III. shortage of demand. The remaining portion of the cost of idle facilities should be included in the works overhead. should be written off to Costing Profit and Loss Account. fall in demand.. Treatment in cost: The cost of idle facilities will include part of standing or fixed charges relating to the machine. etc. e.. stoppage of production due to non-availability of raw materials. there may be some idle time.890 hrs. when there is a surplus capacity of plant and machinery which the management decide not to work.g. The unproductive labour element is charged to a special standing order number. Productive Causes which may be further classified as follows: (i) (ii) (iii) (iv) (v) Waiting for work Waiting for tools and/or raw materials Waiting for instructions Power failure Machine breakdown.90 Idle facilities may be calculated as follows: Maximum possible capacity in the year (48 X 50) = 2. idle time arising out of economic and administrative causes. and share of general overhead. Less: Actual hours recorded 1. uncontrollable. Some of the causes mentioned are controllable internally while others are beyond the control of management. idle time may be of two types: (i) (ii) controllable. e. or to a series of them. When responsibilities can be identified with a department.920 hrs..800 Add: Idle time 90 1. This is represented by idle facilities. it denotes payment made to a worker for a period during which he remains 'idle' and does no work. etc. Treatment in costs: The cost of idle time includes wages of operators for 'lost hours'. II. from the standpoint of controllability. proportion of machine standing charges and general overheads. etc. etc. therefore. Control of idle time: For effective control. overtime is paid at a higher rate than the normal time. the premium paid should be treated as an excess cost and. For example. Waiting for instructions: Idle time due to waiting for instructions can be prevented if the production control department issues clear instructions to the workers as to how to handle the job in sequence. the wage rate of the workers gets inflated. a routine check of all the machines at periodical intervals is normally a cure for any major breakdown. (d) (e) Although the above items can be controlled by proper planning. load shedding. power failure or for any other unavoidable reason. lockouts. etc. e. the standing orders may be for: SO SO SO SO SO SO 1 Waiting for material 2 Waiting for instructions 3 Waiting for tools 4 Waiting for machine repairs 5 Waiting for change-over time 6 Waiting for machine setting. As a result of merger of idle time cost. such as improper inspection and maintenance of power plant. Before dealing with the treatment of overtime premium. Idle time due to internal power failure may be reduced by keeping a proper inspection and maintenance of the power plant. In other words. But power failure due to external reason. To make up time lost due to breakdown of machinery. etc.: Considerable amount is being spent for idle time due to waiting for tools and/or materials. the overtime premium should be directly charged to the job concerned and treated as direct wages. some amount of idle time is bound to occur due to the time taken in changing from one job to another. Machine breakdown: Machine breakdown can be prevented by keeping proper maintenance system. The instructions and drawings should be clearly laid down for all jobs taken in hand. they should be treated as overhead which would be allocated and recovered 19 . They are: (i) (ii) To complete a work or job within a specific date as requested by the customer.workers.g. therefore. In other words. breakdown of the transmission wires or due to external reasons like failure from the main power supply station. The report will enable the management to locate the persons or departments responsible for any controllable lost time and to take effective remedial actions. necessary to give consideration to the circumstances under which overtime work is generally required. Power failure: It may be due to internal causes. Idle time due to productive causes are more or less subject to internal control. Waiting for tools. it is advisable to prepare a report showing the analysis of lost time so that action may be taken to control idle time where necessary. But in case of (ii). shortage of demand. is generally uncontrollable. Overtime Generally. The procedure in this respect may be outlined below: (a) (b) (c) Waiting for work: All the jobs in hand should be properly planned so that machines can always take up the jobs in sequence and workers do not have to wait for them. Therefore. The additional amount expended on overtime work is known as overtime premium. it is.. setting up the tools for a different job when the previous one is complete. (iii) To work as a matter of policy due to labour shortage or for any other reason. This should be charged directly to Costing Profit and Loss Account.12. This can be prevented by ensuring proper stores control and tool scheduling system. The object behind this is to keep the cost structure more or less comparable at different times and not to allow this to be disturbed by any unforeseen contingencies. In case of (i). (c) Cost of abnormal and uncontrollable idle time: This represents the cost of idle time for such reasons as strike. A suggested specimen of such a report of an engineering firm is given in Figure 3. The normal wages paid form part of direct labour cost while there is considerable controversy as regards treatment of overtime premium. transmission wires. fire. should be kept out of prime cost. each type of idle time should be allotted a separate Standing Order Number1 and booking should be made against each of them. it may be recovered as overhead by means of a separate percentage on basic wages. the premium payable should be charged to Costing Profit and Loss Account. 20 . When a worker cannot be provided with factory quarters. This may be done with the help of an average rate calculated by dividing the total wages payable by the total clock hours worked.from jobs completed during the period. (Separate standing order numbers are to be used for booking each type of allowance. However. However... installation of machinery. to meet the. In many organizations. employer's contribution to provident fund. retirement allowance. (iii) State insurance and medical benefits. are treated in accounts as follows: 1. treated as training cost which forms part of overhead. therefore. Therefore. Employer's Contribution to ESI The contribution made by the employer to Employees' State Insurance Corporation may be treated as follows: 1. learners' wages are. compensatory allowance is paid to the workers for natural hardship in a locality. Wage rate is inflated to include it in direct wages. Charge directly to the work on which a worker is engaged. evening overtime. holiday overtime. Fringe Benefits These are payments for which direct efforts of the workers are not necessary. in order to avoid loading the job with excess labour cost. and (vi) other cost representing a present or future return to an employee which is neither deducted on a payroll nor paid for by the employee. flood.. as a matter of policy. the premium paid may be treated as part of labour cost by spreading the overtime premium over various jobs completed. the amount contributed by the employer may be treated as general overhead. Recovered as overhead by means of a separate overhead percentage on direct wages. etc.) Alternatively.e. 2. (ii) Holiday pay. the entire cost of overtime should be charged to the Capital Order. e. All these payments are made with an idea to keep the basic pay structure of the workers unaltered. 2. 3. when the wages cannot be identified with a job. Learner's Wages Generally. Included in general overhead for recovery. For instance. Fringe benefits. Charge to general overhead. etc. in contract or process costing. if payment made to each worker and the work done by him is identifiable.g. they should be treated as overhead. House Rent Allowance. Dearness allowance is paid to the worker in addition to basic wages to cover increased cost of living. such as strike. a worker takes more time to do a job during his training period than a trained worker. Sometimes. it is possible to treat it as direct charge while in the case of a general engineering works which is engaged on jobbing work. half of his wages may be charged to the job direct while the other half allocated to overhead. if there is a special circumstance as visualized in case of overtime (i.g. house rent allowance is also paid for the purpose.. For overtime on capital works. the additional amount is charged directly to the job concerned. (iv) Attendance bonus and shift allowance. include: (i) Leave and sick pay. Dearness Allowance. Such additional payment is allocated to overhead like overtime premium. The logic behind it is that jobs will not show disproportionate labour only because they are produced at different times. Payments made on account of dearness allowance. In other words. holiday work is paid at a higher rate than normal day's wages. etc. etc. Work on Holiday and/or Weekly Closed Day Usually. In case of (iii). (v) Pension provision. usual working hours. the job or work order (in case of direct workers) or standing order number (in case of indirect workers) is to be charged directly. requirements of the customer). When overtime is worked on account of abnormal conditions. e. 2 = Rs.The cost of fringe benefits is included in the departmental overheads when department-wise identification is possible. 1 per hour up to 9 hours in a day at single rate and over 9 hours in a day at double rate. whichever is more beneficial to the workmen. Solution Total hours worked 8 to 9 11 9 4 51 : : : : 4 hours @ Re. 2 = R s. 4 hrs.54 Total wages Thus. 6 Normal working hours 8 8 8 8 8 4 44 44 Overtime hours At Single Rate At Double Rate — — 1 1 1 — 1 2 1 — _ — 4 3 Hours worked 8 hrs. Rs. 1 = Rs. wages payable to the workman is Rs. Problems and solutions Problem 1 (Normal and Overtime Wages) Calculate the normal and overtime wages payable to a workman from the following data: Days Monday Tuesday Wednesday Thursday Friday Saturday Normal working hours 8 hours per day Normal rate Overtime rate Re. 1 = Rs. 48 R 6 s. Rs. 1 = Rs. 54. 11 hrs. 9 hrs. Problem 2 (Overtime Impact on Labour Cost) 21 . it should form part of general overheads. Days Monday Tuesday Wednesday Thursday Friday Saturday Total Normal wages Overtime wages At single rate At double rate Total wages or Normal wages Overtime wages : : 44 hours @ Re. If not. 4 3 hours @ Rs. or up to 48 hours in a week at single rate and over 48 hours at double rate. 3 hours @ Rs. whatever method is followed. 9 hrs. 51 hrs. 10 hrs. 10 54 48 hours @ Re. Separate standing order numbers should be used for each type of fringe benefits. 45 0. This necessitates the application of the average wage rate as follows.000 Clock hours Time plus one-third 40.800 0.200 Weekend overtime 200 100 Job Z Clock hours 8. 500000 (a) Since overtime is worked regularly throughout the year as a matter of company policy due to labour shortage.000 5.45 per hour and its overtime rates are: Evenings—time and one-third. therefore.000 10.000 Evening overtime 600 1.424 Job Z 10.45 1.000 2.48 3.45 + x 0.40. the following hours we.000 0. average wage rate = Total w ages paid Total hours w orked Per hour £ 0. Solution Basic rate 1 0. Job X 22 Job Y Job Z .700 0.60 0.40.000 40.45) Evening rate Average wage rate during the previous year = Particulars Normal time Evening overtime Weekend overtime Total Thus.40.000 Clock hours The following times have been worked on the stated jobs: Job X Job Y Clock hours Clock hours Normal time 6. Job X 6.90 Hours worked 4.48 5.A company's basic wages rate is £ 0. (c) Where overtime is worked specifically at the customer's request to expedite delivery. re worked Normal time 4.000 £240000 = £ 0.00.98.48 5.45 3 Weekend rate (2 x 0.136 Total Clock hours Rate per hour (£) Labour cost chargeable (£) (b) In this case.300 0. During the previous year.000 Rate per hour (£) Wages paid (£) 0.100 600 You are required to calculate the labour cost chargeable to each job in each of the following circumstances: (a) Where overtime is worked regularly throughout the year as company policy due to labour shortage. overtime is an abnormal and irregular feature and.000 £ 2. jobs completed during overtime (evening or holiday) should not be overloaded by charging more while those completed during normal time should not be under-loaded.000 Clock hours Double time 20. (b) Where overtime is worked irregularly to meet spasmodic production requirement. State briefly the reason for each method chosen. Weekends—double time.48.60 24.000 20.90 18. overtime premium should be treated as production overhead while the jobs should be charged at basic rate only.000 0.264 Job Y 11. e. in underdeveloped countries.700 Rate per hour (£) 0. viz.300 10. the wage system should be simple and capable of being understood by workers of average intelligence. Besides all these. the customer would be ready to bear the excess labour cost. The amount of remuneration or wages payable to each of the employees depends on a number of factors. Because of the greater number of units produced. Therefore. Increase in productivity will result in lower labour cost per unit. Remuneration for labour is wages as remuneration for capital is interest.. Sufficiency in production will also help to check inflation.g.085 4.800 11. which by chain action needs increased output all round. the unit fixed cost will also tend to come down. by hour. (a) Simplicity: Unless the wage system is understood by the workers. 2. The terms of employment generally specify the rate or scale of pay and other allowances payable to workers. high wages may ultimately result in low cost of production. FACTORS TO BE CONSIDERED The following factors must be given due consideration before selecting a system of payment. the fullest advantage cannot be obtained out of it. High wages induce workers to produce more. (1) Time basis. is crucial to labour cost management. Further. for land is rent and for organization is profit.. Simplicity from the point of view of analysis and recording in the Cost Accounts may also be considered. we discuss methods of remuneration by grouping them under two main headings. On the other hand. day or week.815 Since overtime is worked specifically at the request of the customer to expedite delivery. e.g. profit-sharing. straight piecework. the overtime premium should be charged to the jobs as follows Methods of Remuneration Labour is one of the four factors of production. the method of remuneration should be such that it encourages increased production. differential piecework. In this Section. On the other hand. as we have seen in the previous Section. incentive and wages plans. one of the main needs of modern days is to raise the standard of living.48 0. Selection of a right person for the right job.45 Labour cost chargeable (£) 3.Total Clock hours 6. Therefore. etc. This is achieved in two ways: 1. (b) Quantity and quality of output: If quantity is more important than quality. (2) Results basis. In the modern industrial enterprise of mass production. negotiated labour contracts. This again requires the larger output of a number of consumer goods. a worker's wages are Dased upon job evaluation. Both direct and indirect labour employed in an organization will have to be paid remuneration for the services rendered by them.45 0.060 5. there are monetary and non-monetary incentive schemes which are also discussed. when quality is 23 . NEED FOR INCENTIVE SCHEMES Low wages do not necessarily mean a low cost of production. This aspect should not also be lost sight of. the minimum wages payable under a given situation. and retain those who are already in employment. the increase in production must yield decreasing rate so as to discourage very high production which may involve heavy rejections. (a) Effect upon workers: High wages will attract efficient workers from outside. The scheme should not be in violation of any local or national trade agreements. so the cost of labour turnover is less. After completing one piece. if any. i. heavy expenses of indirect nature (overhead) are incurred. After a certain stage. However. 2. turnover. The wages should be related to the effort put in by the employee. Piece Rates Combination of Time and Piece Rates Premium Bonus Schemes Group Bonuses Others 24 . The operating and administrative cost of the scheme should be kept at a minimum. 6. and expected savings in time in producing it. 4. they remain constant even when volume of production fluctuates with a range. ESSENTIAL FEATURES OF AN EFFECTIVE WAGE PLAN These may be enumerated as follows: 1. 3. Consequently. It should be fair to both the employees and employer. 7.e. that is to say.more important. 3.. 6. 9. the government legislation. Time Rates 2. 5. 4. (b) Statutory provisions: There may be legislative measures to protect the right of wage earners and to emphasize managerial obligations in this regard. There should be guaranteed minimum wages at a satisfactory level. wage payments should be preferably based upon time rather than on production quantities. A major portion of overhead is again fixed. The role of workers' union should also be assessed and it should be taken into consideration in selecting the wage system. the workmen should be able to go over to the next without waiting. In this connection. generally sets the floor. the various methods of remuneration may be broken down into the following main heads: 1. 5. remuneration. the factor 'incidence of overhead' is of outstanding significance and lies at the basis of all schemes of remuneration. It should be emphasized that an increased volume of production results in lower unit fixed cost whereas a decrease in production results in increased cost of production per unit of output. There must be continuous flow of work. The scheme should aim at increasing the morale of the workers and reducing labour It should be based upon scientific time and motion study to ensure a fair output and a fair METHODS OF REMUNERATION For convenience. (c) Incidence of overhead: In large manufacturing enterprises. The scheme should be flexible to permit any necessary variations which may arise. 8. two things should be considered: (i) (ii) expected volume of output. The features of a high-wages plan may be summarized below: 1. Standards of performance are set and there is stricter supervision to ensure the attainment of the standards. so that in return a much higher standard of performance from the workers is ensured. an extra premium will be usually paid. When payment is made on the basis of hours worked by the employees. wage board award or by the Government through Payment of Minimum Wages Act.The different methods included in each of the above groups can be diagrammatically shown. 2. It is the employer who may gain arising out of extra efficiency of his workers or lose due to their inefficiency. payment is made on the basis of time which may be hour. The rate of pay should not be less than that prescribed by a tribunal. wages are to be calculated as follows: Wages .e. (b) Time rate at high wage levels: This system is similar to the previous one except that the day rates are made high enough. The standards set should be capable of being accomplished by an efficient worker.2 Wage System and Incentive Schemes Time Rate Systems The general characteristic of all the time rate systems is that the workers do not get anything beyond their time wages.Hours worked x Rate per hour For overtime work. day. i. (a) Time rate at ordinary levels: Under this method. wages are paid at time rates which vary with changes in local 25 . The hourly rate is higher than normal wage for the industry. (c) Graduated time rates: Under this method. Time x Rate. Figure 3. 3. Henry Ford was of the opinion that time rates at high wage levels are equally effective like other incentive plans. We discuss below the features of three time rate systems. week or a month.. Various systems may now be considered in greater detail. Overtime work is not permitted. g. 3.e.g. the workers tend to adopt 'go-slow' tactics. e. tool-making and pattern-making) where care is more important than speed. Where the work demands a high degree of skill and quantity of production is less important. It is paid at a certain rate per unit produced or job performed or operation completed irrespective of the duration of time taken by the workers. The advantages and disadvantages of the piece rate systems in general may be summarized as follows: Advantages 1. the employer does not stand to lose anything because of variation in the efficiency of the workers.g. In their bid to earn more. 2. 2. night watchmen.. Where work is not repetitive. 5. the basic wage rates normally remain fixed and it is the dearness allowance that varies with the cost of living. For precision work (e. Where worker does a work in his own interest.g. tool-making. Since the workers are certain about their wages. This leads to contented body of workers which in turn improve the employer-employee relationship. etc. Advantages and Disadvantages of Time Rate Systems Advantages 1.g.. etc. This will lead to frustration of efficient workers and consequently more labour turnover. 3. Workers are paid only for the work they have done. e. Where machine performs the job and the workers have no control over the work. Generally.. They are: 1. they may not care to improve their efficiency to increase production. Sometimes. Piece Rate Systems. wage rates are adjusted with changes in the selling price of the product. 26 . Payments by Results Systems based on work are otherwise known as piece rate systems.. cleaners and sweepers. Efficient workers' efforts are not rewarded. 2. Where it is difficult to measure the work done by workers. The workers are more or less certain about the amount they will earn so long as they remain in employment. 6. the general dexterity and skill of the workers are enhanced. According to these systems. e. Application of Time Rate Systems There are many circumstances in which lime rate systems are suitable. in process industries the flow of work is regulated by the speed of the conveyor belt. As a result. It is simple to understand and operate. Where work is of such a nature that efficiency can be ensured by close supervision. workers will try to adopt better and more efficient methods in order to increase production.. the time rate systems will help in maintaining quality of products.. 4. in jobbing type industries. The slogan may be "produce more and earn more". Disadvantages 1. This leads to higher cost of production inasmuch as more time means more labour cost and consequently more overheads. workers stand to gain or lose as a result of a standard efficiency which they attain. construction of accommodation. This is applicable in case of indirect workers such as supervisors.cost of living index. machine manufacturing. the extent or volume of work done forms the basis for determination of the wages payable to the workers. 2. In other words. Thus. In India. e. i. watch-making. Guaranteed wages according to time rate plus a piece rate payment for units above a required minimum. wasted time.3 Hourly rate of pay Standard lime per unit (ascertained by time and motion study) Rs 2 . e. 3. Earnings = Number of units x Rate per unit The fixation of piece rate generally depends upon: (i) (ii) comparable time rate for the same class of workers.'. Because of (2).3.g. the increase in production may be achieved at the cost of quality. the ultimate cost of production will be higher. the workers will get more. the workers will be paid on the basis of time rate. lead to reduction in cost and a greater margin of profit. in turn. Where quality of the product is no less important than the quantity. A piece rate system with graduated time rate may include any one of the following: (i) If earning on the basis of piece rate is less than the guaranteed minimum wages. high tool cost. Disadvantages 1. a larger output will generally result.. if earning according to piece rate is more. Piece rate with a fixed dearness allowance or cost of living bonus. Therefore. 4. Cost ascertainment becomes simplified to some extent because exact cost of labour for each unit is available. etc. opposition from the workers is bound to come. if increase in production is effected through more wastage of material. high cost of inspection and quality control. for ascertaining rates. Thus. 6. On the other hand. as the payment is made only for the turnover of work and consequently idle time will be reduced to minimum. 2. 5. 27 (ii) (iii) . This will. workers are paid minimum wages on the basis of time rates. The piece rate is usually fixed with the help of work study Standard time for each job is ascertained first. Over-strain on the part of workers will cause frequent absenteeism and bad health. a very careful time-study is necessary. The fixation of piece rates on the basis of standard time required a considerable amount of work at the outset and also during the operation of the scheme. (a) Straight Piece Rate: Under this method. the workers will have to lose when there will be no work. Piece rate is then ascertained with reference to hourly or daily rate of pay. Illustration 3. if flow of work cannot be maintained. 4. If day wages are net guaranteed. Change-over time. 2 90 minutes (b) Piece Rates with graduated time rates: Under this system. in a given time. Increased production does not necessarily mean reduced cost. and expected output. are not paid for. For instance. Thus. payment is made on the basis of a fixed amount per unit or per fixed number of units produced without regard to time taken. Piece rate = x 90 = Rs. 5. payment on the basis of piece rate system may induce the workers to increase production disregarding all this which will affect costs adversely. 3 60 Rs. The workers will always try to produce more to earn more. The operation of piece rate wage system provides a sound basis for standard costing and production control. There were two rates: below the standard. the punitive lower rate is not imposed for performance below standard. 80% of Re. earnings vary at different stages in the range of output. or a volume of output is taken as standard. a high piece rate was fixed. the piece rate will be: Re. (b) A standard time is set for each job or operation. This method also does not guarantee day wages. the father of scientific management. On the other hand. Day wages were not guaranteed. the system was designed to: 1. When at or above standard. the worker is paid his hourly rate. Thus. 28 . this plan rewards the efficient workers and encourages the less efficient workers to increase their output by not penalizing them for performance below 834%.A. Thus. Under this plan. 0. a very low piece rate and above the standard.05. 0.. 0. The factory has introduced the following differentials in the matter of wage payment: 80% of piece rate when below standard 120% of piece rate when at or above standard.4 A factory works 8 hours a day.e. The standard output is 100 units per hour and normal wage rate is Rs. by F. Taylor.S. piece rates were determined by time and motion study. The rates which are applied are: Efficiency Up to 83 1% Above 83}% but up to 100% Above 100% Piece-rate applicable Normal rate 10% above normal rate 30% above normal rate. (d) From 66y% up to 100% efficiency. In other words. reward the efficient workers by setting a high piece rate for high level production. (c) Below 66 -|% efficiency. 5 per hour. payments are made on the basis of step bonus rates. there is more than one piece rate to reward efficient workers and to encourage the less efficient workers or a trainee to improve. This scheme was first introduced in the U. These are now discussed below. and was subsequently modified by Merrick. However. The Taylor differential system is often criticized as "unfair" due to the fact that minimum wages of the worker are not guaranteed.. Thus. 0. (i) Taylor Differential Piece Rate System: In the original Taylor differential system. 100 units When below standard. Combination of Time and Piece Rates (i) Emerson's Efficiency Plan: The main features of the plan are: (a) Day wages are guaranteed.06. 120% of Re.05.04. Illustration 3. the piece rate will be Re. i.W. performance above a certain level is rewarded by more than one higher differential rates. Taylor's system is suitable to those industries where products including the processes and operations can be standardized. 0.e. discourage below-average workers by providing no guaranteed wages and setting low piece rate for low level production. (ii) Multiple Piece Rates or Merrick Differential System: Merrick afterwards modified the Taylor's Differential Piece Rate. i. and 2. two piece rates will be fixed as follows: Normal piece rate = (a) (b) Rs 5 = Re.(c) Differential Piece Rates: Under this system.05. 320. high piece rates and bonus.80 32.66 0.69 0.00 64.00 384.64 0.5 Time Rate: Rs. 2. — 3.20 12.00 32.00 384.60 Labour cost per unit Re.00 73.(e) Above 100% efficiency. Emerson's Plan may be illustrated below: Bonus Clock Card Production No.00 323.80 352. 29 . Illustration 4. 3. facilitate an easy transfer from time wages to payment by results scheme..66 0.82 0.64 0. But this scheme is not meant for skilled and competent workers.60 Total wages Rs. Performance below standard is paid on the basis of time rates (guaranteed). Efficiency for this purpose is calculated as follows: (1) On time basis: Percentage Efficiency (2) Standard time allowed x 100 Time taken On production basis: Percentage Efficiency = Actual Production x 100 Standard Production Emerson's Efficiency Plan is suitable to: (1) (2) encourage slow workers to better their performance. Its main features are: 1.00 352.00 64.62 0.00 32.00 393.81 0. Day wages are guaranteed. Standard production per week of 40 hours: 600 units.63 (ii) Gantt Task and Bonus Scheme: This system combines time rales. an additional bonus of 1% of the hourly rate is paid for each 1% increase in efficiency. Standards are set and bonus is paid if a work is completed within the standard time allowed. Step bonus rates are: Efficiency (%) 67-75 76-85 86-95 96-100 Bonus (%) 1 4 10 20 With the foregoing basic data.20 332.00 352. 0. 8 per hour. per week 10 11 12 17 19 20 26 28 30 390 400 480 530 550 570 580 600 620 Percentage Efficiency 65 67 80 88 92 95 97 100 103 Percentage — 1 4 10 10 10 20 20 23 Amount Rs. But. each minute of standard time is called the Bedaux point or "B". 3. The Gantt Task scheme may be introduced in: 1. a worker is paid a bonus of 50% of the time saved at time rate in addition to his normal time wages. 1. Thus.(Hours worked x Hourly Rate) -t. lack of attempt to control material costs.— (Time allowed . It is a means of strong managerial control and accordingly receives managerial support.e. if any . and The Rowan scheme.4. when time taken is less than standard time allowed) is paid at high piece rate. Time wages are paid until 100% efficiency rate is reached.Time taken) x Hourly Rate. Illustration 3. Contract costing where work is to be completed within a specified date. If the job is completed in less than standard time. Thus. 2. Under this scheme. Under the original plan. The Halsey-Weir scheme. Standard time is fixed for each job or operation. The time and bonus rates are fixed for each job. Premium Bonus Schemes The various schemes under this method combine time wages with piece rates. The main features of this scheme are: (a) The Halsey Scheme: 1. The limitations of the scheme are: high cost due to additional clerical work and inspection. Machine tool manufacturing industry.e. this plan provides an incentive for efficient worker to reach a high level of performance and also protects and encourages the less efficient workers by ensuring the payment of their minimum wages in case their performance is below the standard level.. Time rate is guaranteed and the worker receives the guaranteed wages irrespective of whether he or she completes the work within the time allowed or takes more time to do it. 3. each operation to be performed can be expressed as being so many "Bs" and payment is made on the basis of the number of "Bs" standing to the credit of a worker. Performance above standard (i. The foreman may also receive bonus if the workers under him qualify for it. the workers nowadays receive 100% of the bonus. the gains on labour efficiency and losses on inefficiency are shared by employer and employee. quantity x high piece rate). 2. There are three chief schemes under this heading.. A competitive element is introduced and this acts as an additional spur to production. according to modified scheme. and when a job is completed the worker goes on with the next. etc. (a) (b) (c) The Halsey scheme. Thus. (iii) Bedaux Scheme or 'Points' Scheme: This system requires a very accurate time study and work study. The advantages of the scheme are. The pay thus earned consists of (i) day wages plus (ii) the sum of all bonuses (i. Heavy engineering and structural workshop.6 30 . Earnings under this scheme will be: Guaranteed wages + Bonus (50% of time saved). As a result. 2. viz. the worker received only 75% of the bonus while the 25% was received by supervisors. 16 -t. 3. a worker will get a bonus of 30% of time saved as against 50% in the case of previous scheme. The earning per unit will come down with the increase in efficiency. Illustration 3. therefore. 2. The employer will share 50% of the bonus due to time saved by the workers.Rs. 17.20 (c) Rowan Scheme: This scheme was introduced by David Rowan in Glasgow in 1901. 2) + ~ (10 . 2 10 hours 8 hours The advantages and disadvantages of this scheme are mentioned below: Advantages 1.2 . Disadvantages 1. the bonus is paid on the basis of time saved.7 8 X Rs. 16+ 1.Normal hourly rate Time allowed for a job Time taken Therefore. (b) The Halsey-Weir Scheme: Under this scheme. The workers may. The more efficient workers will be able to increase hourly rate of earnings more rapidly with the increase in hours saved. In other respects. the final result will be the same. The incentive. both Halsey and Halsey-Weir Schemes are similar. This may induce him to introduce better equipments and methods. 4. Formulae: (i) (ii) Time wages + (Time wages X Bonus ratio) Time taken x (Hourly rate + Hourly rate x Bonus ratio) 31 . it takes into account a proportion as follows: Time saved Time allowed The bonus may be calculated in two ways: (i) (ii) adding it to the normal time wages. 2 + Continuing the previous illustration. or adjusting the hourly rate. 18 Rs. Simple to understand and operate. But unlike a fixed percentage in the case of Halsey Scheme. 2 100 = Rs.8) x 2 = Rs. total earnings will be: 1 (8 x Rs. the earnings under this scheme will be: 30 (10 .20 = Rs. This may make the workers feel that it is the employer who gains more by their efficiency. object to share their bonus with the employer. But whatever method may be followed. is not strong enough to induce the more efficient workers to work harder.8) X Rs. 2. As before. Inefficient workers are not penalised as they get day wages for the hours worked. as compared with other high incentive schemes. 2 10 − 8 2 1 = = 10 10 5 1 5 = Rs.80 5. 16 x 1 8 hrs. — 2.80 15.20 Method (ii) 8 hrs. Comparison of Halsey and Rowan Schemes The following table may be of interest in making the comparison between these two premium bonus schemes: Rate Time Time Time Time per hour allowed taken saved wages (1) Rs. It is more complicated than the Halsey System. Advantages 1.20 16. the workers cannot take undue advantage as only a proportion of the savings is passed on to them.40 2. even if the rale setting department being newly established in a factory sets erroneously the time allowed. 20. bonus ratio is = Earnings : Method (i) 8 hours 10 hours Rs.67 3.Bonus Ratio = Time saved Time allowed Time saved = Time allowed .00 Rs.Time taken Illustration 3.00 5. x Rs .20 4. 20.40 = Rs.00 Rs.00 32 Rs. --3.8 Time taken Time allowed Rate per hour Therefore. For example. It is suitable for learners and beginners.20 5 The advantages and disadvantages of this method are mentioned below.00 2.00 4.00 15.00 Rs. 2 2 2 2 (2) (3) (4) (5) = (1 x3) Rs.25 2. 2. 2. 3. This will adversely affect the morale of the efficient workers. A beginner and a more efficient worker may get the same amount of bonus. 3. It provides a safeguard against loose fixation of standard.80 3. 2.20 = Rs. x Rs. 20 16 12 10 Bonus Total earnings Earnings per hour Halsey Rowan Halsey Rowan Halsey Rowan (6) (7) (8) (9) (10) (11) (5 +6) (5 + 7) (8-3) (9 + 3) Rs.00 16.00 Rs.00 2. 2 + Rs. 19.00 18. 19. Efficiency beyond certain point is not rewarded.00 10 10 10 10 10 8 6 5 Nil 2 4 5 . 16 + 3. The workers share the benefit with the employer.2 + 2 x = 8 hrs. 2. Disadvantages 1.00 19. 2. X Rs. 20 3.50 6. 50% efficiency is the cut-off or break-even point for both the schemes. Figure 3.00 7. when the work is done in 6 hours. the bonus is the same under both the schemes. when the time taken is 50% of the time allowed.80 while the same amount is payable to another worker who takes only 4 hours to do it. the bonus increases steadily with increase in efficiency. 33 . (ii) Rowan scheme provides better bonus than the Halsey scheme until the work is completed in half the standard lime. Although this is unfair. 4.3 Bonus under Halsey and Rowan Schemes (iii) When the work is completed in half the standard lime.60 (1) Bonus earned: A comparative position of bonus at different efficiency levels under both the schemes is shown in Figure 3.80 3. Again.80 12. As for instance.00 4.Standard wage rate x (ii) Bonus under Halsey Plan will be equal to the Bonus under Rowan Plan when the following condition holds good: Standard wage rate x or 50 x Time saved 100 Time taken = Standard wage rate x Time allowed Time taken 1 = Time allowed 2 x Time taken or Time taken = 1 of Time allowed 2 Hence.2 2 10 10 4 2 6 8 8 4 6.00 3. But in the Rowan scheme. the bonus increases up to a certain stage and then starts decreasing. This can be proved as follows: Bonus under Halsey plan = Standard wage rate x 50 x Time saved 100 Time saved Time allowed x Time taken (i) Bonus under Rowan plan .00 12.3.00 8.20 14. Rowan scheme may provide a safeguard against loose fixation of standard.20 3. under Rowan scheme a less efficient worker may get the same bonus as a more efficient one will get. the bonus payable is Rs. The main points may be summarized below: (i) In the Halsey scheme. the bonus under Halsey and Rowan plans is equal. earnings under Rowan scheme will be lower than that of Halsey. 2 Rs. Under the Rowan scheme. an average worker cannot himself determine his own wages. 2 5 x 6 . in that owing to the high incentives the workers may rush through work to earn more. earnings under both the schemes will be equal. (e) Accelerating Premium Bonus: Under this scheme. beyond that the labour costs are less than that under the Halsey scheme. bonus increases at a faster rate.8 110 1. At 50% efficiency level. This scheme is not suitable for machine operators. Therefore. a graph of y = 0. disregarding quality of production.) Wages per hour Rs.) It appears that when efficiency increases.83 2. Wages payable are arrived at by multiplying the hourly rate by square root of the product of the time allowed and time taken. 10 5 x 4 = Rs. in the Rowan scheme. the earnings per hour increase at an accelerating rale.8x2 may be given as a general picture of the scheme (where x is percentage efficiency ÷ 100 and y = wages). Therefore. 9 (approx.5 2. Beyond 50% efficiency level. 1.25 1. Group Bonus Schemes 34 .35 150 1.3 1. each firm has to devise its own formula. Worker X Time allowed (hours) 5 5 5 Time taken (hours) 6 Wages payable Hourly rate x S x A T T Rs.00 2. 11 (approx.1 1.6. (d) Bank Scheme: Under this plan day wages are not guaranteed.21 0. one gets percentage earnings against percentage efficiency.(iv) When the work is completed in less than half the standard time. total earnings or labour costs steadily decrease with increase in efficiency. the rate of increase in the total earnings falls. However. by way of illustration. the following points will emerge: (i) (ii) (iii) (iv) Below 50% efficiency.9 Hourly rate Time allowed for a job Rs 2 5 hours Find wages payable when time taken is given to be 5 hours. 4. There is no simple formula for this scheme. it increases steadily.8x2 100 1 1 0.Hourly rate -Time allowed X Time taken Illustration 3. Thus.69 1. (3) Earnings per hour: In the Halsey scheme. bonus under Halsey scheme is greater. But this plan is most useful for beginners and trainees and unskilled workers.80 Multiplying the values of x and y by 100. But it is suitable for foremen and supervisors. Percentage efficiency X x2 y = 0.Rs. total earnings will vary depending upon the amount of bonus. 2 Rs. 6 hours and 4 hours respectively by three different workers. Another disadvantage of this scheme is that because of complication involved in calculating wages. The decrease.50 Y Z 5 4 5 x 5 = Rs. Wages . earnings under Rowan method will be greater than that under Halsey. (2) Total earnings: Time wages under both the schemes remaining constant at a particular level of efficiency.97 130 1. In other [words. For example. one may get 175% of basic wages for 175% efficiency. A diagrammatic representation of the comparison between Halsey and Rowan schemes is shown in Fig. In the Halsey scheme. so that they may obtain the maximum possible production from workers under them. is at an accelerating pace up to saving of 50% on the time allowed. 5/25 x Rs. 400 100 Time wages of the workers: P 90 hrs. Under these circumstances. 1. 100 will be shared pro rata among the 10 members of the group.00 35 Rs.80 Q Re.2. a group bonus based on the results of the team effort may be introduced. In a factory.10 Standard production Number of men working in the group 40 units per week 10 Bonus—for every 25% increase in production. receives: Rs.80 0 72 hrs.11 under time rate.10 = Rs. 2. R and S: (i) (ii) (iii) Output of the group Piece rate per 100 units No. the output depends upon the combined effort of a team.50 s x 16. 150 Each member of the group. of hours worked by: 16.20 S Re.00 R Rs. Group Bonus system is in use which is calculated on the basis of earnings The following particulars are available for a group of 4 workers P. 1. 150 H. Total Piece Earnings for the group = R . But bonus scheme for a group of workers working together may also be introduced where: (a) (b) (c) it is thought necessary to create a collective interest in the work. @ Re.80 Calculate the total of bonus and wages earned by each worker. 0.In all the schemes discussed so far. Q.000 units Rs. @ Re. 72 72 = = . the bonus payable has been ascertained on an individual basis. Illustration 3.50 P 90 Q 72 R 80 S 100 (iv) Time rate per hour for: P Re. 100) = Rs. 0.000 = Rs. therefore. Actual production Standard production Increase in production 55 units 40 units 15 units or 37.5% Bonus: Rs. it is difficult to measure the output of individual workers. a bonus of Rs. Actual Production during a week 55 units Calculate bonus payable to each member of the group. 100 + (12. 15. 0. 1. Illustration 3. 12 In a mass production factory. The effort of more efficient workers are not properly rewarded. Illustration 3.50. measured similarly. Principal Group Bonus Schemes Sometimes the idea of group bonus may be extended to the whole factory.000 points 6. @ Re.20 = 100 hrs. 3. this system can operate in a factory where there is mass production of a standard product with little or no bottlenecks.50. or "Share of Production" Plan. Harmonious working in a group leads to increased output and hence lower cost of production. Therefore.000 workers are employed. Put in another way.000 points 1. and Towne Gain Sharing Plan. the employees will. It eliminates excessive waste of time. 1.000 points. Rucker. 2. etc. It is difficult to fix the amount of incentive and its principle of distribution among the members.000 points. 2. If actual output. 0.00. The alleged disadvantages are: 1.000 36 . exceeds standard. Standard output for a week is set at 5.R S 80 hrs. The various schemes which may be introduced for this purpose may include the following: (a) (b) (c) (d) Priestman's Production Bonus. Scanlon Plan.00. (a) Priestman's Production Bonus: Under this system. During a week actual output is valued at 6.80 = 96 80 320 The advantages of group bonus scheme are: 1. the workers will receive a bonus in proportion to the increase. @ Rs. 1. a standard is fixed in terms of units or points. therefore. In addition to the basic wages. It creates a team spirit. receive a bonus calculated as follows: Standard output Actual output Increase 5. materials. the share of inefficient workers may be the same as that received by more efficient members of the group.50. Overheads 1. Note: Unlike conversion cost.50. Their results were as follows: Labour cost Production. VA = Sales less cost of bought-in materials and services or VA = Profit before tax + Conversion costs + Other costs where conversion costs include manufacturing labour and manufacturing overheads. excluding the cost of purchased materials and services. Admn.00. The value added concept has become increasingly important in recent years. Any reduction in the ratio entitles appropriate bonus payment. or "Share of Production" Plan: According to this plan. 2. selling and distribution costs (including interest. The ratio of labour cost to VA is: 200000 400000 x100 = 50% Assume that bonus is payable for reduction in the ratio at 1% of the added value. 4. and Selling & Distribution Overheads Profit before tax Value added Rs. However. a ratio of labour cost to value added is set based on normal relationships. Value added measures the value added by an enterprise to its product or the provision of a service. Illustration 3. Labour cost to VA is: 220000 450000 x 100 = 48.20.50. labour will receive a constant proportion of 'added-value'. 37 .000 Profit before tax 60.000 Value added Rs 4.or 30% All employees will be entitled to a bonus of 30% of their wages. and other costs include administration.40. In the following year. But profit-sharing schemes are still relatively widely used in industry.000 80. and Selling & Dist. (b) Rucker. value added includes profit.000 Production. this system presupposes a great deal of consultation between management and workers so as to make the effort more effective.50.000 Rs. etc.000 . Many firms are using it both as a measure of performance and as a labour incentive scheme.500 The value-added scheme appears to be a more satisfactory method than the normal profit-sharing scheme for many reasons.000 1.13 A Ltd shows the following average pattern over the past five years: Rs. 4.5% Since the ratio was reduced. According to Rucker.000 4. Labour cost 2.00. the bonus payable was: 1% of Rs. depreciation.) In introducing an incentive scheme based on value-added. location or availability of a product or service. In other words. sales and added value increased.000 = Rs. employees receive a constant proportion of the 'added value' or 'value added1. The term value added is defined in the Terminology as follows: The increase in realizable value result ing from an alteration inform. Admn. When only direct workers enjoy incentive schemes. canteen. As for example. savings in time or expenditure effected over the standards set. merit rating.). (ii) Banus to repairs and maintenance staff. the efficiency of machine operator is bound to decrease. etc.g. e. 3. therefore. checkers. indirect workers who work side by side with them are dissatisfied with such discrimination. staff of stores. Incentive Schemes tor Indirect Workers One of the main conditions of the incentive systems is that actual output and/or time taken in relation to standard set is determinable. etc. Therefore. dispensing staff. In case of direct workers the measurement of performance does not involve any problem. 4. 3.g. and reducing costs (this is possible if production and productivity are increased). canteen workers. It should be so organized as to achieve all round efficiency. internal transport. For the purpose of incentive schemes. indirect workers may be grouped as under: (a) Indirect workers working with direct workers.. overall improvement in efficiency. supervisors. But in case of indirect workers. yearly. 2. if the plant and machinery is not properly and regularly maintained by the staff concerned. sweepers.. reduction of scrap and waste. This. dispensing. increasing production and productivity. there is no reason why the indirect workers should not be brought under some incentive schemes. improvement in the quality of product. For routine and repetitive maintenance.. Here bonus is calculated on the basis of reduction in labour cost vis-a-vis the standard set. The supervisory staff may also receive a share of the bonus. etc.. When the work of the direct workers is related to or dependent upon that of the indirect workers. e. e. etc. whose performance cannot be directly measured (e.g. A few examples of incentive schemes to indirect workers are stated below. Rewards should be related to results. It should be guaranteed for a specific period. and reduction of labour turnover. (i) Bonus to foremen and supervisors: Supervisors and foremen may be paid a weekly or monthly bonus based upon the following: (a) (b) (c) (d) (e) (f) output of the section or department concerned. half-yearly. introduction of an incentive system may appear to be difficult. scrap. bonus may be based on the output of direct workers whom the indirect workers serve. (b) Indirect workers rendering general service. affects morale and hence efficiency of the indirect workers. 2. a percentage of bonus payable to the direct workers.g.. job evaluation. a group bonus system can 38 . maintenance staff. any deficiency on the part of the latter due to lack of incentive schemes will also affect adversely the efficiency of direct workers. In designing an incentive scheme for the indirect workers. packing. output of a department or of the whole factory. 50% of "gain" (savings in cost) is paid to individual workers pro rata in addition to their basic wages. In this case. machine maintenance staff. inspectors. If direct workers are rewarded for their efficiency. an incentive scheme for indirect workers will increase their efficiency and promote team spirit. etc. Incentive for supervisors and foremen would assist in: (a) (b) (c) reducing idle lime. waste. weekly. supervisors. Bonus to be paid will be determined on a wider basis. transport workers.(c) Scanlon Plan: This plan is similar to the Rucker plan except that it adopts the ratio between wages and sales value of production. (d) Towne Gain Sharing Plan: According to this plan.g. monthly. On the other hand. It should be paid at regular intervals. to attain all round efficiency it is necessary to have incentive schemes both for direct and indirect workers. etc. Still it is essential to provide for incentives to the indirect workers for the following reasons: 1. e. the following points must be considered: 1. (b) Non-monetary Incentives These types of incentives relate more to the conditions of employment rather than to job functions. Canteen—free or subsidized 39 . 3. This will increase employee morale and thereby reduce labour turnover. a minimum period of service is a condition of participation in the scheme. there will be increased productivity. 2. The industry. lockout. certain objections are often raised. As a result. and (ii) Co-partnership. The employees do not have any access to the accounts of the enterprise and. The shares held by the employees may or may not carry voting rights. Promoting better health amongst the employees so as to build up a happy and contented staff. efficiency percentage can be evaluated for the purpose of payment of bonus. 2. 2. employees are allowed to have a share in the capital of the business and thereby to have a share of the profit. the "available surplus" is generally distributed amongst three parties: 1. they cannot ascertain the propriety of the amount paid to them as bonus. Under this Act. This type of scheme recognizes the principle that every worker contributes something towards profits and hence he should be paid a percentage thereof. When co-partnership operates in conjunction with profit-sharing. profit-sharing schemes take the form of an annual or other periodical bonus. The employees feel a greater "sense of belonging" to the enterprise and this leads to careful handling of costly materials and plants and machinery. to a share of profits at an agreed percentage in addition to their wages. therefore. by virtue of an agreement. employees frequently receive additional remuneration based on the prosperity of the concern. contributes something towards profit. lead to disputes which may turn to strike. the minimum and maximum bonus payable is respectively 8^% and 20% of salary. Making the conditions of employment more and more attractive. and 2. In other words. the employees are entitled. Sometimes. and 3. the employees are allowed to leave their bonus with the company as shares or as a loan carrying lucrative interest. The employees. Schemes like Profit-sharing. Non-monetary incentives may be entirely free or subsidized by the company. This induces them to increase their efficiency to work hard. Other Incentive Schemes (a) Indirect Monetary Incentives Of late. Advantages 1. (ii) Co-partnership: Under this scheme. There were considerable disputes as regards the quantum of bonus to be paid to the employees. The Govt. Employees are not paid bonus on the basis of output and hence efforts of more efficient employees are not properly rewarded. These schemes are becoming more and more widespread and are growing in importance. Co-partnership. etc. of India set up a Bonus Commission and on the basis of its report the Payment of Bonus Act had been adopted in 1965. will recognize the principle that every employee. and very often does. This may. (iii) Bonus to stores staff: It may be based on value of materials handled or number of requisitions.be established on the basis of reduction on the number of complaints or reduction in breakdown. etc. More profits may lead to more bonus to the employees. When standards are set. (i) Profit-sharing: Under this scheme. Alternatively. The shareholders. However. They are wide in number and may include: 1. They are: 1. The objectives behind these schemes are two-fold: 1. In India. The principal schemes under this heading include: (i) Profit-sharing. directly or indirectly. efficiency percentage may be calculated for the purpose. 2. 4. 5. 4. 40 . etc. Provident Fund schemes. Health and safety Recreational facilities Housing facilities Educational and training Pension. 3. Components A supply chain may consist of variety of components depending on the business model selected by a firm. storage facilities and retailers that perform functions like procurement and acquisition of material. and finally. The customer order is filled by the retailer. or by placing a fresh order with the wholesaler/manufacturer. the physical distribution of the finished goods to intermediate or final customers. either form the existing inventories. processing and transformation of the material into intermediate and finished tangible goods. He caters to the needs of the customer by making the products available at his store. the customer places an order directly with the manufacturer. distributors. Figure 4. the retailer places orders with the inanufacturer to replenish the stocks. 41 . transporters. Wal-Mart has such an arrangement with P&G.Chapter 4 Financial aspect of supply chain management A supply chain is a network of manufacturers. In some cases a customer bypasses all these supply chain components by getting in touch with the manufacturers directly. the POS information with manufacturers the manufacturer monitors the stock levels' and replenishes it automatically. As part of this process. A customer activates the processes in a supply chain by placing an order with the retailer. A typical supply chain consists of the following components: • Customers • Distributors • Manufacturers • Suppliers Customers The customer forms the focus of any supply chain. For example in the case of an online purchase of a computer from Dell Computers. but in some cases where there is arrangement to share. In a typical supply chain. purchase orders originate at the retailer's end. suppliers.1: Supply Chain Network S u p p lie M r s a n u f a c t u r e r sD i s t r ib u t i o n C e M n a t e r s t s / C u s t r k e Retailers/Distributors The retailer acts as a link between the customer and the distributor/manufacturer. production. Then the customer service teams design the product or service agreements specifying the level of service that is to be offered to each of these customer groups. According to the definition given by the Global Supply Chain Forum. Suppliers Suppliers facilitate the manufacturers'. Customer Relationship Management Customer relationship management involves establishing a framework for building and maintaining relationships with customers. the manufacturer either uses the pull or the push strategy to generate demand required for the movement of products in the supply chain.add value for customers and other stakeholders. manufacturers. Supply chain management involves the use of a set of approaches to integrate efficiently the activities of suppliers.1 shows the various business processes that are performed across the supply drain. These teams work in close coordination with the key account customers to reduce demand variability. It plays a major role in balancing the customer's requirements with the firm's supply capabilities. They are: • • • • • • • • Customer Relationship Management Customer Service Management Demand Management Order Fulfillment Manufacturing Flow Management Procurement Product Development and Commercialization Returns Each of the above processes consists of a set of activities from within various functions of the organizations comprising the supply chain. Figure 4. to the right locations. Demand management involves determining 42 . The manufacturer then plans for a production schedule depending on the resultant demand. Suppliers help manufacturers to decrease their inventory levels by arranging for Just-in-time supplies. Depending on the market situation. Customer Service Management Customer service management is concerned with providing the customer -with up-to-date information relating to shipping dates. SUPPLY CHAIN MANAGEMENT PROCESSES Although there are many views of supply chain management. manufacturers try to integrate their processes with those of the suppliers to be in a better position to respond to fluctuations in customer demands. This involves identifying the customer-groups who form the target for achieving the firm's business objectives.to original suppliers that provides products. product availability. Since it is very difficult to forecast demand accurately. product application. finance. Various aspects of customer service management are discussed at length in Chapter 12. There are eight business processes that are carried out across the supply chain. Manufacturers1 place orders with suppliers on the basis of 'forecasted customer demand. and at the right time.Manufacturers The manufacturer plays a key role in deciding the structure of supply chain. and information that-. research and development. etc. at present. The customer service management teams act as an interface between the customers and the functional departments like production and logistics in administering product and service agreements. These functions include marketing. logistics etc. in order to minimize system-wide costs while meeting customer service expectations. services. Performance reports are designed in order to measure levels of service made available to the customer and the profits resulting from serving each of the customer groups. warehousing providers and retailers. many practitioners look upon supply chain management as the management of key business processes across the network of organizations that form the supply chain. so that goods are produced and distributed in right quantities. supply chain management is the integration of key business processes from end-user. production process by ensuring continuous supply of raw materials. Demand Management Demand management is the key to effective supply chain management. the way a firm handles its returns. The product development and commercialization process involves establishing cross-functional product development teams. But with opportunities for saving cost and making profits arising from improving the financial flow. defining the for order fulfillment. v. evaluating the logistics network developing plans for order fulfillment etc This topic is discussed in detail in Chapter 13. iv. Traditionally. developing product rollout plans. etc. designing and building prototypes. receiving orders. Some of the other objectives of supply chain management are to: i. Procurement Supplier relationship management guides the interactions of the firm with its suppliers. Product Development and Commercialization Reducing the time to market is one of the objectives of supply chain management. ix. Firms in the past. This includes payments for goods and services to the suppliers and collection 43 . Returns Management Many companies are forced to recall products to rectify defects upgrade the products or recycle them. Hence. There may be many environmental issues associated with. Manufacturing Flow Management Manufacturing flow management is concerned with ensuring the smooth production of goods and developing flexible production processes that can respond to the demands of the target markets. This process aims at developing long with suppliers to ensure uninterrupted flow of supplies for the firm's manufacturing processes. xi. synchronizing demand with the supply capabilities of the firm. focused mainly on improving the material flow in their supply chains. Such relationships are essential for effective supply chain management.forecasting methods to gauge customer demand. viii. determining manufacturing capabilities. Reduce inventory levels Improve customer service Make more efficient use of human resources Ensure better delivery through reduced cycle times Increase the sharing of information and technology among the participants in the supply chain. and developing contingency management systems to handle variations in demand. ii. The order fulfillment process includes activities like. firms have begun to streamline the financial flow as well. vii. Customer Order Fulfillment The effectiveness of a supply chain is determined by its ability to fill customer orders on time. synchronizing production and demand. Thus the returns management capability of a firm also plays a major role in providing a competitive edge to the firm. Financial flow is an important flow in any supply chain [apart from material and information "flows]. iii. The returns management process is discussed at length in Chapter 11. Steps involved in planning demand and supply in a supply chain are discussed in Chapter 4. vi. backward flow of cash from customers to the product manufacturer or service provider is considered as the financial flow. This requires the integration of customers and suppliers into the product development process to ensure speedy rollout of new products. manufacturing and material planning. managing the products returned is also a major part of supply chain management. OBJECTIVES OF SCM One of the major objectives of supply chain management is to reduce the total amount of resources necessary to provide the required level of customer service to a particular customer group. Decrease the time required to market new products Enable firms to focus on core competencies Enhance the public image of companies Induce greater trust and interdependence between supply chain partners Increase shareholder value Gain competitive advantage over others. etc. Technological advances that facilitate automation. distribution and transportation. This supply chain process includes activities like determining the degree of manufacturing flexibility required. x. A high order fulfillment rate with low costs requires coordination between various organizations across -the supply chain and their internal functions like manufacturing. have enabled firms to improve the financial flow. Figure 4. and this reduces the time and costs in matching the invoices and the errors that occur due to repeated data entry. and enhancing customer satisfaction. the accounts department pays the supplier. This reduces the time and costs involved in routing and approving the purchase orders. thus eliminating the need for an invoice.) can reduce paperwork and processing costs. Then. we discuss both the processes in detail and the ways to speed them up in order to achieve cost savings and profitability.2: Purchase-To-Pay-Process R e q u i s i t i A o np p r o v R S e n d a l P u r c h a s eG O r d e r e c e i v o o d s eI n v o i c e P r o c e s s i n g P S u p p l i e r a y m e n t Some of the measures to improve efficiency of purchasing transactions are discussed below. This involves faster collection of the accounts receivables and efficient management of accounts payable. we examine the various options available for automating the financial flow in a supply chain. the firm pays the supplier for what it receives.2 describes the purchase-to-pay process. Use of electronic invoicing. Purchase-to-Pay Process (PTP) Purchase-to-pay process starts with the buyer making the requisition and ends with the payment to the supplier. Figure 4. In ERS. the approval again at the time of payment to the supplier should be eliminated to reduce the delay in the purchasing process. the firm checks the shipment and the invoice to confirm whether the shipment matches the purchase order arid the product quality and quantity is as desired. Focus on reducing processing time and costs There are various ways of reducing processing time and costs in order to expedite the purchasing process. viz. and the amount is calculated based on the price quoted in the purchase order. In this chapter. After getting the approval of the purchasing manager. up to a certain permissible limit. Purchase-to-pay process consists of financial transactions with the suppliers and order-to-cash process consists of financial transactions with the customers. The buyer makes a purchase requisition and it is passed on to the purchasing department for approval. improving collaboration between the supply chain partners. Electronic Invoice Presentment and Payment etc. Upon confirmation. On receiving the goods. COMPONENTS OF FINANCIAL FLOW IN A SUPPLY CHAIN There are two key components that constitute the financial flow in a supply chain. we first discuss the components of a financial flow and how they can be improved. we discuss the ways by which an integration of material and financial flows can be achieved.of payments from the customers for providing goods and services. without approval.. Efficient management of cash flow in these two processes can improve the profitability of the supply chain. the buyer compares the packing slip and the goods with the purchase order. This can reduce the errors and disputes that arise due to manual processing. Use of Evaluated Receipt Settlement (ERS). In cases where the purchase requisitions are approved before the order is placed with the supplier. Then. 44 . An efficient financial flow can help the firm in reducing inventory. Thus. On receiving the purchase order the supplier dispatches the shipment along with the invoice. In this section. the payment is made to the supplier. the buyer makes the payment as and when he receives the goods. increasing cash flow. a purchase order is sent to the supplier. Firms should allow the buyers (an employee who is involved in purchase activities) to order goods. purchase-to-pay process and order-to-cash process. Electronic invoicing (EDI. On receipt of the goods. Finally. Another application that aid the automation of financial processes is Electronic Invoice Presentment and Payment (EIPP) systems. The firm then checks the customer credit status to decide whether or not to extend credit to the customer. check printing. But an E-procurement application can only improve the physical process of purchasing and not the financial processes. electronic funds transfer. processing costs incurred. reporting & analysis. Outsourcing provides the firm flexibility and the ability to scale up the operations as and when needed. Then. By outsourcing time consuming and routine activities. The risks involved in FTP operations can be reduced by sharing the operations with a third party. In some cases the entire FTP process is outsourced. If the customer has placed the order within the credit limits and has nil or permissible receivables. processing cost per invoice etc. There are two types of performance metrics in the PTP process: top down performance metrics. resolve disputes. Finally.2 describes the order-to-cash process. and bottom up performance metrics. and make payments electronically. to enhance the effectiveness of the PTP process. The goals need to be based on industry benchmarks. the customer's credit limit and the status of receivables from the customer are checked. EIPP systems enable the suppliers and buyers to exchange invoices. Order-to-Cash Process Order-to-cash process starts with the customer placing the order and ends with receiving the payment from the customer. By expediting the order-to-cash process. ERP and accounts payable for effective functioning. Bottom up metrics include time taken for processing each payment voucher. the firm has to establish a new credit line for the customer. The benefits from outsourcing include reduction in processing costs. Figure 4. fax. Many ERP systems contain various modules of PTP process that may help in the automation of financial components. the firm has to evaluate whether to fulfill the order or to reject it or put it on hold. then the order may be put on hold for farther analysis. which measure the overall performance of the PTP process. Thus. Outsourcing Outsourcing some of the components of the PTP process to a third party is an option that a firm can consider. The order is placed by the customer directly through phone. If not. This can provide some inputs to make the PTP process more efficient.Performance management A proper performance management process needs to be established to effectively measure the FTP process. A firm has to identify the functions that can be outsourced so that cost savings or faster processing can be achieved. or the Internet. which measure individual or team performance. supplier management etc. cash flows can be improved. If the customer is an existing one and has high credit risk. then the order may be rejected. a firm can focus more on strategic functions and the personnel can be used for productive purposes. The metrics are measured against the goals set to analyze the extent to which goals have been achieved. The steps involved in the order-to-cash process are explained below. Some of the steps that can be carried out to expedite the order-to -cash process are as follows: • • • • Review of processes and procedures Identifying the processes fit for automation Developing appropriate performance metrics Designing an effective reporting system 45 . For this. Automation of PTP process A firm can enhance the efficiency of the PTP process by automating it. the collection of the payment is done either at the convenience of the customer or as per rules and norms set by the firm. If the order is placed by an existing customer having low credit risk. purchase order error rates etc. the customer is billed and the invoice is sent to the customer. managing international payments. The metrics need to be aligned with the goals set by the firm. Top down metrics include percentage of payments made using checks and electronic payments. EIPP systems need to be integrated with the internal systems like procurement. these systems enable collaboration between supply chain partners. The disputes that are raised by the customer are then examined and resolved. the inventory is checked for the availability of the product in the quantity required by the customer. If it is a new customer. dispute handling. then the product can be delivered to the customer. Many financial institutions offer cash management services like receiving invoices. Firms can implement an E-procurement system and streamline the purchasing process. After delivering the goods. Such a policy is advisable when the firm wants to increase its market share. the firm only accepts those customers who have a good credit history and high credit ratings. The first type of credit policy puts high credit risk limits and stringent measures of collection. Automation helps in faster and more accurate risk assessment of customers. In such a policy. Such a policy may increase the risk of bad debts and the collection process may take a long time and become tedious. It can also help the firm identify opportunities to improve the process. Automating receivables management Another important step in enhancing the efficiency of receivables management is the automation of a part. But the collections are made liberally. Such a policy enables the firm to obtain payments faster and reduces the risk of high bad debt. It has to evaluate its competitive environment and develop a credit policy that differentiates it from its competitors. There are four key types of credit policies which a firm can adopt. • • • • • • • Percentage of invoice errors Percentage of bad debts Average time taken for credit approval Percentage of orders executed perfectly Percentage of cash collected within the stipulated credit terms Percentage of invoices issued manually Percentage of invoices issued electronically 46 . several factors have to be considered. which enable it to evaluate a customer while providing the credit. While developing the credit policy and procedures.Review of processes and procedures B2B firms generally provide goods on credit to the customers. and should be developed in line with organizational objectives. credit is interest free and the firm has to bear the credit costs. Activities like payments and credit analysis can be automated. Firms can easily distinguish between the customers with low credit profiles and customers with high credit profiles. which while being customer friendly. or whole of the process. But such a policy is not customer friendly. making the collection process liberal will not have any impact on the receivables. In such a policy. thus forcing the suppliers to make their policies towards such firms liberal. only customers who have high credit ratings and 'good track record are allowed. Days Sales Outstanding (DSO) is the key measure that is generally used to evaluate the order-to-cash process. But such a policy is not advisable for firms which handle large orders. In most of the cases. The firm should also consider customer preferences and requirements. Firms. at the same time. should not impact the collection and quality of the receivables. that can be measured for better performance analysis. Yet. Performance measures are needed for all the elements of order-to-cash process. By automating receivables management a firm can track and monitor the receivables and evaluate as to how the receivables process can be improved. the firm accepts customers with even low credit ratings but the collection will be strict and no kind of lenience towards the customers is allowed in the collection policy. Big retailers wield more power. related to each step in the order-to-cash process. Such a policy is customer friendly but it increases the collection costs and the risk of bad debts. This enables the firm to decide upon the customers to whom credit can safely be extended. the firm may also have strict collection policies such as imposing penalties and fines. Credit policy needs to take into account the industry within which the firm is operating and its size. a firm can analyze its position in relation to its competitors. They are. The second type of policy is to be liberal in providing credit but strict in collecting dues. The idea behind such a policy is that a customer with a good track record will pay the dues promptly. By matching the measures to the industry standards. have to carefully evaluate and set guidelines for providing credit to the customers. but has liberal collection policies. Firms may have to provide credit on liberal terms. they have to make sure that the bad debts generated on account of those liberal policies are kept under control. Developing relevant performance metrics Developing relevant performance metrics helps the firm assess the effectiveness of the receivables management process. for late payments. therefore. The firm has to choose an optimal credit policy. The fourth kind of credit policy allows customers with low credit ratings and a liberal collection policy. At the same time. and take necessary action to improve upon those measures. In such a policy. The third kind of credit policy allows only customers with high credit ratings. But there are other metrics. therefore. to reduce time and costs and to improve the receivables collection and management. It also needs to develop credit risk analysis guidelines. They should also be based on industry standards. Faster credit processing enables the firm to process orders without much delay thus increasing customer satisfaction. This linking can also be extended to the supply chain partners thus enabling the physical order information flow to closely match with the payment information flow. on time. Proper information sharing enables the departments to have accurate and up to date information. Improved customer satisfaction. This would help the firm collect receivables and also resolve customer grievances faster. AUTOMATING FINANCIAL FLOW IN A SUPPLY CHAIN One of the key elements which helps in efficient financial flow in a supply chain is the use of IT solutions in the purchase-to-pay and order-to-cash processes. Firms have also used IT solutions to automate the material flow. By automating these processes firms can minimize inefficiencies and improve the effectiveness of the supply chain. This may help in developing a long term relationship with the customers. Many firms have adopted best practices of cash flow management to improve the financial flow. By entering the customer data into these systems. Collaborative Planning. INTEGRATING MATERIAL AND FINANCIAL FLOWS IN A SUPPLY CHAIN Firms in the past have mainly focused on improving the material flow in a supply chain using various innovative methods like cross docking. so that the right order can be delivered to the customer. 47 . This enables increased collaboration between supply chain partners. which in turn helps them to take timely action. This would help the firm to distinguish between the customers who need to be focused upon and the customers who need to be ignored. This information needs to be shared with the other supply chain partners like logistics service providers and financial institutions as well. these systems provide instant credit analysis information about the customers. With the emergence of the Internet. By providing the required credit rules to these systems. Supply chain partners help in providing the right product to the right customer at the right time. For example. Many firms have automated the same or all of the elements of the financial flow in a supply chain through implementing ERP systems and cash flow management solutions. by linking the procurement system with the accounts payable system or the ERP system. suppose a customer holds back payment due to quality or quantity issues. they have also begun to focus on improving the financial flow in the supply chain. these firms have begun to provide these services on the worldwide web. However. such as credit limit and credit terms. By integrating material and financial flows. This helps the firm to improve its revenue as well as to reduce its credit risks. firms can remove the inefficiencies in the supply chain. This helps the sales representatives in taking faster decisions at the point of sale. As customers expect timely and accurate order delivery. For example. Today. This information is first received by the accounts receivables department. Assigning ratings to the customers. Some of the prominent IT solutions that are used in automating the financial flow are: • • • Electronic Invoice Presentment and Payment (EIPP) solutions Electronic trade financing systems Credit information and management systems.Developing an effective reporting system Information needs to be shared between different departments for efficient receivables management. a firm can obtain the ratings of its customers as per the predefined credit rules. Integration of these two flows can be done in three different ways. Three prominent firms Dun & Bradstreet. Sales representatives can also decide upon the pricing of the product based on the credit risk. Coface and Equifax provide such applications. Linking of functional systems with financial systems. thus reducing the errors arising due to improper information flow between the two systems. A firm can charge a higher price to the customers with high credit risk and a lower price to customers with low credit risk. Vendor Managed Inventory (VMI). any deviations can delay the payment process. An effective reporting system would help provide accurate information to the supply chain partners. to sell higher range products to the customers to provide liberal credit terms to the customers with high credit limits and good credit history. Forecasting and Replenishment (CPFR) etc. Helps sales representatives during the sales process. the physical order information can be matched with the financial information. most firms have not focused much on integrating the material and the financial flow in a supply chain. If this information is communicated to the manufacturing department then it can take timely action to improve the quality of the products. Linking supply chain partner's or customer's preferences and behavior with the financial elements. Firms can track and analyze the behavior of supply chain partners and customers. Based upon the needs and requirements, firms can provide financial options to the customers and supply chain partners. Suppose, a firm orders a large consignment from a supplier. Then, the firm can provide the option of paying the amount through traditional means like checks or through electronic means. The supplier can decide upon the payment option. If the supplier wants a faster payment, he may opt for the electronic payment means. Linking financial and physical flows based on business intelligence. Firms can set the pricing of the product and payment options based on the customer's requirements and the existing market conditions. This may help the firm in maximizing its revenue. This policy is well utilized by airline companies where flight ticket prices are changed depending on supply and demand conditions. In order to align financial and physical supply chains, firms need to reengineer the physical flow processes so as to integrate them with the financial processes. Automation of financial processes is an area in which firms have to focus. Integrating the financial flow with the material flow provides many benefits to the members of the supply chain. Members can obtain the products as per their requirement and pay the supplier using a suitable payment mode. With such integration, members share a common and full view of all their transactions, increasing efficiency in the supply chain. Specific benefits for the members of the supply chain are: • Suppliers can make accurate forecasts about working capital requirements and also product demand. Thus inventory levels and working capital can be reduced as they have a better view about the situation. They can resolve disputes easily as both the supplier and the customer share the same information about the transaction Payment processing can become faster. The processing costs due to personnel and paperwork are reduced. Errors are minimized, thus helping the supplier to obtain correct payment. Buyers can benefit from perfect order delivery. This helps the buyer to forecast and plan effectively. Thus the buyer can reduce working capital requirements to deal with the payables. With the automation of the processes, buyers can reduce the time and costs in processing the invoices like routing for approval, matching the invoices and payments. Trade terms can be negotiated more effectively between the buyer and the supplier because of the availability of precise information about a transaction. Buyers and suppliers have an accurate view about the risk involved. Hence, the buyer and the seller can negotiate financing options like insurance, supplier credit etc., more optimally. COST CENTRE, COST UNIT, PROFIT CENTRE AND INVESTMENT CENTRE Cost Centre It is a location, person or item of equipment in respect of which costs may be ascertained and related to cost units for control purpose. Broadly speaking, a cost centre may be of two types: Personal cost centre which consists of a person or group of persons; and Impersonal cost centre which consists of a location or item of equipment (or group of these). From the standpoint of functions, a cost centre may be of two types: Production cost centre, i.e., a cost centre in which production is carried on (this may embrace one specific operation, e.g., machining, or a continuous process, e.g., distillation), and Service cost centre, i.e., a cost centre which renders services to the production cost centres. When the output of an organization is a service rather than goods, it is usual to use some alternative term such as support cost centre or utility cost centre for supporting services,1 If machine and/or persons carrying out similar operations are brought together, a cost centre is known as operation cost centre. Again, when machines and/or persons are grouped according to a specific process or a continuous sequence of operations, a cost centre is termed as process cost centre. Division of production, administration, selling and distribution and other functions into cost centres is necessary for two purposes; (i) cost ascertainment, and (ii) cost control. Costs are ascertained by cost centres or cost units or by both. For example, direct costs can be identified with the cost centres or cost units easily. Indirect costs are allocated to the cost centres based on volume (e.g., direct labour hours, machine hours, etc.) or activity (e.g., number of set-ups, inspections, material movements, etc.). Similarly, cost control is facilitated by pinpointing responsibility through cost centres. In other words, different persons are allotted different cost centres and a person is held responsible for the control of cost of the cost centre or centres running under him only. It is in this sense that cost centres are also termed as responsibility centres. 48 • The type, size and number of cost centres in an undertaking will depend upon the nature and size of the business, attitude of the management towards cost ascertainment and cost control, and so on. However, it should be noted that too many cost centres tend to be expensive while too few cost centres tend to defeat the very purpose of accurate cost ascertainment and cost control. Cost Unit It is a quantitative unit of product or service in relation to which costs are ascertained. For ascertainment of costs, it is necessary to express them in terms of physical measurement like number, weight, volume, area, length or any other convenient unit. When single type unit does not serve the desired purpose, composite units may be used for the purpose of cost measurement. For example, in transport costing, ton-miles or passengermiles are better measures than only tons or passengers as the latter do not take into account distance carried or distance travelled. A few examples of cost units applicable to different industries are given below. Name of industry Furniture, ship building, automobile, etc. Printing Mines and quarries Chemicals Steel and cement Motor transport Canteen Boiler-house Electricity Soap Bricks Coal mining Gas Confectionery Paper Timber Cost units used Number Job Ton Litres, gallons, kg, etc. Ton Ton-miles, passenger-miles Meals, persons served Thousand kg of steam kW h kg, litres Thousand Tonne Cubic foot kg Ream 100 ft. Illustration 4.1 Specify the methods of costing and cost units applicable to the following industries: (i) (ii) (iii) (iv) (v) (vi) (i) (ii) (iii) (iv) (v) (vi) Toy-making Cement Radio Bicycle Ship-building Hospital Industry Toy-making Cement Radio Bicycle Ship-building Hospital Method of costing Batch Unit Multiple Multiple Contract Service Cost units Per batch Per tonne or per bag Per radio or per batch Per bicycle Per ship Per bed per day or per patient per day. Profit Centre Profit is the difference between revenues and costs. Therefore, a profit centre represents segment of a business that is responsible for both revenues and costs. This may also be called a business centre, business unit, or strategic business unit, depending upon the concept of management responsibility prevailing in the entity concerned. 49 Investment Centre An investment centre is a responsibility centre that is accountable for revenues, costs and investments. It is defined as "a profit centre in which inputs are measured in terms of expenses and outputs are measured in terms of revenues, and in which assets employed are also measured, the excess of revenue over expenditure then being related to assets employed." Thus, the relationship between cost, profit and investment centres may be stated as follows: Cost Centre—formal reporting of costs only; Profit Centre—formal reporting of revenues and costs; and Investment Centre—formal reporting of revenues, costs, and investment MATERIAL CONTROL Material constitutes a substantial portion of the production cost in many industries. Sometimes, it may be the major item of all the items constituting total cost. Therefore, it is natural that large amounts will be invested in it. But there should be optimum level of investment for any asset, whether it is a plant, cash or inventories. Inadequate inventories will disrupt production and result in loss of safes. All this calls for an effective material control programme. The main objectives of material control will, therefore, be: 1. To ensure that material is available: (a) (b) 2. for use in production and production services, as and when required; for delivery to customers to fulfil orders for supplies from purchasers, if any. To minimize investment in inventories. ORGANIZATION In order to exercise effective control on material, there should be proper co-operation and co-ordination in the following departments: 1. 2. 3. 4. 5. 6. 7. Purchase Receiving and Inspection Stores Production Stock Control Sales Accounts For instance, the Sales Manager will intimate as to the number or quantity of finished goods to be kept in hand so that no customer is ever turned away or forced to wait because of lack of stock. Similarly, the Accountant or the financial manager should ensure that only optimum stock of materials is kept in stock so that additional funds may be channelled into more profitable investment. INSTALLATION OF THE SYSTEM The various steps involved in introducing a material control system can be broadly grouped under two heads mentioned below: • • Primary steps, and Operational steps. Primary Steps These will include the following: 1. Classification and codification of material and fixation of stock levels in respect of each item of stock. Materials may be classified into: (a) Raw materials 50 (b) Work-in-progress (c) Component parts (i) Manufactured (ii) Purchased (d) Consumable stores, etc. Again, the above materials may be further classified into: (a) (b) fast-moving items, and slow-moving items. After making the classification in the above line, the following stock levels in terms of quantities are to be fixed in respect of each type of material: (a) (b) (c) Maximum stock level, Minimum stock level, Re-order stock level, and Order size. We have discussed these aspects earlier in detail. 2. Consulting and advising engineer about current and proposed product design, programmes of production, schedules of materials, tools and jigs, packaging, etc. to achieve desired quality specifications. Standardization and simplification of material are to be done after giving due importance to substitution, if necessary. Establishing material budget to accomplish the objectives. Training of workmen and staff responsible for material control. 3. 4. Operational Steps After the primary steps are taken, it is necessary to ensure: 1. Control over: (a) (b) (c) Purchasing Receiving and Inspection Storing and Issues We have discussed earlier the role of EOQ and various stock levels under conditions of certainty and uncertainty in controlling costs of inventory. We now discuss the other aspects of purchasing. Control over purchasing means that the Purchase Requisition and the Purchase Order should be in writing in prescribed forms and shall be duly authorized by the executive concerned. Further, the quality of materials should be according to specification or design and price should relate to quality and market condition. In short, it should ensure materials of right quality and quantity at the right price from the right source and at the right time. Control over receiving and inspection means that: (a) (b) (c) Materials received are checked with the Delivery Note and copy of Purchase Order. Quantity as revealed by physical verification agrees with that shown in the Delivery Note, and Quality is as per specification mentioned in the Purchase Order. On the other hand, control on storing and issues will include the following: (a) To ensure that the goods received are in accordance with the instruction detailed in the Purchase Order and Goods Received Note. (b) To ensure that the material received are placed in appropriate bins, racks, etc. and quantities are entered in the respective Bin Cards to facilitate easy location and perpetual record of stores received. (c) Material to be issued only against properly authorized requisitions and appropriate Bin Card should be credited with the quantity issued. (d) Material returned from shops should be checked with properly authorized Shop Credit Note and appropriate Bin Card to be debited with the quantity received. 51 the following may be mentioned: (i) Cost of materials to Production Cost. price is only one of the components. waste. machines. (ii) Value of materials scrapped to Production Cost. (vi) Raw Materials and Stores to total Inventories. tax. The selection of proper ratios will depend upon their suitability to the requirements for control purposes. warehousing. Proper implementation of the Perpetual Inventory System. work-in-progress or finished goods in case of a manufacturing firm. When management estimates these costs correctly. So companies adopting JIT purchasing must select their suppliers very carefully and pay attention to developing long-run relationship with them. Selective control through ABC Analysis. Very often it is difficult to estimate the relevant inventory carrying costs probably because the accounting system does not routinely collect such costs. and opportunity cost of capital. etc. insurance. It represents a system of records which reflects the physical movement of stocks and their current balance. A standard for scrap.. costs of spoilage and obsolescence. tools. JIT reduces the inventory carrying costs.g. effect on labour cost. In an extreme case. etc. size. EOQ declines and JIT becomes more attractive. 5. However. (iv) Stock of materials to Working Capital.(e) Checking the Bin Card balance with that shown by Stores Ledger and physical verification. materials handling and breakage. carrying costs of inventories become higher than expected and consequently. tax. viz. JIT purchasing is the purchase of materials or goods such that delivery immediately precedes use or demand. spoilage. JUST-IN-TIME (JIT) PURCHASING JIT purchasing is considered to be one of the modern techniques used for management of costs associated with inventories. The success of JIT purchasing depends on costs of quality and timely deliveries. warehousing. as a general guide. should also be laid down for all major materials used in production. 2. Establishment of standards for materials and analysis of material variance according to their originating causes. (v) Stock of materials to Current Assets. Spoilage and Wastage Variance The analysis of variance will pin down responsibilities so that proper action can be taken where necessary. Comparison of material costs of different periods with the help of different ratios. 3. 4. This facilitates pricing decision.. goods for resale for a retailer) are held. It is easy to overlook some spoilage. e. (iii) Cost of materials to Average Stock of Materials. quality of materials. no inventories (raw materials. the issue price is likely to be closer to the replacement price. (vii) Profit to material cost. 2. Detailed analysis in respect of minor materials may not be feasible and in such a case a monetary limit on consumption may be laid down. insurance and opportunity cost of capital. (a) (b) (c) (d) (e) Price Variance Usage Variance Yield Variance Mix Variance Scrap. Due to frequent purchase of materials or goods. obsolescence. elc. Standards for materials should be fixed after considering factors like specification. Defective materials and late deliveries may disrupt the operation. 52 . The perpetual inventory system is an aid to material control. The advantages of JIT purchasing are as follows: 1. It should be emphasized that in the evaluation of suppliers. Material consumed should be properly recorded and compared with standards fixed in order to develop material variances. 6 onth 19 . customers get better quality products.200 Material B Rs. 2.5 times p.000 3.000 2.2 The following information is available from the books of a company for 2005: Material A Rs. JIT purchasing.600 2. The Stock Turnover Ratio will facilitate such a classification and it will act as a tool for exercising control on raw material inventories. speaks of better inventory management. As for example.000 Material B Rs. i. loss of goodwill. raw materials stocks may be classified (a) (b) fast-moving items.000 1. and slow-moving items.400 23. C ost of m aterials consum ed Average stock of m aterials during the period during the period The turnover ratio8 should normally be 2. 2. cost of not having materials or goods.600 5. 1. a.400 1.3. 12 = 8 months 5 365 Or = 243 1 .000 3. accumulation of obsolete stock. a high ratio is an indicator of fast-moving stock and.000 24. purchasing is now attempted to extend daily deliveries to as many items as possible. therefore.400 Opening Stock Purchases Closing Stock Calculate the material turnover ratio of the above types of materials and determine which of the two materials is more fast-moving.200 23400 1200 = 19.400 ÷ 2 = 2. Material A Rs. Examples of such costs are loss of contribution. 4. It helps to develop a long-run relationship with the suppliers.400 23. milk and breads are supplied daily to the retailers. On the other hand.000 2.200 2.e. carrying of loo much stock. however. Illustration 4. loss of customers. A low ratio indicates bad buying. STOCK TURNOVER It has been stated earlier that to minimize the amount of investment.400 1.a. 12 = 0. etc.400 4.5 .5 53 3200 2200 = 1. etc. so that the goods are stored in the warehouse or on store shelves for a minimum period before they are sold to the customers.400 ÷ 2 = 1. Materials Consumed: Opening Stock Add: Purchases Less: Closing Stock Average Stock: Opening Stock Closing Stock Materials Turnover Ratio: Cost of Materials consumed Average Stock Average stock holding period 1.5 365 Or in 19 19 . This will reduce the cost of quality and stock-out costs.5 times p..000 23.600 2. may result in stock-out costs.400 3.400 1. As a result. In retail business using JIT purchasing. shows that an average stock is being held for less than one month (i.3 The bin card for Material M 27 shows the following position: Maximum stock level Minimum stock level Re-order quantity (EOQ) Issues during the year 5. 2. shows that an average stock is being held for 8 months (or for 243 days). a Credit Note is to be prepared.. the students may use the last-mentioned formula which uses the economic order quantity. (The treatment of surplus or deficiency of stock in accounts has already been explained elsewhere in accordance with originating causes. Different sections of the Store are taken up by rotation. In other words. This is measured as follows: Cost of materials consumed during the period 1 (Maximum stock level + Minimum stock level 2 ) However. Therefore. A perpetual inventory is usually checked by a programme of continuous stock-taking. Similarly. Under this method. the method to be used depends on the availability of information. in case of shortage of stock.a. The formula is: Material consumed 1 Minimum stock level + EOQ 2 Illustration 4. if stock control system involving stock levels is not in operation.days days A stock turnover of 19.400 units 750 units 300 units 5. If the physical balance is greater than the balance shown by the Bin Card or Stores Ledger. material B is very slow-moving material while material A is very fastmoving. the balance shown by the Bin Card or Stores Ledger should agree with ground or physical balance. whereas continuous stock-taking means the physical checking of those records with actual stocks.e. Information permitting. 19 days).) The operation of the perpetual inventory system is outlined below: 1. etc. measuring. 3. proper investigation will have to be made and a report will have to be submitted (see Fig. Perpetual inventory means the system of records. On the other hand. when the records are maintained up-to-date. For this purpose. the formula that uses re-order or economic order quantity is considered a more refined method of measuring stock turnover. stores balances are recorded after every receipt and issue. listing.27).a.5 times p. a Debit Note is to be prepared and stock records adjusted accordingly. An alternative method of measuring stock turnover is one involving the use of maximum and minimum stock levels. which reflects the physical movement of stocks and their current balance. a list showing priority of sections 54 . PERPETUAL INVENTORY It represents a system of records maintained by the controlling department. The stock-taking programme is divided into a number of functions such as counting.. and work is distributed to different members of the team. one has to depend on the first-mentioned formula. 1. a stock turnover of 1. On the other hand. The perpetual inventory system is intended as an aid to material control.5 times p. But the two terms 'perpetual inventory' and 'continuous stock-taking' should not be considered synonymous. When there are discrepancies.400 750 + (300) times per annum.400 units Stock turnover In examination. weighing. 7. The lower portions are detached at the end of counting and checking of inventory. As a result of (6) above. A detailed and more reliable check on the stores is possible. malpractices. 55 . 6. after counting. will be quickly discovered. The physical stock. it does not hamper production. The physical balance and issues and receipts during stock verification are recorded in it. Any one of the following documents may be used for this purpose: (i) Bin Card: The balance as per physical verification together with date of verification is entered usually in different ink (preferably red) in the line below the last entry in the balance column. 2.or stock items or both are prepared. is properly recorded. 3. Inventory Tag (iii) Stock Verification Sheets : Separate sheets may be maintained to record the results of stock verification.26): It consists of two portions. it facilitates preparation of interim Profit and Loss Accounts and Balance Sheets. 4. 3. The balance as per bin card is also entered in it by the stock verifier for comparison. so that appropriate steps are taken to prevent their recurrence in future. 5. 4. It obviates the need for the physical stock-taking at the end of the period. weighing or measuring. Advance notice is given to storekeeping staff concerned whenever a particular stock item is verified each day. Stores received but awaiting inspection is not mixed up with regular stores at the time of verification. 3. etc. Like periodic inventory. The top portion is fastened to bins to indicate that the item has been verified. the investment in stock cannot exceed the amount arranged for. It ensures that adequate stocks are maintained within the prescribed limits. Any bin not having an inventory tag would indicate that the item is yet to be verified. When this method of recording is followed. This is possible by comparing actual stock with the authorized maximum. Since stock figures are available quickly. as the case may be. Thus. the sheets are maintained date-wise so as to indicate a chronological list of items verified. The advantages of the Perpetual Inventory system may be summarized as follows: 1. (ii) Inventory Tag (see Fig. Discrepancies. it avoids the disadvantage of carrying excessive stocks. minimum and re-order levels. The lower portions of inventory tags are torn off and collected together to constitute inventory records. the importance of inventory management to the company depends upon the extent of investment in inventory. the liquidity aspects of inventories become highly important to the manager of working capital. breaking bulk. 2. Sometimes. this description is accurate. Current Asset: It is assumed that inventories will be converted to cash in the current accounting cycle. absorption of moisture. this is not entirely true. Some characteristics that are important in the broad context of working capital management. include: 1. etc. work-in process inventory and finished goods inventory. With economic slowdowns or changes in the market for goods. are revealed only after stock-counting at the end of a certain period and. The discrepancy. INTRODUCTION Inventory Management involves the control of assets being produced for the purposes of sale in the normal course of the company's operations.that are associated with holding inventories. For firms with highly uncertain operating environments. which is normally. Role of Inventory In Working Capital Inventories are a component of the firm's working capital and.direct and indirect . for slow-moving items of low value). a manufacturer of fine pianos may have a production process that exceeds one year. In some cases. Or. the analyst must recognize that inventories are the least liquid of current assets. a vintner may require that the wine be aged in casks or bottles for many years. 2. the prospects for sale of entire product lines may be diminished. discrepancy. 1. Stock-taking will take a considerable time and this may affect production and other important work. the periodic inventory system is adopted for determining the physical movement of stock and its closing balance as on a particular date. we will view all inventories as being convertible into cash in a single year. PERIODIC INVENTORY This refers to a system where stock-taking is usually done periodically. In the absence of a continuous check. there is possibility of greater fraud. periodic inventory is the only alternative. However. The goal of effective inventory management is to minimize the total costs . Level of Liquidity: Inventories are viewed as a source of near cash. therefore. the analyst must discount the 56 . At the same time. Again. may follow periodic inventory system for others. when the Perpetual Inventory System becomes very costly (say. viz.Figure Stores Audit Note The usual reasons for discrepancy are breakage. At a minimum. In case of clerical errors. if any. there is little scope for taking preventive action. But the oft-quoted disadvantages of the system are. wrong posting or nonposting of entries. for example. companies even adopting ABC Analysis and Perpetual Inventory System for some of stock items. etc. In spite of these and similar problems. Interim Profit and Loss Accounts and Balance Sheets cannot also be prepared for want of stock figures. most firms hold some slow-moving items that may not be sold for a long time. short or overissue. It is industry-specific. as such. one year. Inventories include raw material inventory. represent a current asset. Thus. In these cases. fraud. 3. say once or twice in a year. corrections are made without any difficulty. evaporation. pilferage. For most products. In case of materials of small value. discrepancy may arise due to clerical errors. Most sales occur on credit and become accounts receivable. This lag represents a cost to the firm. The willingness to place large orders may allow the firm to achieve discounts on regular prices. 1. c. a firm must be prepared to deliver goods on demand. workers. and overhead expenses before the goods are actually sold. Gaining Quantity Discounts: In return for making bulk purchases. By placing fewer orders. These are then absorbed as production begins. Avoiding Lost Sales: Without goods on hand which are ready to be sold. This liquidity lag offers a benefit to the firm b. they normally do not create cash immediately. Or for goods purchased for resale. approvals have to be obtained. Even when sales are moving briskly. Within this broad statement of purpose.000 to move machinery and begin an assembly line to produce electronic printers. inspected. however. 4.200 printers are produced in a 57 . and goods that arrive must be accepted. An automobile is an item of shelf stock. Even though customers may specify minor variations. most firms would lose business. They get converted into receivables which generate cash and invested again in inventory to continue the operating cycle. the basic item leaves a factory and is sold as a standard item. or more. and counted. particularly when an item must be made to order or is not widely available from competitors. 12. the smaller the costs to begin production of the goods. Forms have to be completed. Creation Lag: In most cases. The utility that provided the electricity for manufacturing is paid after it submits its bill. Thus. startup costs are incurred. PURPOSE OF INVENTORIES The purpose of holding inventories is to allow the firm to separate the processes of purchasing. month. Each of these costs will vary with the number of orders placed. inventories are purchased on credit. perhaps a week. Labor is paid on payday. 3. 4. the cash to pay production expenses is transferred at future times. These discounts will reduce the cost of goods sold and increase the profits earned on a sale. Sale Lag: Once goods have been sold. This lag also represents a cost to the firm. the item must be sold. creating an account payable. Some customers are willing to wait. 2. In most cases. The firm must wait to collect its receivables. manufacturing. Reducing Order Costs: Each time a firm places an order. consumer products. the firm will pay less to process each order. the firm may have 30 or more days to hold the goods before payment is due. Achieving Efficient Production Runs: Each time a firm sets up workers and machines to produce an item. they will not be immediately converted into cash. the firm will hold inventories for a certain time period before payment is made. a firm will hold inventory as a backup. and marketing of its primary products. When the raw materials are processed in the factory. Shelf stock refers to items that are stored by the firm and sold with little or no modification to customers. many suppliers will reduce the price of supplies and component parts. As an example. the firm will usually pay suppliers. an invoice must be processed and payment made. 3. Whether manufactured or purchased.liquidity value of inventories significantly. suppose it costs Rs. and light industrial goods. First. The goal is to achieve efficiencies in areas where costs are involved and to achieve sales at competitive prices in the market place. Liquidity Lags: Inventories are tied to the firm's pool of working capital in a process that involves three specific lags. If 1. Circulating Activity: Inventories are in a rotating pattern with other current assets. we can identify specific benefits that accrue from holding inventories. Later. Storage Lag: Once goods are available for resale. The longer the run. it incurs certain expenses. The same situation exists for many items of heavy machinery. namely: a. screws. To allow each area to function effectively. The sales force can respond to customer needs and demands based on existing finished products. Raw Materials Inventory: This consists of basic materials that have not yet been committed to production in a manufacturing firm. To avoid starting a production run and then discovering the shortage of a vital raw material or other component. These benefits arise because inventories provide a "buffer" between purchasing.10 per unit (12. clamps.single three-day run. The purpose of maintaining raw material inventory is to uncouple the production function from the purchasing function so that delays in shipment of raw materials do not cause production delays. longer runs involve lower costs.200). The manufacturing process can occur in sufficiently long production runs and with pre-planned schedules to achieve efficiency and economies. 58 . inventory separates the three functional areas and facilitates the interaction among them. Stores and Spares: This category includes those products which are accessories to the main products produced for the purpose of sale. the firm can maintain larger than needed inventories. the cost of absorbing the startup expenses is Rs. This role of inventory is diagrammed in Figure Figure 4. and marketing goods. 2. Raw materials that are purchased from firms to be used in the firm's production operations range from iron ore awaiting processing into steel to electronic components to be incorporated into stereo amplifiers.5 per unit (12. nuts.3 A V O S E A D O F I D L O S S S A L E S E S P U R C H A G I N I S C H S Q O U U A N N T T S I T Y F H I N V T O I R L E O M S D I N N T O P G R R I E O S D U CW E H I C H E L P R E C D O U S C T E S O R D E R S S E P A R A T E E L L I E V E E F F I C I E N P R O D U C T A C H T I O N 5. the absorption cost would drop to Rs.000/2. Reducing Risk of Production Shortages: Manufacturing firms frequently produce goods with hundreds or even thousands of components. If the run could be doubled to 2. Examples of stores and spares items are bolts. with consequent heavy expenses. Raw materials and other inventory items can be purchased at appropriate times and in proper amounts to take advantage of economic conditions and price incentives.000/1.400 units. producing. the entire production operation can be halted. If any of these are missing. etc. TYPES OF INVENTORY Four kinds of inventories maybe identified: 1. Frequent setups produce high startup costs.400). the larger will be the investment in work-in-process inventory.43 100.38 11. it can be easily seen that a company can reduce its total ordering costs by increasing 59 .32 2. the Finance Manager should realize that costs may be closely related. preparation of purchase order and follow-up measures taken by the purchase department. five categories of costs can be identified of which three are direct costs that are immediately connected to buying and holding goods and the last two are indirect costs which are losses of revenues that vary with differing inventory management decisions. then ordering costs refer to the costs associated with the preparation of requisition forms by the user department. Finished Goods Inventory: These are completed products awaiting sale. the total ordering costs can be reduced by increasing the size of the orders. Ordering Costs: Any manufacturing organization has to purchase materials.50 14. Size of order (units) Number of orders in a year 100 12 150 8 Rs.17 Process Finished Goods Stores and Spare Parts Total COSTS ASSOCIATED WITH INVENTORIES The effective management of inventory involves a trade off between having too little and too much inventory. But this is not going to significantly affect the behavior of ordering costs.602.1 Investment in Inventories Types of Inventories Cadbury Value in Rs.1 provides the details of the investment in inventories in confectionery industry. Raw Materials 715.These spare parts are usually bought from outside or sometimes they are manufactured in the company also. set-up costs to be incurred by the manufacturing department and transport. Material Costs: These are the costs of purchasing the goods including transportation and handling costs.17 36.90 21.200 order From the above example. 1. The purpose of a finished goods inventory is to uncouple the productions and sales functions so that it no longer is necessary to produce the goods before a sale can occur. Suppose.800 200 6 Rs. some of the components and/or material required for production may have facilities for manufacture internally. 100 per Rs. If it is found to be more economical to manufacture such items internally. As ordering costs are considered invariant to the order size. By and large. In achieving this trade off. The size of the order and the total ordering costs to be incurred by the company are given below. Work-in-Process Inventory: This category includes those materials that have been committed to the production process but have not been completed.01 Packing Materials Work-in387. To examine inventory from the cost side.00 0. 4. The five categories costs of holding inventories are. the cost per order is Rs.600 937. transportation of materials ordered for. inspection and handling at the warehouse of the user department. The more complex and lengthy the production process. Table 4. 3. ordering costs remain more or less constant irrespective of the size of the order although transportation and inspection costs may vary to a certain extent depending upon order size.100 and the company uses 1200 units of a material during the year. At times even demurrage charges for not lifting the goods in time are included as part of ordering costs.58 % m total Inventory 27.70 551.00 Total ordering costs @ Rs. In that event. the ordering costs refer to the costs associated with the preparation of purchase requisition by the user department. Sometimes. Its purpose is to uncouple the various operations in the production process so •that machine failures and work stoppages in one operation will not affect the other operations. Table 4. inspection and handling at the warehouse for storing. lakh India Ltd. carrying costs are considered to be a given percentage of the value of inventory held in the warehouse. Cost of Running out of Goods: These are costs associated with the inability to provide materials to the production department and/or inability to provide finished goods to the marketing department as the requisite inventories are not available. Then. salaries of storekeeper.000 Rs.2.3.000 Rs. By and large. In the example considered in the case of ordering costs. his assistants and security personnel. When marketing personnel are unable to honour their commitment to the customers in making finished goods available for sale. Whatever the source of funds. Again. rent/depreciation of warehouse. Excess inventory represents unnecessary cost. These costs have both quantitative and qualitative dimensions. A systems approach considers in a single model all the factors that affect the inventory.750 200 Rs.the order size which in turn will reduce the number of orders.4. spoilage and taxes.40 and that on an average about half-of the inventory will be held in storage.000 From the above calculations. greater is the carrying costs. These are. it is using funds that otherwise might have been available for other purposes. inventory has a cost in terms of financial resources. 150 Rs. The greater the investment in inventory. it can be easily seen that as the order size increases. This is its opportunity cost. reorder point and stock level. However. However. Once the goods have been accepted. Its cost has qualitative dimensions as discussed below. the sale may be lost. while the total ordering costs can be decreased by increasing the size of order. Here also proper balancing of the costs becomes important. Even if the stock-out cost cannot be fully quantified. Carrying Costs: These are the expenses of storing goods. Economic Order Quantity 60 . These costs include insurance.500 . As a consequence of this. This can be quantified to a certain extent. 1. a firm should use a systems approach to inventory management. obsolescence. the carrying cost also increasing in a directly proportionate manner. the requisite items have run out of stock for want of timely replenishment. if a company wants to avert stock-out costs it may have to maintain larger inventories of materials and finished goods which will result in higher carrying costs. the importance of effective inventory management is directly related to the size of the investment in inventory. the uneconomical prices associated with 'cash' purchases and the set-up costs which can be quantified in monetary terms with a reasonable degree of precision. despite some fixed elements of costs which comprise only a small portion of total carrying costs. A system for effective inventory management involves three subsystems namely economic order quantity. the loss of production due to stoppage of work.000 Rs. In other words. Size of order (units): Average value of inventory: Carrying cost @ 25 percent of above: 100 Rs. 150 and 200 along with carrying cost @ 25 percent of the inventory held in storage are given below. reduction in ordering costs is usually followed by an increase in carrying costs to be discussed now. financing cost of money locked-up in inventories. INVENTORY MANAGEMENT ECHNIQUES As explained above. in the case of raw materials. Cost of Funds Tied up with Inventory: Whenever a firm commits its resources to inventory. let us assume that (he price per unit of material is Rs. the production department may not be able to reach its target in providing finished goods for sale. the erosion of the good customer relations and the consequent damage done to the image and goodwill of the company fall into the qualitative dimension and elude quantification. Thus. the average values of inventory for sizes of order 100. the carrying costs increase with the increase in order size indicating the need for a proper balancing of these two types of costs behaving in opposite directions with changes in order size. The firm has lost the use of funds for other profit making purposes. they become part of the firm's inventories. Approximately. To manage its inventories effectively. carrying costs are considered to be around 25 percent of the value of inventory held in storage. a reasonable measure based on the loss of sales for want of finished goods inventory can be used with the understanding that the amount so measured cannot capture the qualitative aspects. As the lead time (i. In view of zero lead time. Figure 4.e. time required for procurement of material) is assumed to be zero an order for replenishment is made when the inventory level reduces to zero. carrying costs and ordering cost. The level of inventory over time follows the pattern shown in figure 4..4. At that point an order for replenishment will be made for Q units.4 it can be noticed that the level of inventory will be equal to the order quantity (Q units) to start with.4 As the lead time (i. As a result of this the average level of inventory will remain 61 . the firm attempts to determine the order size that will minimize the total inventory costs. By calculating an economic order quantity.The economic order quantity (EOQ) refers to the optimal order size that will result in the lowest total of order and carrying costs for an item of inventory given its expected usage. It progressively declines (though in a discrete manner) to level O by the end of period 1.4: Inventory Level and Order Point for Replenishment From figure 4. The level of inventory over time follows the pattern shown in figure 4. the inventory level jumps to Q and a similar procedure occurs in the subsequent periods..e. time required for procurement of material) is assumed to the zero an order for replenishment is made when the inventory level reduces to zero. 000 units. Suppose a firm expects a total demand for its product over the planning period to be 10. The order quantity Q becomes EOQ when the total ordering costs at Q is equal to the total carrying costs.5 From figure. the value of Q* indicates the size of the order to be placed for the material which minimizes the total inventory-related costs. we can say In the above formula. carrying costs and total costs for different levels of order Quantity (Q) is depicted in figure 4.2. The economic order quantity. From the previous discussion. it can be seen that the total cost curve reaches its minimum at the point of intersection between the ordering costs curve and the carrying costs line. The value of Q corresponding to it will be the economic order quantity Q*. We can calculate the EOQ formula. Behavior of costs associated with inventory for changes in order quantity Figure 4. Substituting these values. denoted by Q*. it amounts to stating: To distinguish EOQ from other order quantities.5.at (Q/2) units. The behavior of ordering costs. 62 . while the ordering cost per order is Rs. we know that as order quantity (Q) increases. the total ordering costs will decrease while the total carrying costs will increase.100 and the carrying cost per unit is Rs. It should be noted that total costs associated with inventory where the first expression of the equation represents the total ordering costs and the second expression the total carrying costs. is that value at which the total cost of both ordering and carrying will be minimized. when 'U' is considered as the annual usage of material. When 'U' is considered as the annual demand Q* denotes the size of production run. From the above discussion the average level of inventory is known to be (Q/2) units. the simple average of the two end points Q and Zero. Using the notation. Instantaneous delivery: If delivery is not instantaneous. Where its assumptions have been dramatically violated. However. The two costs involved in this process are: (i) set up cost and (ii) inventory carrying cost. As inflation pushes interest rates up.that is buying in anticipation of a price increase in order to secure the goods at a lower cost. the lower will be the set-up cost per unit. redefining total costs and solving for the optimum order quantity. 5. the original EOQ model must be modified by including of a safety stock. The costs are the added carrying costs associated with the inventory that you would not normally be holding. special EOQ models have been developed to deal with this. come from buying the inventory at a lower price. While this modification is somewhat complicated. the original EOQ model must be further modified. Independent orders: If multiple orders result in cost savings by reducing paperwork and transportation cost. the cost of carrying inventory increases. which results in a decline in the optimal economic order quantity. The set-up cost is of the nature of fixed cost and is to be incurred at the time of commencement of each production run.000 unit lot sizes. If this is the case. Moreover. 4. In other words. not known in advance . it will minimize its total inventory costs. 2. the EOQ model can generally be easily modified to accommodate the situation. there is an inverse relationship between the set-up cost and inventory carrying cost. The benefits of course. Of course. Inflation and EOQ Inflation affects the EOQ model in two major ways. 3. The larger the size of the production run. In the EOQ model this means that C increases. Thus. Constant or uniform demand: Although the EOQ model assumes constant demand. First. This situation can be handled through a modification in the original model similar to the one used for variable unit price. the EOQ model may lose its applicability and may be replaced with anticipatory buying . The optimum production size is at that level where the total of the set-up cost and the inventory carrying cost is the minimum. The model's assumptions are as follows: 1. bulk purchase discounts or quantity discounts are offered by suppliers to induce customers for buying in larger quantities. an understanding of the limitations and assumptions of the EOQ model will provide the Finance Manager with a strong base for making inventory decisions.Thus if the firm orders in 1.the model must be modified through the inclusion of a safety stock. 6. demand may vary from day-to-day. The second way inflation affects the EOQ model is through increased carrying costs. Constant unit price: The EOQ formula derived is based on the assumption that the purchase price Rs. many times major price increases occur only once or twice a year and are announced ahead of time. Constant ordering costs: While this assumption is generally valid. its violation can be accommodated by modifying the original EOQ model in a manner similar to the one used for variable unit price. Quite often. in spite of which the model tends to yield quite good results. while the EOQ model can be modified to assume constant price increases. Determination of Optimum Production Quantity: The EOQ Model can be extended to production runs to determine the optimum production quantity. at this level the two costs will be equal. These assumptions have been pointed out to illustrate the limitations of the basic EOQ model and the ways in which it can be easily modified to compensate for them. perhaps decreasing because of economies of scale or storage efficiency or increasing as storage space runs out and new warehouses have to be rented. The formula for EOQ can also be used for determining the optimum production quantity as given below: 63 . Examination of EOQ Assumptions The major weaknesses of the EOQ model are associated with several of its assumptions. which is generally the case. If demand is stochastic that is. The inclusion of variable prices resulting from quantity discounts can be handled quite easily through a modification of the original EOQ model. Constant carrying costs: Unit carrying costs may vary substantially as the size of the inventory rises. the carrying cost will increase with an increase in the size of the production run. as with most decisions.P per unit of material will remain unaltered irrespective of the order size. there are trade offs associated with anticipatory buying. there will be a reduction in the total ordering cost. Q' Q' 64 . Only three possibilities can arise out of the comparison. The procedure for such an approach is outlined below: The first step under the general approach is to calculate Q*. The question may arise whether Q*. This is so because the company can avail itself of the benefit of quantity discount with an order-size of Q* as it is at least equal to Q'. In case Q* is greater than or equal to Q'. D of discount per unit of material. Only in the case of Q* being less than Q' the need for the calculation of an optimal order size arises as the company cannot avail itself of the discount with the order size of Q*.80. A decision to increase the order-size is warranted only when the incremental benefits exceed the incremental costs arising out of the increased order-size. with an increase in order-size from Q* to Q'. F) U U − xF = Rs.Illustration 4.F per order irrespective of the order size. EOQ calculated on the basis of a price without discount will still remain valid even after reckoning with the discount. If we assume Rs. then the total discount on the annual usage of material of U units amounts to: Annual usage of materials in units x Discount per unit of material = Rs.UD Secondly. While no general answer can be given to such a question we can certainly say that a general approach using the EOQ framework will prove useful in decision-making . the total amount of discount available on the amount of material is to be used. EOQ without considering the discount. = (The difference between the number of orders with sizes of Q* and Q') x (the cost per order of Rs. The incremental benefits will have two components: First. Thus. As the ordering cost is assumed to be Rs.4. the number of orders will be reduced. then Q* will remain valid even in the changed situation caused by the quantity discount offered. the reduction in ordering cost. The set-up cost for each production run is Rs. The optimum production quantity per production run (E) is Modified EOQ to include Varying Unit Prices: Bulk purchase discount is offered when the size of the order is at least equal to some minimum quantity specified by the supplier. An incremental analysis can be carried out to consider the financial consequences of availing oneself of discount by increasing the order-size to Q'.4 Arvee Industries desires an annual output of 25. the minimum stipulated order size for utilizing discount.whether to avail oneself of the discount offered and if so what should be the optimal size of the order. The cost of carrying inventory per unit per annum is Rs.000 units. Let us suppose Q' is the minimum order-size stipulated by the supplier for utilizing discount. After calculating Q* the same will be compared to Q'. U/Q'}x F With an increase in the order-size.D which will go to reduce the price per unit for the valuation of inventory. Ltd.Q. {U/Q* .O.200 per order and the carrying cost 20 percent of the average value of inventory.50 per unit Rs. Otherwise Q* will continue to remain valid even in a situation of bulk purchase discount. Illustration 4.500 units and above.2 per unit 0.O. The increase in the average value of inventory will result in higher incidence of carrying cost.000 units Rs. we have to calculate the incremental benefits and incremental costs. For utilizing discount the minimum order size Q' = 1. = Rs. 65 . UD + Rs. A numerical illustration is given below to illustrate the procedure to be adopted in a situation of bulk purchase discount.200 per order Rs. The supplier has recently introduced a discount of 4 percent on the price of material for orders of 1.Thus. Incremental carrying cost = Q' (P −D )C Q' P C − 2 2 The net incremental benefit can be obtained by subtracting the incremental carrying cost from the total incremental benefits.Q. The price of the raw material is Rs.000 units for the Hy Fly Co. What was the company's E.. U x D + Rs. This is given by the expression. 2 Q' Q' If the net incremental benefits are positive. the total incremental benefits will be the sum of the above two expressions and is given by Total incremental benefits = Rs.50 per unit.500 units. U F P D C = = = = = 40. then the optimal order quantity becomes Q'.500 units. assumed to be C percent of the average value of inventory. As Q* is less than Q'. Net incremental benefits C U Q' (P −D ) C −Q' P U − s F −R . The ordering cost is Rs. prior to the introduction of discount? Should the company opt for availing the discount? What would be the optimal order size if the company opts to avail for itself the discount offered? Let us first arrange the data contained in the problem in accordance with the notation familiar to us by now. there is likely to be an increase in the average value of inventory even after reckoning with the discount per unit of material of Rs. Total amount of discount available with an order size of 1.20 E. without discount.5 The annual usage of a raw material is 40. 000 + Rs. Reorder Point = Normal consumption during lead time + Safety Stock.1.e. the reorder point for replenishment of stock occurs when the level of inventory drops down to zero. and if the firm places the order when the inventory reaches the reorder point.200 . Since the delivery time stock is the expected inventory usage between ordering and receiving inventory..(2) = Rs.875 .7.Rs.6.'...80.000 .2 per unit. the new goods will arrive before the firm runs out of goods to sell.1. In summary.000 Incremental carrying cost = = Rs. it is clear that although EOQ value of 1. . As a result the reorder level is always at a level higher than zero. how low should the inventory be depleted before it is reordered. Several factors determine how much the delivery time stock and safety stock should be held. the level of inventory jumps to the original level from zero level.80.265 units (Q*) is not relevant in the present situation of bulk purchase discount. Rs. the efficiency of a replenishment system affects amount of much delivery time needed. The two factors that determine the appropriate order point are the procurement or delivery time stock which is the inventory needed during the lead time (i. In real life situations one never encounters a zero lead time. that is.. The decision on how much stock to hold is generally referred to as the order point problem.. There is always a time lag from the date of placing an order for material and the date on which materials are received.. In view of instantaneous replenishment of stock. the general framework of the EOQ model has provided the necessary basis for subsequent calculations and the decision reached therefrom.000 units x Rs...000 . And the determination of level of safety stock involves a basic trade-off between the risk of stock-out. 66 . the minimum order size required for availing of the discount. Consequently. efficient replenishment of inventory would reduce the need for delivery time stock.875 = Rs. the difference between the order date and the receipt of the inventory ordered) and the safety stock which is the minimum level of inventory that is held as a protection against shortages.... and the increased costs associated with carrying additional inventory.500 units.80..80.125 As the net incremental benefits is a positive sum of Rs.(1) Savings due to reduction in ordering costs = (32-27) x Rs.125. From the illustration. The optimal order-size will be 1...325 Rs.. resulting in possible customer dissatisfaction and lost sales. Reorder Point Subsystem In the EOQ model discussed we have made the assumption that the lead time for procuring material is zero..(3) Net incremental benefits (=1+2-3) = Rs.200-Rs.. the company should opt for availing the discount offered.= = U x D = 40. where the weights are taken to be the corresponding probability values.25 67 . lead time which is the amount of time between placing an order and receiving the goods and the safety stock level expressed in terms of several days' sales. The probabilities and the values of usage rate and lead time are based on optimistic. Safety Stock Once again in real life situations one rarely comes across lead times and usage rates that are known with certainty. Once we realize that higher the quantity of safety stock. the expected stock-out costs) and the carrying costs will be at their its minimum. It is possible to a certain extent to quantify the values that usage rate and lead time can take along with the corresponding chances of occurrence. Average Daily Usage Rate (units) 200 500 800 Probability of Lead Time Probability of Occurrence (No. it is possible to work out the total cost associated with different levels of safety stock. known as probabilities. By the time the inventory level reaches zero towards the end of the seventh day from placing the order materials will reach and there is no cause for concern. upon the degree of uncertainty surrounding the usage rate and lead time. If the average daily usage rate of a material is 50 units and the lead time is seven days. the formula for estimating the reorder level will call for a trade-off between stock-out costs and carrying costs. of days) Occurrence 0.25 + 500 x 0. We consider below through an illustration the way of arriving at the reorder level in a situation where both usage rate and lead time are subject to variation. then Reorder level = Average daily usage rate x Lead time in days = 50 units x 7 days = 350 units When the inventory level reaches 350 units an order should be placed for material.3 per unit. lower will be the stock-out cost and higher will be the incidence of carrying costs. Illustration 4. Based on the above values and estimates of stock-out costs and carrying costs of inventory.25 0.6 Below are presented the daily usage rate of a material and the lead time required to procure the material along with their respective probabilities (which are independent) for Sigma Company Ltd. inter alia. However. then ' the reorder level should naturally be at a level high enough to cater to the production needs during the procurement period and also to provide some measures of safety for at least partially neutralizing the degree of uncertainty. From the above formula it can be easily deduced that an order for replenishment of materials be made when the level of inventory is just adequate to meet the needs of production during lead time.25 The stock-out cost is estimated to be Rs. These probabilities can be ascertained based on previous experiences and/or the judgemental ability of astute executives. realistic and pessimistic perceptions of the executives concerned. The question will naturally arise as to the magnitude of safety stock.10 per unit while carrying cost for the period under consideration is Rs.50 0. Thus. it depends. The expected usage rate is nothing but the weighted average daily usage rate. The reorder level will then become one at which the total stock-out costs (to be more precise.25 12 16 20 0. expected daily usage rate = 200 x 0. There is no specific answer to this question.25 0.50 0. Reorder level = Average daily usage rate x lead time in days. What should be the reorder level based on financial considerations? From the data contained in the table we can calculate the expected usage rate and expected lead time.Another method of calculating reorder level involves the calculation of usage rate per day.5 + 800 x 0. When usage rate and/or lead time vary. 000 units.0625 0.600 units with 0. 4.000 units with a probability of 0. Levels of Safety Stocks and Associated Costs Safety Stock (1) 8.1250 Expected Stockout (4) -(2x3) 0 200 units 375 units 350 units 725 units 400 units 400 units 50 units 850 units 68 Rs.50 0.500 Rs. 8.800 Rs. Let us enumerate the situations with lead time consumption of more than 8.1250.0625 12800 0.000 units respectively..200 units 400 units Probability (3) 0 0. 16.5 800 0.250 Carrying Cost (6) Total Cost (7) Rs.25 3 + 8 + 5 = 16 days Normal consumption during lead time can be obtained by multiplying the above two values. 4. Thus. 12.1250 16000 0.25 Units 12 16 20 12 16 20 12 16 20 Probability 0.800 units 2. 14.000 units.5 + 20 x 0.50 0.25 0.000 units Stockouts (2) 0 3.25 Possible levels of usage Units Probability 2400 0.400 Rs. 13.0625 probability.0625 3200 0.000 Rs.1250 8000 0. 2.250 10000 0.0625 6000 0.800 units with 0.250 . 24.25 0.000 Rs.25 0.0625 0.1250 0.000 units. 7.1250 and 16.300 Expected Stockout Cost (5) 0 Rs. 6. along with their respective probabilities of occurrence.600 units 6.400 Rs. safety stock level can be maintained at any of the above levels.000 units with 0.25 0. 1.50 0.e.0625 500 0. (i.000 units 4.= 50 + 250 + 200 500 units Similarly expected lead time = = 12 x 0.000 units 2.600 units.000 Rs. 9. 24.1250 9600 0.25 From the above table it is clear that the situations with the lead time consumption of more than 8. And the levels of stock-out are 2.800 units and 8.1250 0.200 units 6.) Normal consumption during lead time = 500 units per day x 16 days = 8.25 + 16 x 0.400 units 3.800 units 1.000 units Since normal consumption during lead time has been obtained as 8000 units. and the stock-out cost and carrying cost associated with these various levels are shown in the table.25 0.1250 4000 0. 13.000 Rs. stock-outs can occur only if the consumption during lead time is more than 8.000 units (normal usage) are 10. The possible levels of usage are: Daily usage rate Units 200 Lead time in days Probability 0. This can be achieved by considering the possible levels of usage.0625 0.0625. 14. there is no chance of the firm being out of stock. The stockout acceptance factor is considered to be 1. If the safety stock of the firm is 4.0625 and 12. using the notation developed earlier. S L R F = = = = Usage in units per day Lead time in days Average number of units per order Stockout acceptance factor (S x R x L ) The stock-out acceptance factor.000 units.000 units with a probability of 0. depends on the stock-out percentage rate specified and the probability distribution of usage (which is assumed to follow a Poisson distribution).0625 0.0625 and 2. If the safety stock of the firm is 2.450 units Rs. Reorder pint = S X L + F Where. the amount o'f calculations involved for arriving at the reorder level is large. The probability of stock-out is. The formula along with its application is given below. What is the reorder level for the company? 69 .800 units. there is stock-out of 6.0625 500 units 600 units 250 units 100 units 1.125 stock-out and the probability of occurrence of stock-out at other levels are calculated in the same way.0625 chance that the firm will be short of inventory. In such cases the approach adopted earlier can become much more complex.6 Value of ‘f’ for different stocks out percentage Illustration 4. there is 0.125 based on the possible usage of 16. For any specified acceptable stockout percentage the value of 'F' can be obtained from the figure presented below.0 8. That is the reason why one can adopt a much simpler formula which gives reasonably reliable results in calculating at what point in the level of inventory a reorder has to be placed for replenishment of stock.500 0 Rs.1250 0.000 units.800 units with a probability of 0.800 with a probability of 0.500 If the safety stock of the firm is 8.800 units 2.600 units 0.000 units with probability of 0.000 units 1. In real life situations the assumption of independence in the probability distributions made in the illustration above may not be valid and the number of time periods may also be large. 14. lead time for procuring material is 20 days and the average number of units per order is 2000 units.1250 0. 'F'.3. Figure 4. therefore zero.7 For Apex company the average daily usage of a material is 100 units.000 units 4. Reorder Point Formula Even in a relatively simple situation considered in the illustration above. and subtracting the cost of goods sold. either because of the carrying and financing costs of excess inventory or the lost sales from inadequate inventory.7 below ties each subsystem together and shows the three items of information needed for the decision to order additional inventory. the issuance of goods. or other factors. historical agreements.3 (S x R x L ) x2 0 (100 x20 00 ) = 2. It maintains records of the current level of inventory.000 units -1. TOTAL SYSTEM The three subsystems are tied together in a single inventory management system.3 x 2. Inventory Planning An important task of working-capital management is to ensure that inventories are incorporated into the firm's planning and budgeting process. Stock-level Subsystem This stock level subsystem keeps track of the goods held by the firm. Figure 4.3 Reorder level = S x L + F = 100 x 20 + 1. Each item maintained in inventory will have a cost. This cost may vary based on volume purchases.600 units Reorder for replenishment of stock should be placed when the inventory level reaches 4. The inventory requirements to support production and marketing should be incorporated into the firm's planning process in an orderly fashion.4.000 . This lack of planning can be costly for the firm. For the purpose of preparing a budget. Every product is made up of a specified list of components. each item must be assigned a unit cost. For any period of time. The figure No. 4. The inventory management system can also be illustrated in terms of the three subsystems that comprise it. The analyst must recognize the different mix of components in each finished product. the current level is calculated by taking the beginning inventory.000 + 1. adding the inventory received. The Production Side The first step in inventory planning deals with the manufacturing mix of inventory items and end products. the firm will begin to place an order for the item.600 units. the level of inventory reflects the orders received by the general manager of the plant without serious analysis as to the need for the materials or parts. Whenever this subsystem reports that an item is at or below the reorder point level.From the data contained in the problem we have J S L R F = = = = 100 units 20 days 2. Sometimes.7 Three Subsystems of the Inventory-Management System 70 . and the arrival of orders. lead time for an order. These are the most costly or the slowest turning items of inventory. This information includes the classification and amount of inventories. The Marketing Department should also provide pricing information so that higher profit items receive more attention. fields and records. and other data. OTHER INVENTORY MANAGEMENT TECHNIQUES The ABC system In the case of a manufacturing company of reasonable size the number of items of inventory runs into hundreds. A group consists about 10 percent of the inventory items that account approximately for 70 percent of the firm's rupee investment. The C group typically consists of a 71 . cost to the firm for each item. From the point of view of monitoring information for control it becomes extremely difficult to consider each one of these items. ordering costs. we are working with a structured framework that contains the information needed to effectively manage all items of inventory. Inventory Data Base An important component of inventory planning involves access to an inventory data base. The first component of an inventory data base deals with the movement of individual items and the second component of inventory management data involves information needed to make decisions on rendering or replenishing the items. This group consists approximately 20 percent of the items accounting for about 20 percent of the firm's rupee investment. The A items are those in which it has the largest rupee investment. Both a sales forecast and an estimate of the safety level to support unexpected sales opportunities are required. The Marketing Side The second step in inventory planning involves a forecast of unit requirements during the future period. carrying costs. The ABC analysis comes in quite handy and enables the management to concentrate attention and keep a close watch on a relatively less number of items which account for a high percentage of the value of annual usage of all items of inventory. A firm using the ABC system segregates its inventory into three groups . B and C.7 which depicts the typical distribution of inventory items.A. from raw materials to finished goods. demand for the items. if not more. In the Figure 4. the analyst can calculate the materials cost for each product which is the weighted average of the components and the individual products.Once the mix of components is known and each component has been assigned a value. A data base is a collection of data items arranged in files. Essentially. The B group consists of the items accounting for the next largest investment. Dividing its inventory into A. Example.24 lakh Rs.26 lakh Rs. are evaluating a pharmaceutical formulation. Therefore if interest on longterm debt is considered for the purpose of determining the net cash flows. Opportunity costs associated with the utilization of the resources available with the firm must be considered even though such utilization does not entail explicit cash outflows. For example. In other words. The post-tax cost of long-term funds obviously includes the post-tax cost of long-term debt.) Since the net cash flows relevant from the firm's point of view are what that accrue to the firm after paying tax. cash flows for the purpose of appraisal must be defined in post-tax terms. while the sunk cost of land is ignored. nails. The cash flows must be measured in incremental terms. 2 and 3 of this chapter clarify this aspect.8 lakh Rs. the income it would have generated if it bad been utilized for some other purpose or project must be considered. a chemical engineer with 15 years of experience. DEFINING COSTS AND BENEFITS The important principles underlying measurement of costs (outflows) and inflows (benefits) are as follows: • All costs and benefits must be measured in terms of cash flows. 16 lakh Rs. the other product lines of the firm. (Illustrations 1.large number of items accounting for a small rupee investment. there will be an error of doublecounting.. and C items allows the firm to determine the level and types of inventory control procedures needed. and washers would be in this group. while the B and C items would be subject to correspondingly less sophisticated control procedures.8 Anand. the increments in the present levels of costs and benefits that occur on account of the adoption of the project are alone relevant for the purpose of determining the net cash flows.36 lakh Rs.e. Control of the A items should be most intensive due to the high rupee investments involved.e. Usually the net cash flows are defined from the point of view of the suppliers of long-term funds4 (i. B. Interest on long-term loans must not be included for determining the net cash flows. and Prakash. its opportunity cost i. They have estimated the total outlay on the project to be as follows: Plant & Machinery Working Capital The proposed scheme of financing is : Equity Capital Term Loan Trade Credit Working Capital Advance 72 : : : : : : Rs. suppliers of equity capital plus long-term loans). then such impact must be quantified and considered for ascertaining the net cash flows. the cost of existing land must be ignored because money has already been sunk in it and no additional or incremental money is spent on it for the purposes of this project. The rationale for this principle is as follows: Since the net cash flows are defined from the point of view of suppliers of long-term funds. the post-tax cost of long-term funds will be used as the interest rate for discounting. Items such as screws. a pharmacy graduate with 18 years of experience. 10 lakh . • The application of these principles in the measurement of the cash flows of a project are illustrated by the following illustrations: Illustration 4. C group consists of approximately 70 percent of all the items of inventory but accounts for only about 10 percent of the firm's rupee investment. Sunk costs must be ignored. The share of the existing overhead costs which is to be borne by the end product(s) of the proposed project must be ignored. • • • • Some implications of this principle are as follows: • • • If the proposed project has a beneficial or detrimental impact on say. This implies that all non-cash charges (expenses) like depreciation which are considered for the purpose of determining the profit after tax must be added back to arrive at the net cash flows for our purpose.. 9 73 .48 Year A B C D E F G H I K L Investment Sales Operating costs (excluding depreciation) Depreciation Interest on working capital advance Profit before tax Tax Profit after tax Initial flow Operating flow (= H + D) + 1(1 .15 22.00 38.00 1.70 28. Therefore.15 14. Define the cash flows for the first three years from the long-term funds point of view.00 44. thanks to the 'rollover' phenomenon. 1961. Further.15 (42.00) 26. the depreciation must be computed in accordance with the method and rate(s) prescribed by the Income Tax Act.00 8.The project has an expected life of 10 years.00) 26. The following illustration illustrates this point: Illustration 4.e.15 2 80. The difference of Rs. The expected annual sales would be Rs.15 (42. a notional salvage value is taken into account in the final year of the time horizon. the depreciation charge to be considered here will be the tax-relevant charge. Plant & Machinery will be depreciated at the rate of 33 1/3 percent per annum as per the written down value method. Working capital advance will carry an interest rate of 17 percent and. But in practice cash flows are defined over the entire project life or over a specified time horizon (if the project life is too long). will have an indefinite maturity.24 lakh in current assets is financed by way of trade-credit and working capital advance. In other words. and the cost of sales (including depreciation but excluding interest) is expected to be Rs. in lakh) 3 80. the contribution of the suppliers of long-term funds towards working capital.42 lakh. The tax rate of the company will be 50 percent. the investment outlay relevant from the long-term funds point of view will be equal to investment in plant and machinery + working capital margin = Rs. interest on short-term bank borrowings must be included in the cash flow statement. Solution Net Cash Flows Relating to Long-term Funds (Rs.15 19.15 Explanatory Notes The investment outlay has to be considered from the point of view of the suppliers of long-term funds. While interest on long-term debt must be excluded for reasons discussed earlier. If the cash flows are defined over a specified time horizon. this charge must be disclosed separately in the cash flow statement and not clubbed with other operating costs.t) Net cash flow (= 1 + K) 01 (42.33 1.70 28.50 lakh per year.48 19.00) 80.00 1.00 12.. Since depreciation is a non-cash charge which has to be added to the profit after tax. we have defined the cash flows only over the first three years of the project's life.80 lakh.30 14.15 14.18 lakh out of the investment of Rs.67 5. then the estimated salvage value of the investment in plant and machinery and the working capital must be considered for determining the net cash flow in the terminal year. In the Illustration discussed above. Term-loan will carry 14 percent interest and will be repayable in 5 equal annual installments.30 14. beginning from the end of the first year. In the given Illustration. we find that Rs.6 lakh is called the working-capital margin i.15 22.00 42.30 14. If the cash flows are defined over the entire life of the project.15 14.70 28. 20 149.19 76.00 10. M.20 149. Solution Cash Flows Relating to Lone-Term Funds 0 Investment (204. Short-term advance from commercial banks will be maintained at Rs.52 59.00 163.20 89.75 6. C. G.00 183.34 182.60 lakh.18 8.00 167.86 68.00 27.20 149.80 7 8 9 (Rs in lakh) 10 350.00 160.00 (36.190 lakh a year.52 89.68 59.68 7.68 59.00 10. F.42 16.68 59. Trade credit will also be maintained uniformly at Rs.A capital project involves the following outlays: (Rs.64 10. in lakh) 100 104 36 60 180 120 Equity Long-term loans Trade credit Commercial banks The project has a life of 10 years.00 350. I.52 59.20 149.52 89. H. Cost of sales (including depreciation.37 A.98 160.09 160.00 179. The expected annual net sales is Rs.02 11.68 59.00 10.58 160-00 10.80 5 350.00 160.00) (60.00) 86.05 22.63 79. At the end of 10 years plant and machinery will fetch a value equal to their book value and the investment in working capital will be fully recovered.00 173.00 350. Plant and machinery are depreciated at the rate of 15 percent per annum as per the written down value method.52 89.00 10. It will be fully liquidated after 10 years.68 59.68 59.20 149.00 175. 350.95 160.91 14.00 10.25 160.68 59.80 149.20 149.51 160.350 lakh.20 149-20 149. but excluding interest) is expected to be Rs. N.80 149.34 67.80 3 350.36 lakh and will be fully paid back at the end of the tenth year.52 89.00) 1 350.80 6 350.44 120. Calculate the cash flow stream from the long-term funds point of view.68 Explanatory Notes • Net salvage value of fixed assets will be equal to the salvage value of fixed assets less any income tax that 74 . The long-term loan carries an interest of 14 percent per annum. E. K.77 71. l.52 89.00) Sales Cost of sales Depreciation Profit before interest and taxes Interest on ST bank borrowing Profit before taxes Tax Profit after tax Net salvage value of fixed assets Net salvage of current assets Retirement of trade credit Payment of ST bank borrowing Net Cash Flow = -A + I + D + J +J+K-LM (204. J. It is repayable in eight equal annual installments starting from the end of the third year.68 82.82 181.49 19. in lakh) Plant and machinery Working Capital The proposed scheme of financing is as follows: (Rs. B.20 89. The tax rate of the company is 60 percent.00 10.68 59.80 10. and will carry interest at IS percent per annum. D.68 35.04 125.00 10.52 89.66 69.52 89.80 4 350.00 170.80 2 350.26 73.00 178.36 160.80 10.00 160.S2 89. 14. deduction available for a new project under Section 80 I of the Income Tax Act has been ignored.3.750 1.100 Year 1.000 at the end of the fourth year.750 1. Solution Cash Flows Associated with Replacement Decision (in Rs.750 per annum New leather-cutting machine Rs. Rs.10 Sandals Inc.900 2. Assuming straight-line depreciation.500) 5. and a 40% tax rate. The estimated salvage value of the old machine in. the net salvage value of any individual item off plant and machinery has lost its significance and therefore for our purposes.000 and can be sold for an expected amount of Rs. incurred at the time of disposing of the fixed assets.900 2.100 3 7.750 1. In other words. 9. 10.500) 1 7. 2.may be payable on the excess of the salvage value over the book value.3.000 cash savings over the old machine. and it is depreciated on a straight-line basis. (The depreciation rates currently applicable to plant and machinery under the Income Tax Act are 25%. 4. we will ignore the impact of tax on the salvage value. The new machine has a four year life.100 (12.100 (12.750 1.900 2.900 2. 1.000 2.000 per annum Incremental depreciation = Rs.3. • 7. define the cash flows associated with the investment.850 5.000 per year. 40%. 3.000 2.000 2.250 per annum 75 .250 4.250 4.four years would be zero. and 100%).100 5. Working Notes Net investment in new machine Savings in costs Incremetal depreciation Pre-tax profits Taxes Post-tax profits Initial flow ( = (1)) Operating flow ( = (6) + (3» Terminal flow Net cash flow ( = (7) + (8) + (9)) 0 (12. we will take only the gross salvage value into consideration.500. 8. Assume that the straight-line method of depreciation is used for tax purposes.e.2. 6.250 4.850 5. In working out the cash flows. The new machine will reduce costs (before tax) by Rs.850 5.12.250 4..000 2.850 2 7. • The depreciation rate assumed in this problem is not indicative of the current rates in force. 5.000 and can be sold for Rs. is considering the purchase of a new leather cutting machine to replace an existing machine that has a book value of Rs. if any.100 5. • • Illustration 4.2. Likewise there will be a tax shield on the loss.100 2.500) 5.000/4 = Rs. costs Rs.100 Computation of depreciation: Existing leather-cutting machine Rs. According to tax laws.000/4 = Rs.) 4 7.000 7. i.7.7. Our Illustrations have so far been focused on estimating cash flows for a new project The following illustration illustrates estimation of cash flows for a replacement project. are relevant while cost control requires the adoption of standards for comparison and involves the measurement of actual costs against the standard costs. Cost control. Cost Accounting can provide financial and non-financial information that help decision-making across all functions of the organization. marginal costs plus expected contribution or estimated total cost plus profit.1 The official terminology of the Chartered Institute of Management Accountants (CIMA). Modern Cost Accounting is often called Management Accounting. the emphasis is clearly put on decision-making. and decision-making. a product or service. therefore. resources sacrificed or foregone to achieve a specific object. Cost measurement must be tied to at least one cost object—the term cost by itself is meaningless. a foregoing or a release of something of value. The cost object may be an activity or operation. Day-to-day applications of plans and policies may require almost any combination of the above and other types of costs 76 . processes. Costs are.. Pricing requires a different set of figures. etc. Budgeting and planning operations (in money terms). viz. It now refers to the gathering and providing of information for decision needs of all sorts. a project. past or historical cost. Periodic profit determination (including valuation of inventory). the boundaries of Cost Accounting have increased tremendously. Of late. For example. Managers need cost information for informed decision-making. Cost Accounting is one of the branches of Accounting and is predominantly meant for meeting the informational needs of the management. COST CONCEPT AND COST OBJECT Cost is defined as the amount of expenditure (actual or notional) incurred on. England. 3. profitability or social use of funds' Management Accounting serves a business to be operated more efficiently and effectively. • • • ascertainment of cost of a product or service. 4. revenue. Accounting is regarded us an information system and cost and Management Accounting are two sub-systems of the same. volume. For item (2). 2. Pricing. and Day-to-day applications of plans and policies. We want to know the cost of doing something. defines Cost Accounting as "that part of management accounting which establishes budgets and standard costs and actual costs of operations. any activity or item for which a separate measurement of costs in desired. summarizes and interprets financial and non-financial information for three major purposes. Why does management need cost information? Some of the purposes for which managers need cost information are: 1. therefore. a department "or a programme.3 A synonym is cost objective. no doubt. estimated costs. for materials used for production the cost is measured by the amount of money that had to be paid to procure the materials. viz. Objects of Cost Accounting are always activities. a specified thing or activity (CIMA). classifies. departments or products and the analysis of variances.Chapter 5 Organization profitability analysis Cost Accounting is a quantitative method that accumulates. 5. Cost object is. The Committee on Cost Concepts and Standards of the American Accounting Association (Accounting Review. operational planning and control. This is. or attributable to. It also represents a sacrifice. 31) supports the view that business cost is a release of value for the acquisition or creation of economic resources and is measured in terms of a monetary sacrifice involved. When cost Accounting is used as a synonym of Management Accounting. vol. Historical costs are required for item (1) mentioned above as it involves the matching of costs and revenues on some consistent basis. 000 for fixed overheads are incurred for producing 10. price of materials. so that variable costs are truly variable. 40. According to this technique: variable costs are charged to cost units and the fixed cost attributable to the relevant period is written-off in full against the contribution for that period.K. the labour employed and the variable overhead expenses that would not have been incurred but for producing this additional unit. while in the U. There will not be any change in pricing policy due to change in volume. Operating efficiency will not increase or decrease.00. This is the marginal cost of one unit and this marginal cost is the direct cost. salaries of staff etc. 1.000 20.. i. 8/- The economist's marginal cost curve is J or U-shaped. Alternatively.000 for direct materials. The number of units of sales will coincide with the units produced.000 Rs. such increase will be included in marginal cost. Rs.A.00.000 units of a product is Rs. Fixed costs will tend to remain constant. Since fixed costs are not included in product costs. Although both marginal costing and direct costing may mean one and the same thing. will remain unchanged. But accountants define4 marginal cost as "the variable cost of one unit of a product or a service. Product-mix will remain unchanged.000 units of a product. CVP analysis refers to the study of the effects on future profits of changes in fixed cost. 5. Rs.Marginal Costing Marginal Costing is a technique of ascertaining cost used in any particular method of costing. etc.000 20. 20. the marginal cost can be ascertained as follows: Materials Direct Labour Prime Cost Variable Overheads Marginal Cost Production Marginal Cost per unit Rs. all costs are classified into two groups: fixed and variable.00.' Under this technique. 40. horizontal line. 20. Suppose the cost of production of 10. 8. 80.... 1. For this purpose. so that there is no closing or opening stock. it becomes easy to find out directly the effect on profit due to changes in volume or type of output. i. 60. such as change in property tax rate. Marginal Cost Economists define marginal cost as "the amount at any given volume of output by which aggregate costs are changed if the volume of output is increased or decreased by one unit".008. marginal cost is the aggregate of variable costs. For example. Marginal costing or CVP analysis is based on certain assumptions.000 units Rs. services.000 for variable overheads and Rs. 2.00.1. 6. If the production of the additional unit involves increase in fixed cost along with variable items as above. when plotted. direct costing is the more popular term. or in management policy. The term marginal costing is generally used in the U.S.000 10. Product specifications and methods of manufacturing and selling will not undergo a change. Thus. 4. or at variable cost. quantity and mix (C1MA). if Rs. 8 (i.000). variable cost. Semi-variable costs can be segregated into variable and fixed elements.000 and that of 10. supplies. Price of variable cost factors. 20. which. a cost which would be avoided if the unit was not produced or provided".e.e.001 units is Rs. Break-even analysis is one of the important tools under CVP analysis or marginal costing and is used by managers for decision-making. cost of producing an additional unit is Rs. insurance rate. They are as follows: 1.000 Rs. is a flat. Therefore. 77 .. 3. etc. 1. In other words. sales price. Rs. there will not be any change in cost factor.008 .2 The term cost-volume-profit (CVP) analysis is also frequently used3 in this context. the accountant's per unit variable cost is a constant. the changes in opening and closing stocks are insignificant and that they are valued at the same prices.e. the fixed and variable elements are also separated from semi-variable or semi-fixed costs and included in respective groups. competition.000 for direct labour. 7. comprising the cost of materials used. wage rates.. a distinction between the two may also be made. Relationship to Fixed costs result from the capacity to Activity produce and they are not a result of the performance of that activity. 78 .. are to be incurred during a period irrespective of the volume of production. these costs may well change. we have taken labour cost as 'direct and variable' as most of these questions set in various examinations assumed labour cost as such. 5. They are not generally influenced by output. be summed up as follows: Particulars 1. direct labour costs are included in marginal cost on the assumption that they are 'variable'. While all variable costs are generally direct. casual labour engaged to cope with additional volume. they may be called 'activity costs'. fixed costs are written-off to Marginal Profit and Loss Account being treated as period costs inasmuch as costs such as supervision. Relevant Fixed costs tend to remain constant only Activity Range within a given range of output or activity. as defined by the accountants. beyond that. they should be excluded from marginal cost. In some cases. Because these costs generally accrue with the passage of time. All other factors given constant. depreciation. variable costs may also be affected by the discretionary policy decisions of management. fire insurance. Fixed costs tend to remain constant irrespective of the volume of output or activity. say. Since variable costs are included in product costs. Fixed costs are 'costs of being in the business'. they may be regulated by changing management decisions. overtime premium. only variable costs form part of product costs. due to annual increment. while it may be an indirect cost for another cost object.g. In reality. If they are not variable. So. etc. It should be noted that even fixed costs may be directly identifiable with the cost object.). Semi-variable costs are segregated into variable and fixed elements and included in the respective groups.g. the decision-maker should keep in mind the limitation of such textbook approach and analyze cost data according to real-life situation for correct decision. Variable costs are 'costs of doing the business'. Only few items are subject to short-run management control. variable costs cannot be affected due to change in period alone.. Variable costs vary in proportion to activity rather than to the passage of lime. That is why. labour costs are not variable—they are fixed. Accordingly. 4. etc. Relevant Period Other things remaining constant. they are known as 'period costs' or "time costs'. 203-205).. Many items of fixed costs are dependent entirely on specific management decisions. The pattern of variable costs also remains constant within a normal or relevant range of operations. 3. Since these costs tend to fluctuate in proportion to changes in output or activity. rates. expressing fixed costs per unit does not make any sense. Type of costs Fixed costs Variable costs Variable costs tend to vary directly with output or activity. a distinction between variable costs and fixed costs has to be made because only variable costs are treated as product costs and fixed costs are treated as period costs. cost of labour should be excluded from the computation of marginal or variable cost: it should be added to other fixed costs and treated as such. There are a few. under stable conditions. These costs are discussed in detail in the Overheads chapter (pp. from zero to full capacity. rent. In India. Even if fixed cost increases due to increase in volume. Variable costs are generally subject to shortterm management control. if any. costs that would remain constant over the wide range of output or activity. salary bills in two periods will not be identical). apart from knowing the incidence of costs per unit. For example. a decision to use a less expensive raw material than that currently used (without impairing quality of product) will reduce the amount of variable cost (although the cost is still variable but at a different rate). such product costs will be a constant ratio whereas fixed costs will be a constant amount. In the above example. Therefore. say 5 to 10 percentage. Controllability .The theory of marginal costing is based upon the assumption that some elements of cost tend to vary directly with variations in volume of output while others do not. however. 2. expressing variable costs in relation to time does not make any sense. all direct costs need not be variable. A comparison between the two with respect to a few criteria may. The most important aspect of the direct cost is the cost object. However. A cost item may be direct cost for one cost object. it will not affect marginal or variable cost. a change in period may lead to a change in fixed costs structure (e. So. is variable (e. On the other hand. salesmen's commission. only an insignificant portion.All fixed costs are controllable over the lifespan of an enterprise. Variable Costs vs Fixed Costs In computing marginal costs. in solving the problems in this Section as well as those in Section II that follows. The basic sources of data are the same. Method of Least Squares. Fixed costs can also be picked up individually without difficulty.700 Semi-variable overheads Rs. From this. rate. etc.e.000 15. such as direct materials. Therefore. 5.200 18.400 13. it is simple to operate. Since fixed portion of the costs is expected to remain fixed for the two periods.000 3. Equations method. In determining these costs. Segregation with the help of this_ method is not difficult.500 3. direct expense. Graphical method. it becomes clear that the change in the level of the expenses must be due to variable portion of the overheads.500 17. Methods of Segregation of Semi-variable Costs The following methods are generally used in segregating semi-variable costs into their variable and fixed parts: 1. the accuracy of marginal costs will depend to a large extent upon the accuracy with which semi-variable costs are segregated into variable and fixed elements.700 4. 3.500 19.100 Now. Job Cards or Wages Analysis Sheets for labour booking.000 4. past overhead expenses at various levels of activity will be analyzed and a tabulation will show the pattern of overhead expenses in relation to volume. etc. Methods of Averages.200 4. however. Where. budgetary control is in operation.800 2.500 14.300 3. High and Low Points method. can be ascertained without any difficulty and these costs will tend to be a constant amount per unit. Material Requisition Notes for direct and indirect material. In this method. High and Low Points This is also known as Range Method.Determination of Marginal Cost Variable costs. Adjustments are to be made for anticipating changes in price. 4.500 4. past actuals will be the basis for estimate. 6. the levels of highest and lowest expenses are compared with one another and related to output attained in those periods. 12. etc. direct labour.600 17.900 16. i. 2. the variable cost per unit is easy to ascertain as follows: Change in exp ense level Change in output level Illustration 5. taking highest and lowest output with relative overhead costs. Semi-variable group frequently represents a significant portion of the total costs incurred.000 17. Variable overheads can be ascertained from previous ledger postings or the budget. company's detailed budget will be a guide.1 Output Month January February March April May June July August September October November December (units) 2. Intelligent estimate of individual expenses.700 3. Expense Analysis Sheet for expenses. one can segregate 79 . Semi-variable items should be segregated into variable and fixed elements and be included in the respective groups.100 16.. Intelligent Estimates In estimating fixed and variable portions of semi-variable overheads.400 4.. from the above table. Although this method is not accurate.100 18.500 4. Illustration 5. 19.100 12.output. 16.000m + c 1. The line of regression drawn on the graph paper will show the relation between the variable overheads and 80 Average cost Rs.500 2. (1) from Eq.500m + c 14. 37Putting value of m in Eq.3 Average output 3.-.2: 12. variable overheads cost per unit will be: Rs.500 x 3 + c Taking the figures for January and February from Illustration 5. fixed costs would be: Rs.0007This method is not always considered to be scientific.100 .700 x Rs. Illustration 5. (2): m = Rs. 825 .(4. The equation is: y = mx + c (5.500 = 500m (I) (2) Method of Averages Under this method. 16.700 units 3.000. 31-) = Rs. 12.500 = 2.100 Rs.425 units 275 units Variable overheads: Rs.700 x Rs. c = Rs.1) where y .000 = 3.275 Rs. (1): . average of two selected groups should be taken out first and then the method of high and low points or the equation method may be used in arriving at variable and fixed portions of semi-variable costs. 5. 6. 19. It is now possible to segregate the fixed and variable portions with the help of the equations with respect to two periods.500 = 2.fixed cost included in semi-variable cost. 5.600 Highest (April) Lowest (January) Change Since variable costs will only change.000 Last four months First four months Change Graphical Method Semi-variable overheads at various levels of activity will be plotted on a graph paper whose abscissa will represent output at various levels of activity and the ordinate will represent respective semi-variable overheads.500 6.200 = Rs. 3 per unit Fixed overheads: Rs.700 2. m = variable cost per unit. 825 4 275 = Rs. Equation Method Here the straight line equation is used. and x .100 .(3.600 4 2.200 Semi-variable overheads Rs.2 (January) (February) Subtracting Eq.the fixed and variable portions as follows: Output (units) 4. c . 3/Therefore.total semi-variable cost. 15. 3) = Rs. 5. Thus. for each period we have an equation in the following form: y1 = mx1 + c y2 = mx2 + c yn ~ mxn + c Adding ∑ y=m ` ∑ x + N. let: x = Then: x 5 6 7 18 Sx y 25 28 31 84 Zy x 2.500 X Y . Method of Least Squares This method is possibly the most accurate of those discussed so far.500 14.2) and (5.3 Month Output (units) Semi-variable overheads Rs. multiplying both sides of the linear equation by x.500 January February March To reduce labour. and y = 500 500 xy 125 168 217 510 "Lxy x2 25 36 49 110 Xx2 Substituting the above values in Eqs.2) [N = number of observations] Again.3) With the help of Eqs.2) and (5.x2 xnyn = mxn2 + c.c (5. the values 'm* and V can be obtained and the pattern of cost line determined accordingly.000 3.500 3. The slope of the regression line will show the degree of variability.xn and which. when added together. become: ∑ xy .3): 84= 18m + 3c (3) 81 . Y 12. This is based on finding out a 'line of best fit' for a number of observations with the help of statistical method. (5. We know the straight line equation y = mx + c. Illustration 5.X1 2 x2y2 = mx2 + c.000 15. This method is widely used in practice. we get: x1y1] = mx2 + c.output and the point where regression line will cut the ordinate will represent the fixed overheads. (5.3). ∑ x 2 (5.m ∑ x + c. they are written-off to Marginal Profit and Loss Account of the period. The argument in favour of this procedure is that no one makes profit per unit manufactured. if production for any month is. the total overheads will be: Y = 3 x 4. the equation becomes: Putting y = and x = 500 500 Y 3X = +0 1 50 0 50 0 Multiplying both sides by 500: Y = 3X + 5. Figure 5. but profit is made out of total activity during a period. 5.000 = Rs.per unit. 17.000 Concept of Profit Profit is known as 'Net Margin'.000 Thus.1 It is also clear that no part of the fixed overheads is transferred to the next period by the addition of some 82 . fixed costs are not included in cost of goods sold or closing stock. the diagram overleaf will demonstrate how profit is made.000 gives the pattern of semi-variable overheads line. (3) by 6: 504= 108m + 18c Subtracting Eq. the above straight line equation shows that Rs.000 + 5. It is generally said that products make contribution and business makes profit. Net Margin5 is arrived at after deducting fixed costs from total contribution or 'Gross Margin'. It may be noted that contribution is the difference between sales value and the variable cost of those sales. 4.510= 110m + 18c Multiplying Eq. say. Thus. (4): (4) (5) ∴ 6 = 2m m=3 Putting this value in Eq. Y X . We now have: y = 3x + 10. Assuming that a manufacturing company manufactures four products. (3): 84 = 54 + 3c c = 10.000 units. Units produced and sold will. In short. contribute to a 'profit pool' which will pay for the fixed charges and whatever will be left thereafter will represent net profit.000 is the amount of fixed overheads present in the total semi-variable and the variable overheads are Rs 3/. Note: The equation Y = 3X + 5. therefore. (5) from Eq. 600 Alpha £ 90 15 18 1.4 Duo Ltd makes and sells available: Production (units): Alpha Beta Sales (units): Alpha Beta Financial data: Unit selling price Unit variable costs: Direct materials Direct labour (£ 6/hr) 83 2. (b) When sales exceed production Under absorption costing.. under absorption costing. Consequently. closing stock decreasing) the amount incurred during the period. Thus. profit is lower than that shown under marginal costing.. The crucial question is whether the total fixed costs incurred during a period should be charged against sales of the period (as is done in marginal costing) or should be spread over more than one accounting period by means of inclusion in closing stocks (as is done in absorption costing). profits tend to vary with volume of sales irrespective of movements -in inventory.250 1. total fixed costs incurred during the period are charged against sales or revenues of the period. under marginal costing.arbitrary amount to the value of closing work-in-progress and finished goods.e.750 2. a portion of fixed costs is carried forward to the next year by means of inclusion in closing work-in-progress and finished goods. absorption costing yields a fluctuating profit figure.e. Absorption vs Marginal Costing It follows from the earlier discussion that marginal costing and absorption costing are based on different concepts of profit. Alpha and Beta.500 1. Illustration 5. Therefore. so that closing work-in-progress and finished goods are valued at marginal or variable costs only. absorption costing shows a higher profit than does marginal costing. Under marginal costing.900 1. (e) When production volume is Profit is directly proportional to sales under either of the methods. But under the same circumstances. periodic profit is affected by changes in inventory as well as in the volume of sales and profit may be shifted from one accounting period to another by increasing or reducing inventories.250 Beta £ 75 12 12 Two products. closing WIP and Finished lower than the amount incurred inasmuch as a portion of fixed goods increasing) production costs of the period is deferred to future periods by means of inclusion in closing inventories. fixed costs charged against revenues exceed (i. The constant but sales fluctuate profit figure may not be the same in amount but it will move in the same direction. profit and loss statement prepared under marginal costing is more intelligible to management. (d) When sales volume is constant Marginal costing shows a constant profit figure because changes in the but production fluctuates level of inventory cannot affect the profit. total fixed costs charged against revenue are (i. (c) When production exceeds sales Under absorption costing. The following information is Period 1 Period 2 . The effect upon profit under absorption and marginal costing under a number of possibilities may be studied as follows: Possibilities (a) When sales coincide and Effect upon Profit under Absorption and Marginal Costing production Under both methods. the entire amount of fixed costs is charged to Profit and Loss Account in the year in which the costs are incurred. on the other hand. Under absorption costing. Therefore.300 1. product costs include fixed costs and as a result. Hence both yield the same profit.700 1. This is because fixed costs previously deferred in stock are charged against revenues in the period in which the goods are sold. Therefore. 07.54.800 22. (b) Prepare profit and loss accounts for period 1 and for period 2 based on absorption cost principles.500 1.000 more over the two periods as £ 9.30.27.700 1.46.750) = £ 10 per labour hour Total cost per unit (£) 13.750 (c) Stock levels are rising over period 1 and 2.000 in period 1 and £ 82. Requirements: (a) Prepare profit and loss accounts for period 1 and for period 2 based on marginal cost principles. (a) Profit and Loss Accounts for Periods 1 and 2 under Marginal Costing Peri £ Sales Less: Cost of sales: Opening stock (Wl) Production od 1 £ 3. the reported profit under absorption costing is £ 15. and a net £ 6.500 54.000 of fixed costs are 'carried forward' from period 1 to 2.800 1.800 30 75 84 20 52 . Less: Closing stock (W2) Profit 1.500 13. Workings: Alpha 45 200 9.250 Less: Closing stock (Wl) Contribution Less: Fixed costs Profit (b) Profit and Loss Accounts for Sales Less: Cost of sales: Opening stock (W2) Production 2.500) + (2 X 1.000 in period 2.300 2 £ 2.46.000 45 Beta 32 150 4. which includes a share of fixed costs in the stock valuation.500 1.10.300 1. Accordingly.10.000 (3 x 2.800 1.55.000 — 78.72.16.68.000 400 18.300 37.750 — 1.800 150 4.30.27.800 1.500 2. Absorption costing.300 22.500 22. (c) Comment on the position shown by your statements.Variable production overheads 12 8 Fixed costs for the company in total were £ 1.800 32 Total Marginal cost per unit (£) Period 1: Closing stock: units value (£) Period 2: Closing stock: units value (£) W2 Period 1: Marginal cost (£) Overheads (£): £ 1. therefore gives a higher reported profit than marginal costing which charges the fixed costs against profit in the period in which they are incurred.700 71.800 2.39.92.250 Absorption Costing Period £ 22.000 62.000 48. Fixed costs are recovered on direct labour hours.25.800 13.800 2.000 Period £ 2 £ 2.000 are 'carried forward' from period 2 to 3.10.300 Period 1 and 2 Based on Period 1 £ 3.250 82. e. there will be no profit or no loss (Total Costs = Total Sales).800 37.800 32 22.Profit.Closing stock: units value (£) Period 2: Marginal cost (£) Overheads (£): £ 82..V = C. popularly known as the P/V Ratio. and P . if any three factors of the above equation are known.800 It has been pointed out earlier that the difference between sales value and the variable cost of those sales is known as contribution. i.250) = £ 10 per hour Total cost per unit (£) Closing stock: units value (£) MARGINAL COST EQUATION 200 15.. the fourth can be easily found out.900) + (2 x 1. From this concept.800 30 75 400 30. i. V . the following Marginal Cost Equation is developed: S-V=F+P [S . contribution is equal to fixed costs and profit (or loss).5) PROFIT/VOLUME RATIO The Profit/Volume Ratio.000 20 52 150 7.000 (3 x 1.Sales.e. C = F + P] (5. Symbolically. In other words. at break-even point. Thus. expresses the relation of contribution to sales.Variable or marginal costs. this equation is used for ascertainment of break-even point. 85 . F = Fixed costs.000 45 150 7.4) where S . Again. This ratio is also known as Contribution to Sales (C/S) or the Marginal Income Ratio. so that P = 0. S1=V1 + F (1) (5. Therefore. products sold will contribute to a fund to meet first the fixed costs and the balance represents the profits of the undertaking. P/V or C/S Ratio = S −V C = S S (5. But if they change. the C/S ratio may be used by the management.7) The above ratio is generally expressed in percentage form multiplying it by 100. The same result can be obtained by multiplying the additional sales figure by P/V ratio (here P/V ratio is 40%). (b) reducing variable costs. 1. so that development of sales strategy is facilitated. Rs. net profit will be increased by Rs. Thus. P/V ratio can be determined by expressing change in profit or loss in relation to change in sales. For example.000 _ 8. processes or departments. The effect on profit may be summed up as follows: (i) If the firm is operating at or above BEP. (ii) If the firm is operating below the BEP. Similarly.5 Sales Variable costs Fixed costs Total costs Net Profit Present volume Rs.6) where C = Contribution. it is to be assumed here that selling price and variable costs. will remain unchanged even for the additional volume. This can be done by. 1. the increase in net profit will be equal to increase in contribution provided fixed costs remain constant. 400. the constituents of the ratio. C/S or P/V Ratio determines the increase or decrease in contribution which can be expected from increase or decrease in volume provided that there is no change in any other factors. i. So long as unit selling price and unit variable cost remain constant.e. (c) altering sales mixture. due to additional sales. 400. and V . The effect on profit due to changes in volume may be ascertained with the help of this ratio. i. (a) increasing selling price. Again. Illustration 5. product having low P/V ratio will be substituted by a product with a higher ratio.000 6. the addition to contribution reduces the loss or changes the loss into profit. S = Sales.000 x 40% = Rs. for price reduction due to acute competition.e. P/V or C/S ratio = = C ontributi Sales on = C hange in contributi on C hange in sales C hange in profit (or loss ) C hange in sales (5. 86 . unit variable cost and fixed cost (total) remain constant. the P/V ratio will also change..000 600 2. However. an improvement of the ratio will mean increasing the gap between sales and variable costs. a high C/S or P/V ratio indicates that comparatively large amount may be spent by way of advertising and sales promotion for obtaining additional sales inasmuch as the contribution from such sales will be adequate to recover fixed costs and 'contribute further towards profit. when unit selling price.000 600 2. Improvement of P/V Ratio CIS or P/V ratio is the function of sales (value and/or volume) and variable costs. Therefore. P/V ratio can also be found out by expressing change in contribution in relation to change in sales..000 400 Thus. 10.000 Additional volume Rs. C/S or P/V ratio will indicate relative profitability of different products. In normal circumstances.Variable costs. It is an important aid to profit planning. It has been defined as 'a chart which shows the profitability or otherwise of an undertaking at various levels of activity and as a result indicates the point at which neither profit nor loss is made'.8) Total Fixed Costs BEP (sales value): = (5. 80. depicts the following information at various levels of activity: 1.9) P ratio V Total Fixed Costs Total Fixed Costs = xS = C C S (5.20 = Rs. 2. BEP (units) = R . 5000 x Rs. 80000 x 200000 =Rs . Each unit sells at Rs.9) Therefore. This is the activity point at which neither profit is made nor loss is incurred. therefore.11) The fixed costs for the year are Rs.000 87 Rs . The number of units involved coincides with the expected volume of output. 4. Perhaps..000 units) Variable cost @ Rs.000 units. 5. fixed costs and total costs.7 The most important use of the BEC is the ascertainment of a break-even point (BEP) from the chart.BREAK-EVEN CHART A Break-even Chart (BEC) is a graphical representation of marginal costing or CVP analysis. variable cost per unit for the single product being made Rs. Margin of Safety. the point at which total costs just equal or break-even with sales. The BEC. i. selling price. Sales value. the relevant variables and their impact upon profit are considered simultaneously.000 20. taking total sales and total contribution at that level. 20. 1. Estimated sales (at 100% capacity) for the period are 10.00. At different activity levels.0 0 s 0 0 =5.000 80..10) But if P/V ratio is calculated at a given level of activity. in this context. ii. the interaction of volume. the BEP is computed as follows: Total Fixed C osts x Total Sales Total C ontributi on (5.0 0 u its 0 n 2 −4 0 or. we can write: BEP = Total Fixed C osts x U ellin nitS U nit C ontributi on g P ice r (5. variable costs and fixed costs. i. 4. when P/V ratio is calculated using unit contribution and unit selling price.100000 160000 .e. Variable costs.000. BEP (units) = Total Fixed C osts U nit C ontributi on (5. a name for the break-even graph that more clearly describes its function would be profit planning chart. Break-even Point.8 . The BEP can be determined from a BEC or can be calculated as follows: i. 3. which is a valuable guide to the management. Profit or Loss. 4 Contribution Rs.e.100000 The same result can be obtained by using the last formula: Check Sales (5. 000 X Y Z Total Fixed costs Profit or Loss Variable cost ratio Rs. In such a case. Sales 10.30000 88 .000 Break –even Sales = Y Rs. 1. 5.500 2.000 x Total Sales Total Rs.200 6.000 Rs. 20.7 What will be the C/S ratio and the profit in the following case? Sales Fixed cost Break-even point We know: BEP = Rs.000 5.000 5.800 5.500 2.20000 = rs.000 Variable cost 6.700 5.000 20.50) – Rs.600 1.500 9.000 2.00.000 3. Illustration 5.000 3. by applying which the break-even sales of the firm has to be computed as above.000 3.000 Rs. it is possible to find out missing information.40000 ∴Profit = Contribution – Fixed Cost = Rs.12000 9500 Sales ratio Rs.500 on = Rs.500 1. Product X Rs.50 or 50% BEP Rs .400 1. at a particular level of activity. From the following data. 20. C/S ratio = FC Rs .000 Variable cost Rs.300 Contribution Rs.20000 = = 0. 60% 50% 40% Variable cost Rs. 3.500 1.700 Nil Once we know the various components of break-even point.000 10.000 12.500 Fixed C ost Total C ontributi Z Rs.000 2. P/V ratio stands for combined P/V ratio for all the products. 5.000 Nil It should be noted that in case of a multi-product firm.(100000 x 0.000 Contribution 4.Fixed costs Profit/Loss 80. calculate the break-even sales for a company producing three Product X Y Z Sales Rs.000 2. 6. 50% 25% 25% 100% BE Sales in previous ratio 6. 5. P C C / S ra tio 40.6 products. Check : Product 5700 x 20000 =Rs .500 Total fixed costs amounted to Rs. 10. Illustration 5.000 10.700. 2. formula (i) cannot be applied.000 or. The following is an example of EEC drawn from the schedule below on the basis of data as in previous illustration.000 1. there is a loss.000 .20. Similarly.10. Nil 50. In other cases. 3. and (d) Sales Value. determine sales value at various levels of activity and plot them on the graph paper and join to zero in the graph.500 10. it 89 Rs. The breakeven sales will be determined by dropping a perpendicular to the 'X' axis from the point of intersection and measuring the horizontal distance from the zero point to the point at which the perpendicular is drawn. Plot the variable costs for different levels of activity over fixed cost line.00.50. For instance. sales value is widely used because profit is not realized unless goods are sold. Join the variable cost line to fixed cost line at zero activity level.500 7. e. — 10. it is difficult to plot them on the basis of percentage activity or volume.000 by a line parallel to 'X' axis. Costs and revenue are plotted on the 'Y' axis and activity or volume is plotted on the 'X' axis.000 Total cost Rs.000 Variable cost Rs. (c) Standard Hours. there is profit. Alternative form of a BEC In Figure 5. and where total cost equals total sales. 2.000 30. 80. The resultant line will represent total cost line—variable cost having been added to fixed cost. The sales 1'ne will cut the total cost line at a point which is known as break-even point.000 Procedure 1. Standard Hours may be the appropriate expression. Where. Interpretation The break-even chart will give a vivid picture of profit or loss at different levels of activity. however. Here. (b) Volume in units. fixed cost line has been plotted first. (a) Percentage level of activity (plant capacity being represented by 100%). This type of presentation is more helpful to the management for decision-making inasmuch as it shows clearly the contribution margin at any volume of sales..000 Fixed cost Rs. Represent fixed cost Rs. it is desirable that a combination of methods of expression is used.Construction of a Break-even Chart A Break-even Chart is drawn on a graph paper. 'X' axis may be expressed in a number of ways. there are a number of products of different measuring units which require different plant capacity. This line will represent sales value.000 2.000 40. there is no profit or loss. where the sales line is above the total cost line.2.000 80. Further. where it is below the total cost line.000 1. Another perpendicular to the 'Y' axis from the point of intersection will indicate (vertically) the break-even sales value. 80. Sales Units Nil 2. 80.g.000 80. Alternatively. variable cost line may be plotted first and then fixed cost line over the variable cost line.000 1. However.000 80. when sufficient data are available.000 90. should be followed. it is the fixed cost which is not being covered fully. Unless. Therefore.2 Break-even Chart Figure 5.00.000 1.g. there is a contrary instruction.3 Contribution Break-even Chart. 1. In the preparation of a BEC. Margin of Safety (M/S) may be expressed in sales volume or value or in percentage.000 units Break-even M/S sales Rs. Present Rs.000 Rs.appears from the chart that below the break-even point.2). Margin of Safety This is represented by excess sales over and above the break-even point.00. known as the contribution break-even chart (Fig.000 10. it is in line with the concept of marginal costing.. one of the assumptions made is that production will coincide sales.000 units or 5. Thus.000 or 2. In the chart. e. Figure 5.000 = 50% 90 units x l00 . 14. 1. it is the distance between the BEP and present sales or production.000 or 5. therefore. or sales 2. it may be said that margin of safely is also the excess production over break-even point.00. this form of presentation.00.00. a small angle will mean that even if profits are being made. i. if the margin is small. The Margin of Safety can also be calculated with the help of the formula: Illustration 5. In such a case. the first mentioned company is in a much stronger position than Company B. it may be concluded that if the rate of profit earned above break-even sales is the same for company A and B.) A P/V graph can be constructed if any two of the following data are known: (i) Fixed Overheads. 1. For instance. 3.000 or 20% Total Sales Break-even Sales M/S Therefore.000 80. if the sales. 2.000 20. 14.00. THE PROFIT/VOLUME GRAPH OR PROFIT CHART This shows the relationship between profit and volume. such as: 1.00. consider the following statement: Company A Rs. a high margin will indicate that profit will be made even if there is a substantial falling off in sales of production. (see Fig.. margin of safety may be used to indicate relative position of firms. in the illustration. 40%. they are being made at a low rate. For instance. Therefore.. if Margin of Safety and Angle of Incidence are considered together. On the other hand. 1. increase the selling price.The percentage form of expression is generally used. This in turn suggests that variable costs form a major part of cost of sales. 4. a small drop in sales or production will be a serious matter. they will be more informative. On the other hand.8 (Data same as in Illustration 5.000 or 50% Company B Rs. This angle is an indicator of profit-earning capacity over the break-even point. falls by even.e. increase the level of activity.000 1. The P/V graph is a simplified form of Breakeven Chart and requires the same basic data for its construction and suffers from the same limitations. i. the company will still be making profits since its margin of safety is very high. 50%.8) M/S is an indicator of the strength of a business. substitute the existing products with more profitable products. say. In inter-firm comparison. 2. Angle of Incidence This is the angle between sales and total cost line (see Fig.000 Rs.00. the aim of the management will be to have a large angle which will indicate earning of high margin of profit once fixed overheads are covered. However. management may take many valuable decisions. reduce costs—fixed and/or variable.3. 91 . 14. For example.e. a high margin of safety with a large angle of incidence will indicate the most favourable conditions of a business or even the existence of monopoly position.00.1). . Figure 5. The point of intersection is the break-even point. Sales: 20. 50. 75. 10 Variable cost (@ Rs. the following can be ascertained: Break-even point : Rs.000 30. Two such uses are shown below.000 Variable cost per unit: Rs. showing the deviations of actual profit from anticipated profit. etc. 6 Selling price per unit: Rs. 'high-tech' company will have a higher amount of fixed cost and hence would be exposed to a greater degree of operating risk. determining break-even point and showing the impact on profits of selling at different prices for a product.000 A profit-volume graph may be used for a variety of purposes.9 The following data relate to a company for the year ended 31st December. In reality. The graph is divided into two areas—the vertical axis above the zero line represents profit area and the vertical axis below the zero line represents the loss or fixed cost area.25. 92 . having lower amount of fixed cost.000 units @ Rs. A scale for profit and fixed cost on the vertical axis is also selected. forecasting costs and profits resulting from changes in sales volume. Thus.(ii) Profit at a given level of activity. viz. In order to construct a graph.000 Margin of Safety : Rs. it is necessary to ascertain profit at the present level of activity. 2. 6 per unit) Contribution Fixed Overheads Net Profit Procedure This can be summarized below: 1. 2005: Units produced: 20. 10 Prepare a P/V graph.4 Profit-volume Graph Illustration 5. would have to face lower degree of operating risk in the event of fall in demand.000 Fixed Overheads: Rs. Points are plotted for profits and fixed cost and they are then connected by a straight line which intersects the sales line at the horizontal axis.000 Rs. and (iii) Break-even point. 2. from the graph.00. (a) Relative profitability under conditions of high and low demands: When two firms are identical in some respects and operate in the same marketplace facing the same kind of competition. 1.000 50. A scale for sales on the horizontal (zero) axis is selected.000 80.20.000 1. their profitability under conditions of changing demand may be compared using the profit graph. The 'lowtech' company. relative profitability under conditions of high or low demand for a product. Thus. 4. 3. Ltd.000 Rs. and state which business is likely to earn greater profits in conditions of— (i) heavy demand for the product.000 50.000 1.000.50.Break-even sales or Profit 4. (a) Sales Less: Variable cost Contribution P/Vratio(§x100 V S ) Break-even Sales (Fixed cost + P/V ratio) A. 1. 1.000 1.000 ————— C.50. B. B.000 1.50. Ltd Rs. Since different prices are being compared.000 33 1% 35.50. Ltd is greater than that of A.000 1.000 1.05. 1.00. Ltd are lower than that of C. Ltd once break-even point has been reached.P/V ratio) Rs. in case of heavy demand. 1. B. A. Ltd.35. Ltd and C. = Rs. D. Ltd will earn more profit than A. for volume above Rs.5 Comparative Profit-volume Graphs It appears from the graph that for sales below Rs. (ii) low demand for the product.e. D. 1.000 35.20.Illustration 5. D. as will be evident from the following graph. Sales Less: Variable cost Fixed cost Net budgeted profit You are required to: (a) (b) calculate the break-even point of each business.000 20% 15. C. B. Ltd sell the same type of product in the same type of market.000 15. 93 .20.000 33--% 1. 1. (b) Although total costs of both the firms are the same. Thus. Margin of Safety (Present sales . D. Ltd Rs. D. B. the break-even point in the former case is reached sooner (i.000 A.000 C. (b) Profit chart for different product prices: The effect on break-even point and profit of charging different prices for a product can be seen from the profit chart. the fixed costs of A.000 30.00.50. both will earn same profit.10 Two businesses A. D. = Rs. B.50. At volume of Rs.000 20% 75.000 45. Ltd will earn greater profits while A. Ltd will earn greater profits in condition of low demand for the product. the use of units is desirable.50.000. B.000 Rs. Ltd will earn greater profit than C. D. Ltd Rs.000 75. Rs.000. C. Figure 5. Rs.000 15. 1. Since the rate of profit-earning in case of C. B. As a result. at a lower level of activity). D. Ltd Rs. Ltd (vide angles of incidence).. 1. Their budgeted profit and loss accounts for the year 2005 are as follows: Rs.35.000 15. e. Figure 5. and indeed desirable.000 Rs.A profit chart is shown in Figure 5. 4 Rs. Figure 5..000.6 Profit-volume Graph at Different Prices.7 Multi-Product Break-even Chart. considering all the products in one chart). the breakeven point is where the average contribution line cuts the fixed cost-line (Fig. it is possible. 12 3.6. Calculate P/V ratio for each product and arrange the products in descending order on the basis of P/V ratios. The chart is based on the following information: Variable cost per unit : Fixed cost (total) : Alternative selling prices of a product : Maximum sales units : Rs. 94 . Rs. 8. to draw a break-even chart for the company as a whole (i. 10 and Rs. The procedure for drawing up a multi-product break-even chart may be summarized as follows: 1. 14. assuming proportions of salesmix remain unchanged. MULTI-PRODUCT BREAK-EVEN CHART When a company deals in a number of products.6). In such a case. 10. 40. and then in order of importance of P/V ratios a table for cumulative sales and contribution should be prepared and plotted on the graph paper. X and Z. 3.000. one by one. the process will end with plotting by the product having the lowest P/V ratio. 20.000 37. 5.000/40. then take the product having second highest P/V ratio and plot cumulative contribution against cumulative sales.000 20% 35. Illustration 5.) Variable costs (Rs. 'X'-axis would represent sales value while Y-axis would represent contribution and fixed cost. 3.000 Contribution Productwise Cumulative Rs.000 40% 25. 2. 50% 40. The break-even point is the point of intersection of average contribution line and fixed cost line.) Y 25.000 Cumulative Rs.000) x 100 = 40% Product Y : X : Z : (20.000 20.00.000/25. Plot the total fixed cost line. Break-even charts with the exception of the last-mentioned one are discussed below.) Fixed costs (Rs. in a nutshell. 4.000 30.000 1.000 Total 1.000) x 100 = 50% (7.000 28. Ltd produces and sells three products—Y. 18500 x 100000 =Rs .000 15.000 65. From the following information relating to these products for a period. Note: The break-even sales determined graphically can be verified by applying the formula: B/E sales = Fixed cos t x Total sales Total contributi on = Rs .000 Z 35.50000 37000 DIFFERENT TYPES OF BREAK-EVEN CHART Different break-even charts may be prepared to suit different purposes.2. Rs.000 7. Detailed break-even chart Cash break-even chart Control break-even chart Break-even chart to determine optimum volume. draw up a break-even chart to determine the breakeven point: Sales (Rs. Obtain the average contribution slope by joining the origin to the end of the last line plotted. P/V ratio : (S −V ) X 100 S (10. Detailed Break-even Chart 95 .000 30. Some of the most common types of charts (in addition to those already discussed) are: 1.000 Thus.000 X 40.000 63. 50.000 20.000) x 100 = 20% Product X Y Z Sales P/V ratio Productwise Rs. the break-even sales can be read from the chart as Rs. Determination of optimum volume and selling price through break-even chart is shown later on (vide Section II).000/35.00.500 The P/V ratio of each product should be calculated first. 4.11 ABC Co.000 18. Take the product having the highest P/V ratio and plot its contribution against sales. e.) Rs. 96 Rs. Detailed analysis.000 4. . advertisement. profit appropriations—income tax. rent. variable overheads—are plotted in the graph. 10 per unit.. insurance. salaries. it is called Profit Appropriations Breakeven Chart. particularly of various elements of variable costs.000. rates. direct labour.000 @ Rs. In addition. deferred expenses such as research and development..8. Fixed costs requiring cash outlay during the period covered by the chart (e. 2 1 1 1 Rs.g. A detailed break-even chart is shown in Figure 5. equity dividend and retentions—are shown. preference dividend. Fixed costs not requiring immediate cash. helps management in both policy decisions and control functions. If the chart contains only details of appropriations of profit. details of variable costs—direct materials. 559 for other information.In this type. 2. 10. depreciation. 40% of profit Rs. 5 Figure 5.) 2.g.8 Detailed Break-even Chart Fixed cost (total) : Income-tax : Dividends : Maximum Sates : Cash Break-even Chart In this type. fixed costs are divided into two groups: 1. The chart is based on the following information: Marginal cost per unit: Direct Material Direct Labour Variable Factory Overheads Variable Selling and Distribution Overheads (see p. etc. etc. sales. By pinpointing deviations between budgeted/standard and actual figures. profits and break-even points is prepared.000 units @ Rs. which are assumed to be payable in cash during the period. 2. A control break-even chart is shown in Figure 5. Figure 5. i. are plotted as usual. 4. But detailed analysis of deviations or variances according to originating causes and also into controllable and non-controllable portions is not possible graphically. If.000 Rs.e. supplement the control chart.000 3. 5. break-even chart comparing budgeted and actual costs. 8. The chart is based on the information given overleaf. 10 Rs.000 97 .9 Cash Break-even chart Sales Variable cost per unit Fixed costs: Requiring immediate cash payment Not requiring cash payment (Depreciation) Tax: 50% of profit Preference Dividends: Rs.e. i.. Cash break-even charts are used in cash flow analysis and are extremely useful to enterprises running short of required solvency. A cash break-ever chart is shown in the figure. after variable costs. It is a valuable guide in both short-run investment and financing decisions. parallel to X-axis like the conventional break-even chart while fixed costs not requiring immediate cash outlay (type 2) are shown last. credit transactions are involved here. it serves as an extremely useful tool in management control and is known as control breakeven chart. Such analysis should. Variable costs. however.000. 5 Rs.. the portion of variable costs not requiring immediate payment should be treated like type 2 fixed costs.10. Control Break-even Chart When Budgetary Control and Marginal Costing are combined. however.The former (type 1) is shown at the base. we have seen that the cost line and sales line look like straight lines. This is possibly due to a number of assumptions mentioned earlier. reduce the costs. Limitations In the simple chart. 4. in practice. It is simple to compile and understand. Many policy decisions. Facts presented to the management in a graphical way are understood by them more easily than those contained in the Profit and Loss Account. The chart may depict the effect on profits of changes in (a) (b) (c) (d) selling price. etc. variable cost. Therefore. Cost Schedules. But. The strength of the business and the profit-earning capacity can be ascertained from the break-even chart by studying margin of safety and angle of incidence together. volume and profits. and/or volume of sales so that management may take many important decisions. The effect of alternative product mixes on profits can also be shown in break-even charts. A break-even chart is a useful tool to guide management in studying the relationships of cost. such as (a) (b) (c) (d) increase the activity level.Figure 5. Operating Statements. a break-even chart is unlikely to be a series of straight lines. 3. If that is so. This will help in selecting the most profitable product-mix. 2.10 Control Break-even chart ADVANTAGES AND LIMITATIONS OF A BREAK-EVEN CHART Advantages 1. a break-even chart can be used only if the following limitations are kept in mind. there might be several break-even points at different levels of activity. 98 . increase the selling price. and substitute the existing products by more profitable products. etc. fixed costs. may be taken on the basis of margin of safety and angle of incidence in the break-even chart. a typical breakeven chart (i.11 Break-even Chart When fact rather than theory is considered. Break-even analysis related to the total costs and sales of a company which manufactures a variety of products will not be explanatory of the position in regard to any one product.. where unit variable cost and selling price do not remain constant and fixed cost rises in steps) may show a number of break-even points. such as: • • • • changes in fixed costs. chart may not be safe and reliable.1. it may take the form of Figure 5. a break-even chart is unlikely to be a series of straight lines. This optimum level is that point where the gap between the sales line and the total cost line is maximum. for the purpose of policy decisions. efficiency in production. Thus. But there will be only one optimum production level where profits will be higher than at any other level. fixed costs and unit variable costs will remain constant at different levels of activity. demand factor. changes in selling price. changes in variable costs.e. A break-even chart does not generally take into consideration capital employed which is one of the vital factors in many policy decisions. policy decisions. additional calculation showing the interaction of the following ratios: IMPACT ON PROFITS DUE TO CHANGES IN VARIOUS FACTORS Marginal costing or CVP analysis is used for studying the results of various changes in factors other than volume. At this point. it is possible to include. and changes in sales mixture. 2. But even in break-even analysis..11. It would look like the above chart and it would not be surprising to see even several break-even points at different levels of output and sales. 99 . For instance. The break-even chart shows a static picture and hence may become out-of-date if the assumptions or conditions prevailing change after it is being made. policy decisions dependent wholly on break-even Figure 5. unit variable cost and total fixed costs. But competition. Therefore. a break-even chart is quite unlikely to look like a straightline graph. But a profit graph can overcome this objection. may bring about changes in selling price. marginal costs equal marginal revenue. it is assumed that selling price. The effect of various productmixes on profits cannot be studied from a single break-even chart. etc. In actual practice. therefore. 3. 10% decrease in selling price has a greater effect on BEP. 2. M/S and P/V ratio.4 ) 5 0 0 0 P/V Ratio = 15 .60 x 100 = 78%. it will increase the M/S and vice versa. M/S and P/V ratio. will change the BEP.180000 – 102857 = Rs.88000 = 16 16 = 5500 units.90000 or 45% P/V Ratio = 16 x 100 = 80 % 20 Change in Variable Cost A change in variable cost without any corresponding change in selling price and fixed costs will change the BEP. Change in Fixed Costs A change in fixed costs will change the break-even point by an equal percentage provided variable costs and selling price remain constant. Margin of Safety.13 Variable costs increase by 10% BEP = R .102564. Illustration 5. or Rs. without a corresponding change in variable costs and fixed costs.200000 – 102564 = Rs.97436 or 49%. i.14 M/S = Rs.80000 x18 =Rs ..77143 or 43%.80000 +10 % Rs .The effect on profits due to above changes can be shown in a simplified way in a break-even chart. However. even if budgeted sales volume is met. 20 .7% P/V Ratio = 18 Thus. M/S and P/V Ratio than 10% increase in variable cost.14 10% decrease in selling price. a change in selling price. the actual profit will be lower than that budgeted if the proportion of low-margin products sold exceeds that anticipated.e.6 (i. Illustration 5.e. M/S = Rs. Change in Sales Mixture Where sales revenue is a composite figure consisting of sales of several types of products having different individual P/V ratios. Once break-even point is changed. 3. we shall study the effect of above changes on: 1. the overall P/V ratio will change with changes in the sales mixture. Break-even Point = Rs . BEP = Rs . 14 x 100 = 77 . In such a case. Break-even Point. 1 . if BEP comes down.8 0 0 s 00 x 20 = Rs. and Profit Volume Ratio.200000 – 110000 = Rs. 2 −4. But a change in fixed costs will have nothing to do with the P/V Ratio.00 Change in Selling Price Similarly. Illustration 5. change in sales mixture will also change the BEP and hence the M/S.12 (Data same as in Illustration above) Fixed costs increase by 10%.102857 Rs . it will also affect the margin of safety but the effect will be reverse as compared to break-even point.. Thus. 100 .110000 Margin of Safety = Rs. Illustration 5.15 Assuming the budgeted sales of Rs. 6,000 represent sales of four products—A, B, C and D— which are expected to be sold in the mixture below, profit of Rs. 630, a break-even point of Rs. 4,200, a margin of safety of Rs. 1,800 (or 30%) and a P/V ratio of 35% will result as follows; A Rs. 2,000 1,200 800 B Rs. 2,500 1,700 800 C Rs. 1,000 800 200 D Rs. 500 200 300 Total Rs. 6,000 3,900 2,100 1,470 630 35 100 Sales Marginal Cost Contribution Fixed Costs Profit P/V Ratio {%) % of total sales 40 33 32 20 60 If, however, sales should shift towards a larger proportion of the products carrying lower P/V ratios, the result would be as follows: A 25% Rs. 1,500 900 600 B 36 1% 3 Rs. 2,200 1,496 704 C 33-% 3 Rs. 2,000 1,600 400 D 5% Rs. 300 120 180 Total 100% Rs. 6,000 4,116 1,884 1,470 414 31.4 % of sales changed to Sales Marginal Cost Contribution Fixed Costs Profit P/V Ratio (%) 40 32 20 60 Budgeted Contribution P/V Ratio Rs. 2,100 35.0% Actual 1,884 31.4% Variance (unfav.) 216 3.6% Two other important areas of cost-volume-profit analysis are to find out: (i) volume necessary to achieve a desired profit, and (ii) effects of multiple changes upon sales. These are discussed in brief. Required Sales Volume to Achieve a Desired Profit Very often, management may fix up sales target for a period based on a desired amount of profit. In such a case, the desired sales volume would be determined as follows: Fixed costs + Desired profit (before tax) Unit contribution 101 Illustration 5.16 Unit selling price Marginal costs per unit Total fixed cost p.a. Capacity 8,000 units p.a. What would be volume of sales for a desired profit (before tax) of Rs. 6,000 p.a.? Required sales = R .1 0 0 +R .6 0 s 00 s 00 R .4 p r u it s e n =4 0 u its p.a. 00 n Rs. Rs. 10 6 Rs. 10,000 When desired profit is taken after tax, the above formula has to be modified as follows: Fixed costs + Desired profit after tax 1 − tax rate Unit contributi on Illustration 5.17 thus: Assuming 40% tax rate in Illustration 14.18, the required sales volume would be computed It may be mentioned that to find out sales value needed to achieve a profit (before or after tax), the above formulae should be adjusted to divide by the P/V ratio instead of unit contribution. Effects of Multiple Changes The management of a firm may sometimes be confronted with multiple changes in its environment. It may be by way of reduction in unit selling price to take advantage of increased sales volume, some changes in production methods which may again reduce unit variable cost but increase fixed cost substantially, and so on. Even in such cases, the required sales to earn a desired amount of after-tax profit may be computed by bringing all these changes together simultaneously by the formula: Fixed cos ts + Required sales volume (in value) = Desired profit after tax 1 − tax rate Variable cos t per unit I− Selling Pr ice per unit But when desired profit is given as a percentage of total sales which are required to be determined, we have to form an equation based on the basic principles of marginal costing and solve it to arrive at the results. Illustration 5.18 Unit selling price Unit variable cost Fixed cost p. a. Corporate tax rate Required; (a) (b) What will be sales to earn a 15% return on sales before tax? What will be sales to earn a 15% return on sales after tax? Rs. 20 Rs. 33.750 40% (a) Sales = Variable expenses + Fixed expenses + Target profit Let desired sales = X 102 Statement of Profit Sales Less: Variable Costs (40%) Contribution Less: Fixed cost Profit before tax Less: Tax (40%) Profit after tax (15% of sales) USE OF PROBABILITIES Rs. 96,429 38,572 57,857 33,750 24,107 9,643 14,464 Under conditions of risk and uncertainty, probabilities may be used to estimate the likelihood that a 'critical' outcome might or might not happen. One of the obvious examples of this is to estimate the probability that an organization will at least break-even with its sales. ADVANTAGES AND DISADVANTAGES OF MARGINAL COSTING The possible advantages of marginal costing, as compared to that of absorption costing, are stated below. 1. Greater control over costs is possible. This is so because fixed costs are excluded from product costs and management can concentrate on marginal cost which is a constant ratio. 2. It is an aid to management in taking many valuable decisions. Under marginal costing, data are presented in a manner revealing marginal costs and contribution that it facilitates making policy decisions in many problems, such as: (i) introduction of a product; (ii) quoting selling prices and tendering for contracts in times of competition; (iii) whether to make or buy; (iv) reduction of prices in times of competition or depression; (v) selecting the most profitable product or sales-mix; (vi) alternative methods to be employed in manufacturing; (vii) limiting factors; (viii) utilization of spare capacity; (ix) profit planning—break-even charts, profit-volume graphs may be used in profit planning; (x) assessment of capital projects to be undertaken; and (xi) selection of the most profitable level of activity, etc. 3. For all practical purposes, marginal costs will be the product costs and hence there will be no vitiation of costs due to change in level of performance as marginal costs will tend to be a constant ratio. Under absorption costing, unit cost will vary depending upon the level of activity and this may lead to confusion. 4. Closing stocks of finished goods and work-in-progress are valued at marginal costs. Apart from simplicity in the valuation of stocks, this will lead to greater accuracy in arriving at profits. 5. The marginal cost statements are understood by management more easily than those produced under absorption costing. For instance, the foremen will be more interested in those costs which are variable and which can be controlled by their actions. It is, therefore, very simple to understand and can be combined with Standard Costing. 103 6. Since fixed costs are excluded, it eliminates the strenuous task of allocating, apportioning and absorbing overheads. As a result, there will be no under- or over-recovery of fixed overheads. The oft-mentioned disadvantages are: 1. It is difficult to analyze overheads into fixed and variable elements because many expenses considered to be variable or fixed may not be exactly the same at various levels of activity. Moreover, in marginal costing, there is no place of semi-variable or semi-fixed overheads which are to be segregated into fixed and variable elements. The segregation of semi-variable costs is also a difficult task. 2. There is the danger of taking policy decisions on the basis of information presented under marginal costing technique. For example, in the long run, selling price should not be fixed simply by looking at contribution as it may result in losses or low profits. The other important factors such as fixed costs, capital employed, etc., should also be taken into consideration in fixing selling prices. 3. There is also the danger of valuing finished stocks, work-in-progress, transfer from one process to another, etc. at marginal costs only. The arguments against valuing stocks at marginal costs may be summarized as follows: (a) In case of loss by fire, full loss cannot be recovered from the insurance company. (b) Profits will be lower than that shown under absorption costing and hence may be objected to by the tax authorities. (c) For Balance Sheet purpose, closing stocks are to be valued at lower of market price and cost. Marginal costs may not be acceptable to the auditor as true costs for this purpose. (d) Circulating assets will be understated in the Balance Sheet and thus the Balance Sheet will not exhibit a 'true and fair view' of the state of affairs. 4. Cost control can also be achieved with the help of other techniques such as Standard Costing and Budgetary Control. In Standard Costing, volume variance will show the effect of change in output on fixed costs and hence there will be no vitiation of costs. Problems and Solutions Problem 1 (Marginal vs Absorption Costing) The following data have been extracted from the budgets and standard costs of Hewitson Ltd, a company which manufactures and sells a single product. £ per unit 45.00 10.00 4.00 2.50 Selling price Direct materials cost Direct wages cost Variable overheads cost Fixed production overhead costs are budgeted at £ 400,000 per annum. Normal production levels are thought to be 320,000 units per annum. Budgeted selling and distribution costs are as follows: Variables Fixed £ 1.50 per unit sold £ 80,000 per annum Budgeted administration costs are £ 120,000 per annum. 104 using absorption costing principles. using (i) marginal costing.650 1. 2005 £'000 £'000 2.050 177.5 2.452.815 330 1. 2005 £'000 4.597.5 355 1.485 1. (c) write up the fixed production overhead control account for the quarter to 31 March.5 = 16.000 (a) prepare profit statements for each of the two quarters.5 Sales (@ £ 45) Less: Cost of sales Opening stock Production costs [@ £ 17-75 (Wl)] Less: Closing stock (@ 17.620 2.000 Production (units) 70. 2005.5) 990 Variable selling and distribution costs Contribution _ 2005 £'000 2.050 1155 165 1.775 1.000 100. and (ii) absorption costing.5 1.5 177. 2005.430 150 2280 90 MA Less: Fixed costs X (400 +80+120) \12 ) Profit (ii) Absorption Costing Profit Statement q/e 31 March.400 and the actual production was 74.000 units. You are required to: April— June 90.700 — 1. £'000 Sales (@ £ 45) Less: Variable cost of sales Opening stock Production costs (@ 10 + 4 + 2.000 There is to be no stock on 1 January. in a columnar format.065 1. Solution (a) (i) Marginal Costing Profit Statement q/e 31 March.75) Gross Profit Less: Under-recovery of . Assume that the fixed production overhead costs incurred amounted to £ 102. (b) reconcile the profits for the quarter January-March 2005 in your answer to (a) above.952.620 150 1470 135 1. 2005 £'000 4.700 q/e 30 £'000 165 June.080 1.5 1.635 105 q/e 30 £'000 June.242.5) Less: Closing stock (@ 16.The following pattern of sales and production is expected during the first six months of 2005: January—March Sales (units) 60. 75 (W2) Normal quarterly production level = .5 30140 1.470 12.5 1.4 Problem 2 £'000 Fixed overheads to work-in-progress (74.5 (Overall Break-even Point and Productwise break-up) Raj Ltd manufactures three products—X. 14.4 102.000 units x £ 1. The corresponding unit variable costs are Rs.00 4. 50.482. Y and Z.000 units .5 90 20 135 20 — 25 2.000 [320.000 units £ 10. 75 respectively.9 102. 100. The proportions (quantitywise) in which these products are manufactured and sold are 20%. The total fixed costs are Rs.000 x 1.000 (b) Reconciliation of Profits Reported for the Quarter Ended 31 March.000 units 4 Actual first quarter production = 70.25 = £ 25.000 = 80.000 units Over-recovered fixed production overheads = 20.-.5 Total absorption cost per unit = Direct materials + Direct wages + Variable overheads + Fixed overheads (£400.5 — 1.x 320.4 £'000 1. 106 . Rs.50 1.25) Variance to Profit and Loss A/c 92.25 17.292. Rs.10.482.500 (W3) Actual second quarter production = 100. 80 and Rs.25/unit Profit as per absorption costing (c) Fixed Production Overhead Control Account Actual overheads incurred £'000 102. 30.000 x £ 1. Under-recovered fixed production . The unit selling prices of these products are Rs. 160 and Rs. deferred in absorption costing) 10.000 x £ 1.00 2.477.622. 2005 Profit as per marginal costing Add: Fixed production overheads c/f in closing stock (written-off in marginal costing.25 overheads = £ 12. 30% and 50% respectively.5 9.000.overheads (W2) Add: Over-recovery of overheads (W3) Less: Selling and distribution cost Variable Fixed |ix80| U Administration costs P-X120) U Profit for the quarter Workings: (Wl) 12.80.5 30 185 2. fixed cost.80.195 X 0. 14.Calculate overall break-even quantity and the productwise break-up of such quantity. 75 30 45 22. 100 50 50 10 Q (Rs.30Q and Z = 0. 107 . Solution Let Q be the overall break-even point of Raj Ltd.202) Y Rs.195 x 0.00 2. Q = 26195units (overall break-even point) Productwise break-up of break-even quantity: Product X : 26.20 = 5.30 = 7. 40.50 = 13.50 = Rs. 14. Rs. we can find productwise break-up of overall break-even quantity as follows: X Rs.300 Z Rs. 50 x 0. 5. Y = 0. break-even point and margin of safety of changes in each of the following: (i) 10% increase in selling price. Ltd for a calendar year: Present production and sales: Selling price per unit Variable cost per unit: Direct materials Direct labour Variable overheads Fixed cost (total) Rs. 80 x 0. BEP and M/S) The following details are obtained from XYZ Co.239 units Y : 26. From productwise unit contribution and total contribution at break-even point (= fixed cost).50Q.500 Unit selling price Less: Unit variable cost Unit contribution Contribution at break-even point At BEP : Contribution = Fixed Cost Hence.200.00 100% of direct labour cost Rs.50 Rs.000 (a) Calculate P/V ratio.5Q (Rs.097 units Problem 3 (P/V Ratio. (ii) 10% increase in variable cost.80.000 Rs.000 or. Then the productwise break-up of overall break-even point in units would be: X = 0. 100 + 24Q + 22.859 units Z : 26.195 x 0. (iii) 10% decrease in. (b) Find the effect on P/V ratio.000 units 20. 8. and (iv) 10% decrease in sales volume. break-even point and margin of safety from the above data. 45 x 0. 160 80 80 24Q (Rs. 02.615 million Activity in 2005 was 20% greater than in 2004 and there was general cost inflation of 5%. the data must be adjusted onto a comparable inflation basis.725 million.000 Rs.000 Margin of Safety Rs.333 Rs. 40.914 million.89) m = £ 4.000 or 71. 36.60.44% or 55% Problem 4 (Target Sales with a given C/S Ratio) Total Surveys Limited conducts market research surveys for a variety of clients. i. Extracts from its records are as follows: Total costs 2004 £ 6 million 2005 £ 6.3 million Change in total (adjusted) cost from 2004 to 2005 = £(6.667 or 58. Fixed cost for 2005 = Total cost .000 = Rs. Activity in 2006 is expected to be 25% greater than in 2005 and general cost inflation is expected to be 4%.615 .04 = £ 2.457 million.Solution Particulars (a) (0 P/V Ratio 10 1 (Contribution Sales) 20 2 Break-even or 50% Rs.3)m = £ 315.000 or 50% 6 Rs.000 No effect BEP on Sales (Fixed Cost P/V Ratio) Rs. Thus.80. 108 .e.000 (Total Sales . Thus. 1. 80. the 2004 cost will initially be inflated by 5% to convert it to '2005 £s': £6 million x 1.200 x 20) .2 = £ 1.888 Rs. Thus.000 73. (7. BE Sales) 80.25 x 1. taking account of further 4% inflation. 1.2 = £ 1. the variable cost for 2006. 1.88.000 = Rs.615 . .89 m x 1. the variable cost for 100% activity (2004 level) = £ 315.000 This is attributable to a 20% increase in activity. giving a variable cost for 2005 = £ 1.33% Rs.80. 72.Variable cost = £(6. the fixed cost for 2006. 40. would be: = £ 4.725 m x 1.04 = £ 4.05 = £ 6.000 x = Rs. Requirements: (a) Derive the expected variable and fixed costs for 2006. 40.44% 44. (b) Calculate the target sales required for 2006 if Total Surveys Limited wishes to achieve a contribution to sales ratio of 80%.£ 1.000 Rs.575 million (in 2005 £s).000 X Rs. 64. 73. taking account of a further 25% increase in activity and 4% inflation.55% Rs.888 = Rs. 1.60.112 or 88.. 1.333 = Rs.000 = Rs.000 44.be: = 1.76.000 12 6 22 == (b) (ii) 11 — or 45% 20 (iii) (iv) on No effect on No effect P/V ratio P/V ratio or 54.000 20 _ Rs. Solution (a) Before using the 'high and low' method on the data given to estimate the variable element due to change in activity level. .6.575 m x 1. would.89 million.000/0.60. 88.72. 32.000 (a) Second year First year Change Assuming that the change in fixed cost is nil.000 10. 14. 22.000 C=F+P or.000 F = 40% of Rs.14.000 Alternatively.V = 0 + 4.10. 19. 36.000 . BEP and Target Profit and Sales) The following data are obtained from the records of a company: First year Rs. the marginal cost equation can be used as follows: S-V =F + P 10.000 = Rs.000 10.Problem 5 (P/V Ratio.000 .000 .000 10. (b) break-even point. = Rs. 90. 50.000 .000 .000. 22.000 14. (c) (d) profit or loss when sales amount to Rs.000.000 = Rs. and sales required to earn a profit of Rs.000 Second year Rs.000 109 . 80. F=C-P F = 40% of Rs.000 4.14.000 Sales Profit Calculate: (a) P/V ratio. Thus. 90.000 V = 6. 80.000 = Rs.10. 90. Solution Sales Rs.000 Profit Rs.000 80. 000 = Rs. P = (-) Rs. cost break-even points between each pair of plant are as follows: Plants A and B: Rs. 6.000 = Rs.102500 P / V ratio 40 % Problem 6 (BEP of Pair of Plants) Find the cost break-even points between each pair of plants whose cost functions are: Plant A = Rs.00.000.00.00. 20.00.000 units Plant A is better for the output below 1.000 + 19. (d) To earn a profit of Rs.00.25.8X= 15. Plants B and C: Rs. When sales are Rs. I0X 12X . Plants A and C: Rs.000 units Plant B is better for the output below 3.(c) Sales Rs. 8X X = 3.000 + Rs. 2.50.00. 9.000 ∴ Re quired sales = [ v C = F + P] Re quired contributi on Rs .000 + Rs. 8X 12X . 12X= Rs. 10X= Rs. 50.000 + Rs. 50. 15.00.000 units 110 .000 + Rs.10*= 9. 12X Plant B = Rs.000 = 22.000 X= 1.000 units since its fixed cost is lower than that of Plant B. 22.000.000 P/V ratio 40% Contribution = 40% of 50.00.000 + Rs.000 + P or.00.00. 6.000 . required contribution: Rs.000 We know: C =F + P Rs.00.000. 2.000 units.50. 19. loss would be Rs. 12X= Rs. 15. Then. 8X (where X is the number of units produced) Solution It is assumed that the selling price per unit is the same between each pair of plants.6.6. 41.000 + Rs.000 + Rs.000 + Rs. 20.00.00.00.00.000 . I0X Plant C = Rs.41000 = =Rs . 15. 9. 9. 6.000.000 X = 2.000 + Rs. 000 units @ Rs. 13 per unit (W2) Particulars Per unit (Rs. (b) the level of sales at which both are equally profitable. 60.000 16.00.000 30.00 30. Similarly.00.900000 +10 x 300000 300000 = Rs.) Sales 3.00 24. 16.00 15.00 6.000 Rs.000 units Variable cost Contribution Fixed cost Profit Per unit (Rs.00 Amount (Rs.000 units and Plant C is better beyond 2. Reconciliation —Plants A and B: Selling Price Rs.000 Machine F 10.00.00 Nil Rs . 24.000 30.00 Nil Selling Price Rs.000 + Rs.00 9. 24.00 4. lakhs) 24. 16 per unit (Wl) A Particulars Sales 1.000 -f 1. The annual market demand for such product is 10.00 B Amount (Rs.00 6.50. 10 per unit.) 16. (Rs. lakhs) 24. At BEP. calculate (a) the break-even point for each.50.00 Nil Per unit (Rs.000 = Rs.00 18.a.00 15.00 Nil Per unit (Rs.) 16. Machine E and Machine F. 10) Contribution (C = F + P) P/V ratio 60% 111 40% Rs. ∴ Sales for 1.00 15. From the information given below. (Profitability of Alternative Machines) A company has the option of buying one machine.00 9.) 13.00 6. 1. Solution Machine E Sales (10.000 24.a. and (c) the range of sales at which one is more profitable than the other: Machine E Output p. 12 x 1.Plant A is better for the output below 2./lakhs) 39. 1.000 Both the machines will produce identical products. Selling Price per unit = Rs./lakhs) 39.13.00 10.00.00.000 units Variable cost Contribution Fixed cost Profit Workings: 1.000 units.00 5.25.00 9.50. 40.) Profit at full capacity (Rs.000 Rs.00 12. 2. 6.000.000 units = Rs. Selling Price per unit = Problem 7 13.00 9.000 @ Rs. Two machines are available.000 .00 C Amount (Rs.00 10.00 3. Total costs = Total sales.000 Machine F Rs.00 B Amount (Rs.00.50. (units) Fixed costs p.00 8.000 = Rs.25.) 10. 19 The following data are available in respect of Product X produced by ABC Co. it would be: 6X + 16. Thus. or.000 units. At 7. Therefore. to capture a new market.000 Since at this level of output. to be taken as to the profitability of the new product. Ltd. The P/V ratio of Machine E is greater than that of F. instead. above 7. both machines will be equally profitable at that level of activity where total cost (fixed plus variable) of production produced by each machine exactly equals. units 40. 6 4 Rs.(a) Break-even sales Rs.000 4. Rs.'. Fixed costs are not taken into consideration on the assumption that these costs will not change or. manpower.999.000 While in case of Machine F. therefore.000 units while it is 5.000 to 6. Thus.000 Rs.000 Contribution per unit Variable cost per unit Rs. How the various concepts may be applied to serve the day-to-day needs of management in taking many strategic decisions will be illustrated in this section.000 units. Illustration 5. if the cost data are presented under total cost method. at 7. 112 . But for taking decision in this matter. . it may appear that the new product is not at all profitable. In case of Machine E. Thus. units 50. Diversification of Products Sometimes. SECTION II Marginal Costing and Management Decisions APPLICATION OF MARGINAL COSTING The concepts of marginal costing have been discussed in the previous section. the rate of profit-earning by E would be greater than that of F. (c) The break-even point of Machine F is 4. A decision has. the old product may appear to be more profitable owing to arbitrary apportionment of fixed costs. in other words. Rs. total costs would be. a product may be proposed to be introduced to the existing product or products to utilize idle facilities. etc.000 units. 4 6 (b) Unit selling price of the products produced by either of the machines being the same.000 units.001 to 10. or. E would be more profitable at an output range of 7.000 X = 7. 4X + 30. the product can be manufactured by the existing resources. The new product may be manufactured if it is capable of contributing something towards fixed costs and profit after meeting its variable costs of sales. both the machines are equally profitable. total cost of production by each machine will be the same. The following are some of such important areas. Let X be the number of units where both the machines are equally profitable.000 units. Machine F is more profitable at an output range of 4. or for any other purpose.000 5.000 = 6X + 16. both the machines will be equally profitable.000 for Machine E. 4X + 30. 000 10.000 16.000 20.000 15.200.800. however.000.000 5.600 Total Rs.200 37. it is clear that with the introduction of Product Z there will be no change in the profitability of Product X and that Product Z is also yielding a contribution of Rs.000 to Rs.000 6.Sales Direct Materials Direct Labour Variable Overheads Fixed Overheads Rs.400 10. There will be no increase in fixed costs and the estimated variable costs of Product Z are: Materials Rs. introduction of a product is associated with 'specific' or 'identifiable fixed costs'.333 50.000 10.600 Thus. 67.000 35.000 1.200 1. Therefore.000 (11) Proposed position Product X Rs.000 1.000 30. Direct materials Direct labour Prime cost Variable overheads Marginal cost Sales Contribution Fixed overheads Profit 20. 1. such costs 113 .000 10.067 10.600 10.000 5.400. the position will be quite different. 10.400 1.200 7.000 8.400 43.000 50.333 43.000 The company now proposes to introduce a new Product Z so that sales may be increased by Rs. 43.667 Product Z Rs. 4.800 2. 4.000 (-)67 Total Rs. Product Z may be introduced assuming that the capacity that will be utilized for Product Z cannot otherwise be more profitably utilized.000 5.333) and that the entire profit is earned by Product X while Product Z will incur a loss of Rs.000 Product Z Rs.800 12.800 2.000 5. 1.000 6.000 10. 2. 50. 24. 45. 4.000 10. 20.400 60.000 5.000 50.667 10.400 10.000 6.400 8. Product X Rs. and Overheads Rs. But if the data are presented under marginal costing technique as follows.000 45. 20. Advise whether Product Z will be profitable or not Under absorption costing method (i) Existing position Direct materials Direct labour Variable overheads Fixed overheads Tolal cost Sales Profit Product X Rs. Labour Rs.200 6.800 12.000 53.400 60. Where.000 10.600 towards fixed costs and profit.000 6. 24.600 Direct materials Direct labour Variable overheads Fixed overheads (apportioned on the basis of sales value) Total cost Sales Profil/(-) Loss The above statement will show that Product X has now become more profitable (its cost having been reduced from Rs. Fixation of Setting Prices It is one of the principal functions of modern business management. it can also be based upon marginal costs if a 'high margin' is added to marginal cost to contribute towards fixed costs and profits.. Under absorption Job No.000 250 11. the amount to be added will vary depending upon demand and supply. 0. 3. selling price should be ordinarily higher than marginal cost.50 per hour Total cost costing Rs. Rs. i.. When the plant should be kept ready for "full production" ahead. 10.000 1.. Direct materials Direct labour — 500 hours @ Rs. or even lower. Of course.000 750 11. which will have bearing on the decision. 3. 1/. marginal costing will be of great help to the price-fixer. even for a short period. such as: 1. 7. and general.750 Under marginal costing Job No Direct materials Direct labour — 500 hours @ Rs. fixed costs will be divided into two groups: specific.e. When a weaker competitor is to be driven out of the market. (a) Pricing in depression Illustration 5. The directors of C Ltd have been approached by a company with an enquiry for a special purpose job. 2 per hour Re. The costing department estimated the following in respect of the job: Direct materials Direct labour Overhead costs: Normal recovery rates: Variable Fixed Rs.000 500 hours @ Rs.50 per hour Re. When the sale of one product will push up the sales of other conjoined profitable products. But pricing at or below marginal costs may be considered desirable for a shorter period in certain special circumstances. i.. 10.. etc.20 C Ltd has been working well below normal capacity due to recession. 2.per hour The directors ask you to advise them on the minimum price to be charged.000 1.250 Here the absolute minimum price is Rs. 4. 4. in accepting additional orders for utilizing spare capacity. When a new product is introduced in market or to popularize it. price under normal circumstances for a long period should be preferably based upon total costs. Thus. 2 Variable Overheads @ Re. When marginal costing technique is used for pricing. total of marginal costs. Therefore. As this will not make any 114 .. 5. if production is discontinued. competition.250. 2 Overheads @ Rs. When it is feared that future markets will go out of hand. and other related factors.. 2. When the goods are of perishable nature. i. 8. The figure for loss will be the same. 6. 11. the amount of loss will be equivalent to total fixed costs. in times of competition and/or trade depression. in such a case. In majority of the cases. Assume that there are no production difficulties regarding the job.should be deducted from contribution of the proposed product for the purpose of taking decisions. When foreign market is to be explored—against foreign exchange earned. the principle that should govern is that price should be equal to marginal costs plus a certain amount.e. which is expected to remain constant and hence has nothing to do with the proposed decision (see Closing down or suspending activities post). under normal circumstances.. and in exporting.. policy of pricing. Product-pricing is necessary: 1. 0. government sometimes allow import quotas from which profits may be made far in excess of loss on export. 10. 1. When employees cannot or should not be retrenched and production is to be maintained.e. However. If the price is equal to marginal costs. nature and variety of products.50 per hour Marginal cost . Selection of Profitable Product-mix Suitable product-mix will denote the ratios in which various products are produced and/or sold. subsidies or any other special favours from government. the effect of direct and indirect benefits8.000 Articles Rs. relative profitability of mixes will have to be assessed on the basis of 'net profit' and not on 'contribution basis'. exploring additional markets.000 (@ Rs. 115 . etc.000 articles can be produced without any rise in fixed costs and that the articles will not be re-exported to home market.000 Administration Overheads (Fixed) 18.000 52. Of course.000 1. Note: It is assumed that the additional 4. 52. the export order is worth trying. Effect on raw materials necessitating an adjustment in the purchase programme.: When additional orders are quoted below normal price. 500 may be added to make the job worthwhile.000 3. Is the foreign market worth trying? Per Article Rs. It may also be assumed that the capacity proposed to be utilized for the purpose cannot be otherwise more profitably utilized. the management should study various effects and problems arising out of a change in the mix. Since the factory is operating above the break-even point.60.04.000 Variable 20.000 Selling and Distribution Overheads: Fixed 10.000 articles for home consumption at the following costs: Rs. a proportion of fixed costs of Rs.000 80. Some of them are: 1.contribution. 40 36 76 20 16 112 125 13 4.000 Total 1.48. So long as fixed costs remain constant.000 Wages 36.000 32. The foreign market for this product can however consume additional 4. 125.000 64.000 4. 155 per article: it can consume no more articles. But when changes in product-mix are associated with changes in fixed costs.000 Factory Overheads Fixed 12. Illustration: A factory produces 1.000 Variable 16.00.000 additional articles cannot be otherwise more profitably utilized. (b) Accepting additional orders. So far as foreign markets are concerned.000 units).000 articles at a selling price of Rs. 1.44. 13 for 4. exporting. In the absence of any limiting factor.52. Rs. Materials 40. it should be ensured that they will not affect the normal market or the goodwill of the company or the relationship with its customers.000 articles if the price is reduced to Rs. such as prestige of exporting. The amount to be added will depend upon the circumstances of the case. Hence. the most profitable salesmix is deterrninable on the basis of contribution only. import entitlements. an increase in contribution will lead to similar increase in profit. should not be lost sight of in fixing the price. contribution under each mix will be considered and the mix that will give the highest contribution will be the most profitable one.000 Materials Wages Prime cost Variable Overheads: Factory Selling and Distribution Marginal cost of sales Sales Contribution The foreign market will yield an additional contribution of Rs.000 The home market can consume only 1. It is also assumed that the capacity which is utilized for producing 4.000 5. The technique of marginal costing may be applied in the determination of most profitable product or sales-mix.000 26. Units 400 400 150 150 (b) Contribution Rs. and (ii) the total contributions resulting from each of following sales mixtures. 4. Illustration 5. From the following information. 150 units of Product A and 150 of Product B. This is evident from the following statement: Products Contribution per unit Rs. 800 200 1. 4 Sales Mixtures Units 100 200 (a)Contributi on Rs. storage. 10 3 Product B Rs. Product A Rs. In short.2. the effect on all physical and financial programmes due to change in product-mix should be considered. Product A is more profitable and therefore the mixture that takes into account the maximum number of Product A would be the most profitable one. it should be adopted. Therefore. Recommend which of the sales-mixtures should be adopted. Expected change in the labour composition or labour training programme. etc. Change in the machine load.21 The directors of a company are considering sales budget for the next budget period. 800 (Variable expenses are allotted to products as 100% of direct wages) Selling price Sales mixture (a) (b) 100 units of Product A and 200 of Product B. 9 2 2 13 15 (iii) (iv) Since the P/V ratio of Product A is higher than that of B.. 5. For principles 116 . 10 3 3 16 20 Product B Rs. you are required to show clearly to management: (i) the marginal product cost and the contribution per unit. 600 300 Units 200 100 (c) Contribution Rs. 9 2 Direct materials Direct wages Fixed expenses (total) Rs. 20 15 (c) 200 units of Product A and 100 of Product B. and Change in the sales programming. The problem of product or sales-mix is generally linked up with the problem of limiting factor.000 A B 300 800 300 900 300 Total 2 Sales Mix (c) will yield highest contribution. Product A (0 Direct materials Direct wages Variable expenses Marginal cost Selling price Rs. 3. Requirements of additional space for production. should be strictly according to relative profitability of products based on contribution in relation to the limiting factor. for the purpose of such sales-mix.50 Rs. In short. availability of which is 10. 23 Rs.) Direct wages cost (Rs. the higher the contribution per unit of limiting factor. pp.55 Rs. 69 0. This is applicable when there is one limiting factor. a statement of profitability under different 117 .575 Rs.) Direct expenses (Rs.) Variable (Rs. the more profitable is the product or product line and vice versa. plant capacity or sales demand. labour.22 (a) The following particulars are extracted from the records of a company. It may represent shortage of materials. the more profitable is the product. 5.000 kg. Comment on profitability of each product (both use the same raw material) when— (i) Total Sales potential in units is limited. 10 15 5 30 15 45 100 Rs. find out the product mix which will yield the maximum profit. product selection will be on the basis of P/V ratio. (a) Per unit Product A Rs. 34.) Product A 100 2 10 15 5 3 5 15 Product B 120 3 15 10 6 2 10 20 Direct wages per hour is Rs. Illustration 5.33 Product B Rs. and maximum sales potential of each product being 3. But when resources are scarce. one having the highest P/V ratio will be selected. Accordingly. (ii) Total Sales potential in value is limited. 659-660). selection of profitable product will be on the basis of contribution per unit of limiting factor.) Consumption of material (kg) Material cost (Rs. when there is no limiting factor. Problems of Limiting Factor Limiting factor is a factor that limits production and/or sales.) Machine hours used Overhead expenses: Fixed (Rs. In such a case. profitability of each product will be determined on the basis of the principle: the higher the contribution per unit of limiting factor. i. (For an illustrative list of limiting factors. a decision has to be taken on whether to make one product or another instead. 27. Ordinarily. (b) Assuming Raw Material as the Key factor. 18.e. (iii) Raw Material is in short supply. (iv) Production capacity (in terms of machine hours) is the limiting factor. When an optimum safes-mix has to be determined in the context of limiting factor.underlying the selection of sales-mix of this nature. 55 0.50 Direct materials Direct wages Direct expenses Prime cost Variable overhead Marginal cost Sales Contribution P/V ratio Contribution per kg of materials Contribution per machine hoar Thus. see Principal Budget Factor. the product preference. This is also known as the key factor. 15 10 6 31 20 51 120 Rs. Per unit Sales (Rs. refer to the discussion under next heading.500 units.. What will be the maximum profit? Market Product demand (units) A B C D E 4.500 1. The selling commission is 10 per cent of the product price. 0.conditions may be prepared thus: Limiting factor (i) Sales volume (ii) Sales value (iii) Raw material (iv) Production (machine hours) Ranking of products BA BA AB BA Ranking based on Unit contribution P/V ratio Contribution per kg Contribution per machine hour capacity (c) Product preference will be in the same order as (a) (iii) subject to the condition that maximum demand for each of the two products is 3. 118 . 2 per hour for all products.4 required per unit (in gm) 700 500 1.00 9.50 per kg. you are required to suggest a suitable sales-mix which will maximize the company's profits. overtime working up to a maximum of 3.000) -s.000 3.500 hours is possible. Overtime will add Rs. The labour rate is Rs. With the following data as basis. But the number of units of a product to be selected in the mix will be restricted to the number as per demand for that product.600 4.40 fixed and Re.000 5.000 Selling price (Rs. the optimum product-mix would be: (d) Product Units Raw Materials per unit (kg) 2 3 Total Raw Materials required (kg) 7.00 7.1 1. Present equipment can produce all the products.3 = 1. Thus. the plant has an effective capacity of 21.000 10. The balance of available raw materials will then have to be utilized for the production of less profitable product.000 3.23 (a) A chemical company manufactures five different products from a single raw material.5 1.) 8. In other words. The factory overhead rate also is Rs.000 labour hours.000 units] In addition to one limiting factor from the production side. There is an abundant supply of raw material at a rate of Rs. limitation may also come from the market in the form of demand.8 1.000 to fixed overheads. Illustration 5.000 A B 3.500 units of more profitable product will be produced first.000 .0 0. 1.500 1. Do you recommend overtime working? (a) For suggesting an optimum sales-mix. 5. product profitability is to be determined first on the basis of contribution per hour which is the limiting factor.500 units. For a certain budget period. 1.00 11. This is done in the following statement.000* 1(10.60 variable).7.500 (b) Suppose. 2 per hour (Rs.50 12.300 1. in the above situation (a). ranking will be based on relative contribution per unit of limiting factor and product selection will be done in that order.00 Labour hours Raw material required per unit 1. 3. Here. a doubling of labour rates and a 50% increase in variable overheads.500 6. 880 A 4. for E the target should be 550 units. accordingly. Rs.55 4.500 Rs.525 1.200 20.) 14. 4.4) of E.00 0.H.75 2.86 Rank 2 1 3 4 5 Thus. Therefore.783 ('Market demand 5.500 •*• 1.112 14.500 additional hours can produce 2.400 Rs. If the number of resources in limited supply increases to more than just one in a particular decision situation.01 Total Contribution (Rs.29 4. Rs.05 2. 1. under condition of limited plant capacity (labour hours). Hours available 770. the proposal should be rejected. 27.40) Rs. on Rs.20 1. 3.00 11.00 Contribution per unit Rs. 3.99 Selling price Rs.90 3.01 Contribution per hour Rs.80 0.750 D 6.975 5.10 2. demand. the product preference according to profitability analysis would be the same subject to the number of units equivalent to market demand.20 0.000 units.00 7.25 2. has to be given due consideration.) 3.21 x 2.000 Rs.92 3.55 4.65 3.65 3.10 Marginal Cost of sales Rs. the ranking given by contribution per unit of one limiting factor may conflict with that given by the contribution per unit of another limiting factor and consequently the decision rule slated earlier in this context becomes ambiguous.40) Product Total Profit Market Demand (units) 3. 8. Rs.500 6. 3.025 Rs. 2 x 1. which can produce 770 •*• 1.500 units @ Rs.75 1.40 .71 6.84 1.e. Additional contribution Less: Increase in fixed cost Loss Hence.92 4. In such a case. the measurement of the effect on alternatives must cope with the complexities introduced by the interactions between scarcities. 41.183 29.60 0.80 0. Commissi O.00 9.600 4. 11) Less: Marginal cost of sales: Cost per unit as per (a) Rs. 3.600 20.25 3.99 Add: Increase in labour rate (Rs.) (b) 3. 6. would be: Labour Hours reqd.206 71.500 units (i.48 0.000 Contribution per unit (Rs.90 1.80 0. product preference would be in the following order: In determining the sales-mix based on above preference. 2.30 x 1..000 C 6. B 2.Product A B C D E Direct Direct Variable Selling Material Labour Fy.45 3.66 0.230 E 550* 770 21.00 0.55 3.500 25. The optimum sales-mix.35 5.000 4..29 4. 0. another limiting factor. In other words. i. and the amount of profit thereof. The complexity increases with the increase in the number of limited resources.e.50 12.925 19.42 10. Mathematical techniques like Linear Programming are to be applied for handling such 119 . The financial effect of the proposal is shown below: Sales (2.58 7.95 2.4) Increase in Overheads (Re. 1.000 @ Rs.60 0.550 units only.740 2.000 Less: Factory Fixed Overheads (21.90 2.90 2. In taking such 'make or buy' decisions. one may ascertain the minimum volume which would justify 'making' as compared to 'buying'. Insourcing or Outsourcing A company may have unused capacity which may be utilized for making component parts or similar items instead of buying them from market.000 hours per annum. the method of manufacture that will give the largest contribution is to be selected. If manufacture involves increase in fixed costs (avoidable). Under such a situation. however. etc. number of operators to work with a machine. Fixed costs are excluded on the assumption that they having been already incurred. 5. it is necessary to include them in product cost. time taken in production is stated. Output per hour Per unit Direct materials Direct labour Variable overheads Marginal costs Selling price Contribution Contribution per hour Annual Contribution Machine X 3. which is called insourcing. if any. both the alternatives are equally profitable. This volume is determined as follows: 120 . determine the profitable method of manufacture: Per unit of Product A Machine X Machine Y Rs. whether one machine is to be employed instead of another.000 10 units Rs. 260 7.a. the basis of selection will be the relative contribution available from each method. 20 13 14 "47 60 73 Rs. however. it will be more profitable to manufacture the component parts in the factory. Make or Buy. When fixed costs remain constant. Taking into account the following comparative costs and selling price.000 14 3 50 60 Direct materials Direct labour Overheads: Variable Fixed Total costs Selling Price Hence. Total machine hours available are 3. the manufacture involves only variable costs. should not be lost sight of.80. In the process of selection. weight should be given to time factor. In short. 20 10 12 42 60 Ts Rs. production in Machine Y will be more profitable. Machine X can produce 10 units of A per hour and Y.problems. If (he variable or marginal costs are lower than purchase price. At this volume.000 20 units Rs. Where.24: Product A can be produced either by Machine X or by Machine Y.000 Machine Y 3. i.e. Outsourcing is the process of purchasing goods and services from outside vendors/producers rather than producing the same goods or providing the same services within the organization. machine work or hand work.40. 20 20 10 13 12 3 -45 60 Profitability Statement Machine hours p. limiting factor. fixed costs change. Rs. Fixed costs are not relevant9 here. Illustration 5. Where.. Alternative Methods of Manufacture Marginal costing techniques are often used in comparing the alternative methods of manufacture. the marginal cost of manufacturing the component part(s) should be compared with price quoted by outside vendors. the decision will be taken on the basis of relative amount of profit. 20 units per hour. 180 Rs. Decisions about whether a firm will make or buy are also known as insourcing versus outsourcing decisions. and dependability of suppliers are very important factors that need to be considered. making will be more profitable. When the manufacturing resources of the firm are limited and it becomes necessary to buy out some products if market demands are to be met. from 1 to 5. Where there is only one resource in limited supply. 16 6 22 3 25 3 28 The company should make component part No. 6 direct labour.000 units that can be acquired for Rs. Rs 3 x 10. 30. buying will be more profitable until additional fixed cost is recovered.e. the qualitative factors should also be taken into consideration. Total manufacturing costs of Rs. A104. 3 fixed overheads (avoidable) and Rs. 30 per unit. A-104 for its final product. the products to be manufactured must be selected on the basis of opportunity costs. But once the increase in fixed cost is recovered. i.001 to 10. 32 per unit include Rs.000. During any one year. Therefore. inclusion of avoidable fixed cost will change the profitability. as if. Direct Material Direct labour Prime cost Variable overheads Marginal cost Fixed overheads (avoidable) Total relevant cost Rs. Rs. quality. (ii) (a) Bought-out price per unit (b) Marginal cost per unit Savings per unit (a .b) Rs. 30 25 5 On comparison of bought-out price and marginal cost of manufacture. making will be more profitable.000. more profitable than buying and in that case there will be a saving of Rs. in a 'make or buy1 decision. it appears that making is.. A-104 (b) Cost to make per unit of component part No. In other words. the selection should be based upon the contribution made by each product per unit of limiting factor of output. (i) (a) Bought out price per unit or component part No. making will be more profitable than buying.[* Purchase price less Variable cost of production. Rs. The company currently has underutilized capacity that can be used 10 manufacture the component part. those products earning 121 . buying will be more profitable and from 6. 4 other fixed overheads (allocated on the basis of capacity utilized). 3 variable overheads. below this volume. 16 raw material. Where the purchase price exceeds the marginal cost and there is a limiting factor of production. (i) Should the company make or buy these parts? (ii) Determine the range of production at which one is more profitable than the other.. Note: Fixed costs (allocated) are not relevant to the issue. We now determine the volume at which both the alternatives are equally profitable: Hence.] Nevertheless.000 units. A-104 as cost of manufacture per unit of A-104 is lower than its purchase price. Illustration 5.999 units. the company will require 10.e. i. buying will be more profitable and above it. The initial comparison made for each product should be between the purchase price and the corresponding marginal cost where fixed costs do not change. For example.30 Rs. When it is necessary to increase the capacity of the firm 'to make'. But making will involve an additional fixed overhead (avoidable) of Rs.25 A manufacturing company traditionally purchases its component part No. 5 per unit. Rs. the increase in fixed costs may be significant and in such a case the minimum volume or the break-even point has to be determined as above and a decision may accordingly be taken. when labour time is the limiting factor. 9 10 (-) 1 (-) 2. (ii) machine time is the limiting factor? A Rs. 22 15 7 14 17.) Machine hour (Rs. When. the same order would be changed to: C D B Working Extra Shift If fixed costs remain constant. If a limitation on a resource still exists after removing A. Component which is showing negative unit contribution should be bought under all circumstances.20 Rs. A should be bought out. However. 17 12 5 10 25 C Rs. Hence. 15 5 20 22 D 0. selection of a further component or components for buying out should be made in order of lower contribution per unit of limiting factor.5 (-) 10. the company is working at full capacity and is considering buying one or more types of component from an outside supplier. the decision will be taken based on additional profit (additional contribution less increase in fixed cost).50 0. 15 15 B 24 Which component or components would you recommend to be bought out when: (i) labour time is the limiting factor. Illustration 5.) Fixed costs have not been given any consideration as they do not change for the firm as a whole with the making in or buying out of the components.10 Rs. 10 2 12 9 B 0.40 0. Illustration 5. however. The operating results of the company for the year just 122 .5 D Rs. 12 4 16 17 C 0.0 B Rs.the highest rates of contribution per unit of limiting factor should be retained.50 Rs.27 XYZ Co. The total fixed costs will remain unaffected for the company as a whole with the making in or buying out of the component.40 Rs. Thus. would be: B C D When machine hour is the limiting factor. if necessary. the decision should be taken on the basis of whether the costs of the shift are exceeded by the benefits to be obtained. the decision will be taken on the basis of additional contribution expected from opening of extra shift work. Ltd currently operates a single production shift.30 0. Relevant data per unit of component are given below: Components Time per unit: Labour hours Machine hours Cost per unit: Marginal costs Fixed costs (allocated) Total costs Bought-out price A 0. the order of selection of components for buying.50 0. 24 15 9 30 18 Bought-out price Marginal costs Contribution per unit Contribution per: Labour hour (Rs. In other words. fixed costs increase.26 Four types of components are currently being produced using a company's own facilities. 000 99.000 1.000 1.20.40. The labour costs in the second shift would be the same as in the first shift plus a second-shift premium.000 .000 @ £ 36) Less: Additional variable costs: Direct materials: Current cost Total cost of materials with second shift: (16.00.400 1.600 1.10.16.000 units) Direct materials Direct labour Variable overheads Contribution Fixed overheads Profit 1.000 20.16.20.000 The company is planning for the activity of the next year. a capacity of producing 1.28 A company hat. but a bulk purchase discount of 5% would be obtained on all quantities of material bought.20.000 x £ 12 x 0. Illustration 5. Should the second shift be opened up? Profitability of Extra Shift Work £ Additional sales (6.000 2.00.95) Direct labour: (£ 1.000 £ £ 2. second shift should be worked. Sales demand exists for an extra 6.00.400 62.ended show the following £ Sales (10.000 X £ 2) Additional contribution Less: Additional fixed cost: Labour Overheads Additional profit Hence.000 x ].25) Less: Fixed portion of labour Variable Overheads (6.000 30. The second shift is paid at time-and-a-quarter.000 25.25.000 10.000 12.82.000 1.00. Additional fixed overheads of £ 10.400 1.000 1.000 £ 6.60.000 units (at the existing sales price) which could be made in a second shift.00.000 units of certain product in a month.600 1.000 would be incurred. Level of Activity Planning The contribution technique may also be used in planning the level of activity.000 £ 3. The Sales Department 123 1.000 90. When management consider expansion programme. Direct material prices are expected to increase by 2%.55.25.000. You are requested to prepare a forecast statement which should show the effect of the proposed reduction in selling price and to include any changes in costs expected during the coming year.000 15.000.000 48. 7. At which volume of production will the profit be maximum? Capacity Units Sales Variable cost Contribution 60% 60. 60.000 60.000.000 Rs. Statement Showing the Effect of Change in Selling Price 124 .000 Rs.000 90% 90.800 100% 1.000 45. 10. Variable overhead costs are expected to increase by 5% per unit.75 0.000 1. Direct wages rates are expected to increase by 5% per unit. Effect of Change in Selling Price Another problem which is very frequently raised is the effect on profit of a change in sales price.000 Rs.000 95. The following additional information is given: Sales forecast: Rs.000 9. Sales Direct materials Direct wages Variable overheads Fixed overheads Profit 2.000 Rs. a price reduction may be contemplated to attract a wider market.61 The variable cost of manufacture between these levels is Re. Fixed overheads will increase by Rs. Illustration 5. 0.00.29 The directors of a company are considering the results of trading during the last year.000 70% 70.000 Rs.000 2. but the key factor is sales demand. The Profit and Loss Statement of the company appeared as follows: Rs. Fixed cost being constant at all levels of production. 40. necessary to ascertain the effect of such a proposal.000 Contribution at 70% level or activity is maximum.000 The budgeted capacity of the company is Rs. therefore.50.000 Rs.15 per unit and fixed cost.000 46. It is.67 0.) 0.500 46.90 0.500 80% 80. 60. 9. The sales manager is proposing that in order to utilize existing capacity. 10. the selling price of the only product manufactured by the company should be reduced by 5%. 63.000 10. 54.20.00.90 0.50. 61.reports that the following schedule of sale prices is possible: Volume of Production (%) 60 70 80 90 100 Selling price per unit (Re.000 6. Rs.000 12.500 52. profit is also maximum at this level.300 13.50.000. 2.000 The above statement will show that although costs have increased and selling price has been reduced.50.000 Rs. Thus.000 units of X and 1. 9.20 per unit.000 Rs.00.000 additional units of Y but only if the production of X is reduced by 20. 0. 3.000 75.20.000 4.00.000 3.Rs.000 3.50. management may be confronted with the problem of taking decisions as to the effect of alternative courses of action.000 Rs. This is because increased volume of sales at the reduced sales price has resulted in increased contribution more than sufficient to cover increase in costs—variable and fixed. 84.000 2.05.000 Rs.000 which is to be taken into account in adjusting increase in cost.000 80.50.50. 2. Sales Direct materials Direct waees Variable overheads Contribution Fixed overheads Profit 3. the profit forecast for the coming year is still more than that achieved last year.000 50. (b) Direct Materials: Last year's figure Add: 33-% due to increase in volume Add: 2% increase in Price (c) year's figure Add: 33% Add: 5% increase in rate (d) Variable overheads: Last year's figure Add: 33% Add: 5% increase in rate Alternative Courses of Action Very often.000 84.000 6. The problem of taking the appropriate decision in such a case can be tackled effectively if the cost data are presented under marginal costing technique.30 The management of a concern.000 60.30.10.000 Rs.50. X and Y. Illustration 5.000 2.25.00. Product X 125 Product Y Total Direct wages: Last Rs.000 units of Y.000 1. 2.00.000 1.10.000 20. (c) To produce and sell 55.000 units. manufacturing two products.06. (b) To reduce the price of X by Re. This will result in a 25% increase in the sale of X without any change in the activity of Y.000 2. Notes: (a) Sales (after 5% price reduction) 5 X 950000 Add: Reduction in Selling Price 95 Sales before price reduction Less: Sales last year Increase in Sales Rs.000 10.000 6.000 50.50. have the following independent possibilities before them: (a) To produce and sell 16.000 . 9.06.000 7.000 10. 1.000 Rs. 40. 1.000 Direct costs included in total costs amount to Rs.50.40.000 Rs.000 Rs.000 Rs. 1. Present the information to the management in a suitable form giving your recommendation.000 1.20.00.000 Rs.50. 1.3.50.50. 126 . 1. 8.000 Rs.00. The alternative proposals to the management have been given in a suitable form on page 607 based on an analysis of unit direct costs and total fixed costs of Products X and Y as shown below.000 Rs.000 Rs.000 for Product X and Rs. 2.000 Rs. 3.Sales (in units) Sales (value) Cost of sales Gross Margin Selling and distribution expenses Net Margin 50. 2.00.000 Rs.000 Rs.40.60. 6.000 Rs.000 for Product Y.50.50. 1.00. 000 7.000 3.40 4.000 7.000 6.00 8.00 6. 16.30. 2. costs . 5.50 8.000 36.40.000 31.000 40.00.500 12.000 1.000 16. Rs.10 6.000 12.000 5. Rs.750 16.000 1.Sales Direct costs Contribution Fixed costs (Costs of sales + S.00.800 7.000 Units Rs.40. 10.200 21.000 15.500 48. it may be contemplated to reduce the selling price more and more to attract a greater volume of sale and thereby earn a higher total contribution. it is possible to determine the volume and selling price at which the margin of profit appears to be the greatest.000 Unit Units Rs.000 Selection of Optimum Volume and Selling Price (Using Break-even Chart) Where the demand for a product is elastic.000 16.000 34.000 6.000 20.000 40.750 8.000 34.000 17.50 6.000 5.500 16. Rs.000 units.50 9. In other words.000 2. If the sales value and costs at different volume of sales are plotted on a graph paper.000 48. Rs.000 3. In order to plot the data on a graph paper.000 4.000 Units Rs.000 3.000 1.000 1.000 8.000 26. and D.000 16.40.000 16. A break-even chart may be of significant help in such a case.000 4.00 2.000 127 .000 90.40 2.000 but to increase output beyond 3.000 19.000 5.60 Product 1.00 7.000 3.10.000 28.000 10.800 47.Direct costs) Net Profit Product 50.50.50.750 18. Selling price per unit Rs.000 14.500 12.60. Illustration 5.31 Given the information below.50. you are required to determine graphically at what volume of sales and selling price a company can maximize profits. 1. the problem arises as to the determination of the volume of sales and selling price at which profit will be maximum.000 6. additional capital expenditure would be necessary and fixed costs would therefore rise to Rs. 2.000 45.000 Y Total Per 1.50 7.000 16.500 8.000 33.000 10.00.00 9.50.000 8. the point at which the margin of profit is the greatest is the optimum volume and the selling price at this volume is the optimum selling price. 8. When sales volume at varying selling prices is ascertainable.10.000. The fixed costs of the company amount to Rs.000 5.400 The variable unit cost is Rs.20.00 5.000 37.50 11.600 17.500 4. 12.000 5.00.000 X Per Unit Rs.500 6.000 12.000 19.000 27.400 46.500 2. sales value and costs at the varying volume of sales are tabulated as follows: Units Sales value Variable costs Fixed costs Total costs Rs.000 2.000 5.50 Sales forecast (units) 1. 8. 40 6.00 per unit. He desires to change the product mix as under: Mix 1 18. (4) 66.000 A B C As a Cost Accountant what mix you recommend? Solution Product Units Variable cost ratio per unit (2) 1. 2.25 for A.800 units.50 for B and Rs.00 1.000 2.50 for C.000 17. 551).75 Total (1) x (2) (3) 15. 6.e..000 7.000 8.000 13. the margin of profit. (5) 4. The fixed charges come to Rs.500 128 Variable cost in total ratio Rs.000 Mix 2 15.000 6.(1) Rs.000 10. Application of Prof It/Volume or C/S Ratio The Profit/Volume Ratio may be applied in a variety of problems.11 Break-even chart determining the optimum volume.000 12. this is the optimum volume and profit will be maximized at this volume at the given selling price. 2.5 : 1.000 Variable cost per unit (4) •*. 2.000 Mix 3 22.000 66. Rs. namely: 1. 547 and p.000 8. Problem 1 (Product Mix) A manufacturer with an overall (interchangeable among the products) capacity of one lakh machine hours has been so far producing a standard mix of 15. 7. is seen to be the greatest at a sales volume of 6.000 35. 10.75 respectively per unit. i.000 units of Products B and C each.50 1.09. Thus. When the unit selling prices are Rs.000 . the total expenditure exclusive of his fixed charges is found to be Rs.000 15.09 lakhs and the cost ratio among the products approximates 1 : 1.Figure 5. On experience. Therefore. the margin by which the sales value curve is higher than the total cost curve.000 77.70 A B C (1) 15. Determination of variable cost for any volume of sales (this is done by deducting P/V ratio from 100% and multiplying the sales by the resultant figure).500 47.000 units of Product A and 10. Determination of break-even point and margin of safety (see p.60 7. he incurs a loss.000 10. 200. Some of the applications have been shown in the previous chapter. Given the following costs.e. the following two illustrations would explain how P/V ratio serves the day-to-day needs of the management. 7. Determination of profit at a particular volume of sales (see p.000 If selling price is reduced 'by 10%.000 = Rs. 100 30 10 140 Direct materials Direct labour Variable overheads Selling price can be found out by dividing variable cost by variable cost ratio (i. Thus. Therefore. you are required to ascertain the selling price that the company should quote: Per unit Rs.000 .fixed cost = 40% of Rs. There is sufficient demand for the product. It is the policy of the company to maintain 30% P/V ratio. 20. the P/V ratio will come down to 33 — % To maintain the same profit. 8. 12. By doing so. 80.. 4. the selling price should be Rs. Illustration 5.000 units.3. to maintain a 30% P/V ratio. Determination of the sales-mix to maximize profit. they anticipate that sales volume may be increased and that present profit may be maintained.000 units. Selecting the most profitable line or lines of products when there is no limiting factor. Determination of sales volume for a desired amount of profit (see p.Rs. the required total safes will be: 129 .P/V%). 572). On the basis of the following information.33 The directors of ABC Ltd propose to reduce the selling price of Product X by 10%.32 A company proposes to introduce a product in the market. advise management as to the proposal: Selling price Variable cost Fixed cost Present production Rs.000 and sales 8. 5. Illustration 5. 100% . The sales manager estimates that it is possible to sell 5. 6. 10 6 20. Determining the additional sales required to maintain the present profit level in the event of contemplated price reduction. Present Profit = 40% of sales . 565). In addition. Fixing selling prices. 400 34.000 A Rs. as a Cost Accountant. but not for carrots or parsnips. In order to provide an adequate market service.000 37.000 69.80 Selling Price Marginal or Contribution Variable cost Profitability Statement Mix 2 Units Contribution Rs.200 22.300 10.50 6. to recommend the optimal mix of vegetable production for the coming year.40 1.550 70.000 300 A market gardener is planning his production for next season and he asked you. but not for potatoes or turnips. (b) Assuming that the land could be cultivated in such a way that any of the above crops could be produced and there was no market commitment.000 Mix 1 Contribution Rs.700 7. you are required to: (i) advise the market gardener on which crop he should concentrate his production.000 27. 2 = Rs.000 36.85 0. 7.000 8.Total Fixed Cost: 35.000 (-) 450 Units 22.300 B Rs.90 C Rs.85 Unit Product A B C Total Less: Fixed Contribution Rs.000 5.70 2.750 6. the gardener must produce each year at least 40 tonnes each of potatoes and turnips and 36 tonnes each of parsnips and carrots. The land being used for potatoes and turnips can be used for either crop.600 63.000 x Rs. 6.80 cost Net Profit/(-) Loss Hence. 40. 10.50 7. Solution 130 . Problem 2 (Limiting Factor and Product-mix) Units 18. and (iii) calculate in sterling the break-even point of sales.000 12.800 19.000 (-) 6.000 Turnips 20 8 £ 125 25 20 15 450 Parsnips 30 9 f 150 45 30 20 500 Carrots 25 12 £ 135 40 25 25 570 Area occupied (in acres) Yield per acre (in tonnes) Selling price per tonne Variable costs per acre: fertilizers seeds pesticides direct wages Fixed overheads per annum: The land which is being used for the production of carrots and parsnips can be used for either crop.000 Mix 3 Contribution Rs. Mix (3) is recommended. 15.300 70.60 0. and (ii) the profit for the production mix which you would recommend.400 70.25 4.000 7. 70.000 8. 1.700 70.400 13. He has given you the following data relating to the current year: Potatoes 25 10 £ 100 30 15 25 400 £ 54. 33.90 2. (ii) calculate the profit if he were to do so. (a) You are required to present a statement to show: (i) the profit for the current year.000 38. 630 Contribution per acre Best area crops Minimum tonnes Acres required Balance Recommended mix (acres) Contribution Fixed overheads Profit from recommended mi? £ 21. Variable cost per acre Tonnes per acre Revenue per tonne Revenue per acre (a) (i) Potatoes £ 470 10 £ 100 £ 1.000 hours per period.000/59.200 £ 2.960 (b) (i) Production should be concentrated on carrots which have the highest contribution per acre (£ 960) £ 96.700 Revenue (see workings) Variable costs Contribution Fixed overheads Profit Workings.000 Turnips £ 510 8 £ 125 £ 1.630 £ 54.000 15.259% Break-even point in sterling = Fixed overheads/CS ratio .000 42.500 17. The standard costs of the products per unit are: Product A £ 131 Product B £ Product C £ .500 24.000/£40.(a) (i) Acres Profit Statement for the Current Year Potatoes 25 £ 25.700 54.250 Turnips 20 £ 20.300 69.500 16.000 (ii) Contribution from 100 acres of carrots Fixed overheads Profit from carrots (iii) Contribution to sales ratio of carrots = £24.000 Parsnips £ 595 9 £ 150 £ 1.000 Total 100 £ 126.000 £ 21.650 Carrots 25 £ 40.000 54.350 Carrots £ 660 12 £ 135 £ 1.750 13.000 56. all of which use the same machine which is available for 50.200 9.259 x 100 = £91.126 Problem 3 (Limiting factor/make or buy) ABC Ltd makes three products.£54.000 10.800 Parsnips 30 £ 40.850 22.620 Profit Statement for Recommended Mix Area A (45 acres) Potatoes Turnips £ 530 £ 490 Potatoes J!9 40 ~5 36 ~ 0 5 Area B (55 acres) Parsnips Carrots £ 755 £ 960 Carrots 36 36 ~4 3 48 4 51 Total £ 75.000 11.020 £ 48.500 X 100 [(from (a)(i)] = 59.450 £ 5. 000 .5 Product B £ 140 £ 112 £28 4 7 Product C £ 200 £ 178 £22 7 3.000 (48/8) 6 18. This will be sufficient to manufacture 22. The next decision to be made is the choice of product(s) that should be made in-house and those that should be bought out (wholly or partially).000 hours available for Product C. £ 175 £ 140 £ 200. leaving 22.28.000 (56/8) 7 35.000 50. 132 .500 (32/8) 4 10. in over buying.500 80 56 42 178 224 5.1 Thus. calculate the profit for the next period based on your recommendations in (b).000 hours (b) Make or buy First we have to decide whether it is worth trying to meet full demand for all products. Meeting maximum demand for Products B and A would use 10. Buy-out price per unit Variable cost per unit Saving from making-in per unit Make-in machine hours per unit Saving per machine hour (£) Product A £ 175 £ 154 £21 6 3.000 63.Direct materials Direct labour Machinists (£ 8 per hour) Assemblers (£ 6 per hour) Total variable cost Selling price per unit Maximum demand (units) Fixed costs are £ 300.000 13.000 Product C 5. The benefit of making.000 per period. determine which product(s) and quantities (if any) should be bought out.000 ABC Ltd could buy in similar quality products at the following unit prices: A B C You are required to: (a) (b) (c) calculate the deficiency in machine hours for the next period.000 40 32 40 112 158 2.000 + 1 = 3. even if some units have to be bought out.000 hours [see (a)]. 70 48 36 154 200 3. Solution (a) Machine hours deficiency Maximum demand (units) Hours per unit Total hours Total hours to meet maximum demand Hours available Deficiency Product A 3. The quickest approach is to assess each product in terms of the benefit of making-in over buying-out per-hour of machining time used—key factor analysis. Since all products will still have a positive contribution (selling price -variable costs) even if they are bought out (in which case variable cost = buy-out price).000 Product B 2.000 -f 18. manufacturing priority should be given to Product B.142 units of C. then Product A and then Product C. it will be worth buying out as necessary to meet full demand. out is measured by the difference between make-in cost (variable cost) and buy-out price. 5. The company can accept either of the two export orders and in either case the company can supply such quantities as may be possible to produce by utilizing the balance of 25% of its capacity.124 £ 138. 15. Alternatively.50 per unit.00 19.00 4.variable cost) From buying-out (selling price .592 (3. The machine hour rate is Rs.858 units) £ 397. Rs.500 Product C 5. a special packing charge of fifty paise per unit has to be borne by the company.buy-out price) Total contribution From making-in From buying-out Less: Fixed costs Profit Product A 3.00 4. The cost sheets of these two products are as under: Product A B 600 400 Rs. and (ii) statement showing the overall profitability of the company after incorporating the export proposal recommended by you. Ltd operating at 75% level of activity produces and sells two products A and B. You are required to prepare: (i) statement showing the economics of the two export proposals giving your recommendations as to which proposal should be accepted.00 4.50 per unit.3. In both the cases.00 23.00 3.000 Total £ 46 £ 46 £ 46 £ 24 £ 144. 2.000 Problem 4 (Export Order/Limiting Factor) V.142 = 1. (c) Profit for next period Sales (units) Contribution per unit From making-in (selling price .532 44. 2 per hour.00 8.000 142.532 44.142 units) (1.Thus.592 442.00 5.000 Product B 2.00 16. 17.000 .000 £ 115.00 Units produced and sold Direct materials Direct labour Factory overheads (40% fixed) Selling and administration overheads (60% fixed) Total cost per unit Selling price per unit Factory overheads are absorbed on the basis of machine hour which is the limiting (key) factor.00 5. the company has another offer from the Middle East for the purchase of Product B at a price of Rs.858 units of Product C should be bought out. The company receives an offer from Canada for the purchase of Product A at a price of Rs.00 19. Solution 133 .124 300. 50 Rs. At present.000 tests a period.464 4. 2. 134 .50 12. Therefore.000 tests each period but.000 per period.320 6. 28.20 12.480 B 867 Rs.70 17.000 tests. contribution per hour should be the criterion for determining the relative profitability of two export proposals.639 17.00 3. (ii) Statement of Overall Profitability A Units Safes Less: Marginal costs Contribution Less: Fixed cost Profit Problem 5 (Shift Work) BSE Veterinary Services is a specialist laboratory carrying out tests on cattle to ascertain whether the cattle have any infection. The current cost of carrying out a full test is: £ per test 115 30 12 50 600 Rs.(i) Statement Showing Economics of Export Proposals Order from Canada Order from Middle for A East for B Per unit Per unit Rs. which would require an additional shift to be worked.00 3.855 5.20 0. 2.13 Direct materials Direct labour Prime cost Variable overheads: Factory Selling and Distribution Special Packing Marginal cost Export price Conlribution Machine hours per unit Contribution per hour Machine hours being the limiting factor.00 6.760 Rs. Product B will yield higher contribution per hour than that of Product A.784 10. demand is expected to increase to 18. the laboratory carries out 12.50 Rs.800 7.00 8.50 3. (ii) discount of 20% to be obtained for all materials if an order was placed to cover enable a quantity 18. the offer from Middle East for Product B should be accepted in preference to that from Canada for Product A.80 2.20 1.50 12.92 1.095 Materials Technicians' wages Variable overheads Fixed overheads Working the additional shift would: (i) require a shift premium of 50% to be paid to the technicians on the additional shift. Rs. 13.00 4. Thus. (iii) increase fixed costs by £ 700.80 2.00 11.00 4. because of current difficulties with the herd.839 10.80 0. 14.30 15.00 4. 1.50 4. 5.375 Total _ Rs. .380x80% 1.000 tests with additional shift Fees Variable costs: Materials Wages Variable overheads (£ '000) (18. 135 .000 x £ 300) ( 18 1.000 x £ 115) (12.600 Profit (b) 18. You are required to: (a) (b) (c) prepare a profit statement for the current 12. material used.000 x £ 12) 1. etc. prepare a profit statement if the additional shift was worked and 18.400 (£ '000) 3. Also.598 (c) The following are to be considered before taking any decision.300 1. it may be worth employing extra staff rather than paying overtime premiums.116 (£ '000) 5.656 \ YL ) 630 (360 + 6 x £ 30 x 150%) 144x 216 V l2y 2.: Increasing activity by 50% using current resources may well lead to a drop in the quality of output—i.000 tests were carried out. and comment on three other factors which should be considered before any decision is taken.380 360 144 1.502 Contribution Fixed overheads Profit (600 + 700) 2.000 capacity.898 1. (1) The duration of the higher level of demand: If it is expected to continue over longer periods. unreliable test results—which could have an adverse effect on future demand.000 x £ 300) (12.The current fee per test is £ 300.000 X £ 50) 1.000 x £ 30) (12.884 (12. The quality of the work done.716 600 1.e. (2) The pricing policy: The urgency of the need for extra tests may mean that fees can be increased without significantly affecting demand. the commitment to extra fixed overheads may extend over a longer period than the extra demand. Solution (a) 12.000 capacity Fees Variable costs: Materials Wages Variable overheads Contribution Fixed overheads (£ '000) (12. 1985 or SICA defines a sick industry as "an industrial company (being a company registered for not less than five years) which has at the end of any financial year accumulated losses equal to or exceeding its net worth". The financial factor relate to the over burdening debt capacity and the insufficient capital. Dun & Bradstreet has assigned percentage values to the causes of business failures. etc. a unit may be considered as sick if the loan/advance in which any amount to be received has remained past due for one year or more.Chapter 6 Corporate restructuring and Finance Before going into the details of financial distress. The economic factor relate to the industry weakness and the poor location of the firm. the financial factors. In case of tiny/decentralized sector units. principal or interest in respect of any of its borrowal accounts has remained overdue for periods exceeding 2 V2 years and b. as per the RBI is classified as sick when: a. Any of its borrowal accounts has become a doubtful advance. The following table reveals the same. The importance of the different factors varies over the time. proprietory concerns. 136 Percentage of total 37. sometimes some factors produce a combining effect so as to make the business unsustainable. A weak Industrial Company should be termed as "potentially sick" company.e. WEAK UNIT A non-SSI industrial unit is defined as 'weak' if its accumulation of losses as at the end of any accounting year resulted in the erosion of fifty percent or more of its peak net worth in the immediately preceding four accounting years.1: Causes of Business Failure Cause of business failure Economic factors Financial factors Neglect.3% 14. Apart from this. Table 6. Studies have provided further evidence that the causes of financial distress are a result of a series of errors. SICK SSI UNIT A small-scale industrial (SSI) unit. DEFINITIONS SICK INDUSTRIAL COMPANY The Sick Industrial Companies (Special Provisions) Act. Causes of Business Failure The basic causes of business failure can be categorized into four major heads . misjudgments and interrelated weaknesses that can be attributed directly or indirectly to the management of the firm. let us try to begin with its background and the consequences. if requisite financial data is not available. We first start with the basic causes of a business failure and then try to go in to the consequences of such failure in the context of financial distress and bankruptcy. disorder and fraud Other factors MEANING OF BANKRUPTCY A firm is said to be bankrupt if it is unable to meet its current obligations to the creditors. 1985 (of industrial companies) but also other categories such as partnership firms. i. There is erosion in net worth due to accumulated cash losses to the extent of 50 percent or more of its peak net worth during the preceding two accounting years.1% 47.0% 1. disorder and fraud and some other factors.the economic factors.6% . factors relating to neglect. Bankruptcy may occur because of a number of external and internal factors. In a recent study. depending on such things as the state of the economy and the level of interest rates. It is clarified that weak units will not only include those which fall within the purview of Sick Industrial Companies (Special Provisions) Act. c. which when diagnosed and corrected in time can save the company from bankruptcy. h.2: An RBI Study Causes of Bankruptcy Mismanagement Faulty initial planning Labor trouble Market recession Others Percentage 52 14 2 23 9 100 SYMPTOMS OF BANKRUPTCY A firm goes bankrupt gradually. it exhibits a number of symptoms. Change in government policies affecting the firm Increased competition Scarcity of raw material Prolonged power cuts Changes in consumer buying pattern Shrinking demand Natural calamities Cost overruns Inadequate funds. e. d. c. d. i. b. Table 6. Failure to make statutory payments 137 . b. Before a firm goes bankrupt. Mismanagement Fraudulent practices and misappropriation of funds by the management Labor unrest Technological obsolescence Disputes among promoters. g. f. e. Internal Factors a. salaries etc.FACTORS LEADING TO BANKRUPTCY External Factors a. Some of these symptoms are • Production • Low capacity utilization High operating cost Failure of production lines Accumulation of finished goods Sales and Marketing Declining/Stagnant sales Loss of distribution network to competitors • Finance Increased borrowing at exorbitant rates Increased borrowing against assets Failure to pay term loans Failure to pay current liabilities. International Models • • • • • • Beaver Model The Wilcox Model Blum Marc's Failing Company Model Altman's Z Score Model Argenti Score Board. Blum Marc tried to accurately predict failure and draw a distinction between bankrupt and non-bankrupt firms. Profitability ratios and Variability ratios. a need was felt to evolve techniques and methods to predict failure of a firm. The Wilcox Model Wilcox proposed that the net liquidation value of a firm is the best indicator of its financial health. Blum Marc's Failing Company Model Blum Marc's model predicts the financial health of a firm using 12 ratios divided into 3 groups: Liquidity ratios. PREDICTION OF BANKRUPTCY As the incidence of sickness became more frequent." He used 30 ratios classified under 6 categories. Liquidation value is the market value of assets and liabilities. can have better predictive ability than when used individually.C.Gupta Model Beaver Model Beaver was the first to make a conscious effort to use financial ratios as predictors of failure. He developed a discriminant score called the Z-score on the basis of these ratios. they are not the best predictors of sickness.2X. + 0. a final set of 5 ratios were selected as they were found to be better predictors of failure. Altman's Z Score Model Airman improved upon the earlier models using ratio analysis to predict failure. Out of these 22 ratios. Discriminant score 138 . Beaver tested these ratios to predict the failure of a company. so that a potentially disastrous situation can be averted. Using these ratios. + 1. A number of models are available to accurately predict sickness of a firm. Weights were given to these ratios on the basis of their significance to predict health of the model. 22 ratios were considered in various combinations as predictors of failure.0XS where.• Others A declining trend in market price of share Rapid turnover of key personnel Persistent cash losses Frequent changes in accounting policies to enhance profits Frequent change of accounting years for undeclared reasons. The net liquidation value can be obtained by the difference in liquidation value of firm's assets and the liquidation value of liabilities. These models provide early warning signals.3X. Altman's model is based on the fact that various ratios when used in combinations. A number of Indian models are also available. A study has revealed that financial ratios are useful in predicting the failure of a firm for a period up to 5 years before sickness accurately. He used a statistical technique called the Multiple Discriminant Analysis (MDA) to distinguish between bankrupt and non-bankrupt firms. Indian Model L.6X4 + 1. The ratio of cash flow to total debt was found to be the best single predictor of failure.4X2 + 3. Most of these techniques involve financial ratio analysis. He defined failure as "inability of a firm to pay its financial obligation as they mature. The study further revealed that financial ratios are useful in prediction of failure of at least five years prior to the event. Z Z = = 1. While symptoms listed earlier are good indicators of the financial health. Some of the models are discussed below. if liquidated at that point of study. Gupta Model 139 .99. developed a score board for evaluating the health of the firm. Any obligation which the company cannot meet if something goes wrong Pass should be less than 15 Financial signs. appear near failure Creative accounting. the firm is likely to go bankrupt. or not updated No costing system.) No cash flow plans.C. If Z score is more than 2. using lower depreciation. old Classification Bankrupt firm Area of ignorance Healthy firm 2 3 3 3 Total Score Mistakes 43 15 15 15 Total Score Symptoms 4 4 45 4 Total Score 12 Total possible score 100 Pass should be less than L. out-of-date marketing In accountancy No budgets or budgetary controls (to assess variance.99 is treated as an area of ignorance.an autocrat will see to that Unbalanced board .1 In management . The range between LSI .81-2. such as untidy offices. Chief executive is the first to see signs of failure and. etc. frozen salaries.2.99 Argenti Score Board J. overvaluing stocks. in an attempt to hide it from creditors and the banks. such as Z-score. Argenti in his famous article 'Company Failure . The cut-off point for a "healthy firm" is a score of 25. All the scores are to be summed up. obsolete directors. firm could get into trouble by stroke of bad luck Overtrading. rumors 25 factory. it is regarded as a healthy company. low morale. He has delineated a list of factors to be looked into along with the respective scores. Capital base too small or unbalanced for the size and type of business Big project gone wrong. Skilled observers can spot these things. Cost and contribution of each product unknown Pass should be less than 10 High leverage.Score The chief executive is an autocrat He is also the chairman Passive board .81 1.too many engineers or too many finance types Weak finance director Poor management depth 15 Poor response to change. for instance. mistakes and symptoms. The weaknesses are classified as defects (management and accounting). Non-financial signs. chief executive "ill". The model is based on numerical assessment of the firms' weaknesses." Defects Box 6.Long Range Prediction is Not Enough'. accounts are "glossed over" by. etc. If Z score for a firm is less than 1.99 >2.81. old-fashioned product. This model has been criticized for being "subjective" and "arbitrary. Z Score <1. Company expanding faster than its funding. high staff turnover.X1 X2 X3 X4 X5 = = = = = Working capital/Total assets Retained earnings/Total assets EBIT/Total assets Market value of equity/Book value of debt Sales/Total assets. In such a situation it is important to ascertain. But in case the long run asset values have truly declined then the firm is said to have incurred economic losses. He used 56 ratios and sought to determine the best set of ratios to predict failure.C. c. Whether the firm should file protection under chapter 11 of Bankruptcy Act. Here we first start our discussion with the informal reorganization and then go into the details of the procedures of the formal bankruptcy.25 Debt). involves restructuring of the firm's debt. To ascertain whether such a failure is due to a temporary cash flow problem or because of the fact that the asset values of the firm has fallen much below its debt obligation. the creditors postpone the dales of the interest or the principal payments as well as both. If it is found out that the problem is a temporary one. Ascertaining the controlling force of the firm while it is being liquidated or rehabilitated. To ascertain whether the existing management be left in charge or should a trustee be placed in charge. To ascertain the value of the firm both on liquidation as well as on working conditions and to take the decision on whether it is profitable to continue the business or liquidate it based on the valuations.L. Gupta's model was the first Indian model proposed to predict failure. d. generally termed as the "workouts". He applied these ratios to a sample of sick and non-sick companies and arrived at the best set of ratios. Informal Reorganization Those companies that possess more strong economic fundamentals. it is very important for its management and creditors to decide whether the problem is a temporary one and it is possible for the firm to continue its operations or whether the problem is more serious and permanent in nature that has the possibility of endangering the life of the firm. Balance Sheet Ratios Net Worth/Total Debt All Outside Liabilities/Tangible Assets. then an agreement with the creditors of the firm can be worked out so that the firm has time to recover and satisfy every one. Few of the pivotal issues that arise in due course are as follows: a. Primary cause of failure on part of the firm to meet the debt obligations. If the firm goes for filing a formal bankruptcy under chapter 11 of the Bankruptcy Act it involves certain costs. Such voluntary plans rendered by the creditors. Thus it is preferable to go for reorganization and liquidation through informal means. because of the fact that the current cash flows of the firm are insufficient to service the existing debt. It is to be noted here that in both the cases of reorganization and liquidation a firm can either resort to informal procedures or work under the direction of the bankruptcy Court. are always prepared to work with these companies so as to help then to come out of their distress conditions and to re-establish themselves on a sound financial basis. These were categorized as profitability ratios and balance sheet ratios. or should it go for informal procedures. The model was found to have a high degree of accuracy in predicting sickness for 2/3 years before failure. The restructuring process typically consists of extension and composition. Issues facing by a Firm in Times of Financial Distress The primary cause of a firm encountering financial distress starts when it finds it difficult to meet the scheduled payments or when the cash flow projections of the firm are indicative of the fact that it will soon be unable to do so. In case 140 . who should bear the losses and how much of share should be given to each. Settlements without going through formal bankruptcy When a firm goes through the period of financial distress. e. it might lead to disruptions. These are given below: Profitability Ratios • • • • • • • EBDIT/Net Sales OCF/Sales (Operating Cash Flow/Sales) EBDIT/(TotaI Assets + Accumulated Depreciation) OCF/Total Assets EBDIT/(Interest + 0. the parties involved in the process decides upon solving the problem either through the intervention of the bankruptcy court or through informal process. Coupled to this. In the former case. So having done this. b. there is also the possibility of the fact that when the creditors come to know that the firm has resorted to the Court. along with a new note that promises six future installments of 10% each for a total payment of 85%.of the latter. then a formal plan is drafted and is presented to all the creditors providing them the reasons why they should be willing to compromise on their claims. This information is then shared with the bankers and the creditors of the firm. Typically. the settlement may provide for a cash payment of 25% of the debt amount immediately. The creditors form a committee with four to five representatives of the larger creditors and a few of the smaller ones so that each side is equally represented. Informal Liquidation When the management of the firm realizes that the value of the firm is more when it is dead than it is alive. the creditors may agree to not only postpone the date of payment but also to subordinate the existing claims to the vendors who show their willingness to extend new credit during the workout period. It is to be kept in mind that the informal voluntary settlements are not limited to the smaller firms. In addition to get away from such costs the debtor feels relieved that the stigma of bankruptcy is not put on him. Generally it is observed that bargaining is taking place between the debtors and the creditors over the savings that in turn results from avoiding the cost of legal bankruptcy. The process of debt restructuring begins with the initiation of both the firm's managers and the creditors meeting for seeking a proper balance. they might be somewhat convinced to accept something less than their full value of the claim. In case where the management and the primary creditors agree for a resolution. Recent studies have confirmed that they can extensively be used even by the larger firms. When the creditors are supplied with this information. This problem termed as the hold out problem is discussed in the chapter. The biggest problem that is encountered by informal reorganization is getting all the parties to agree to the voluntary plan. This follows by developing the information that shows the value of the firm in different scenarios. It is also sometimes seen that the bargaining process may lead to the process of restructuring that may involve both extension as well as composition. the creditors may also be willing to accept a lower interest rate on the loans during the extension period. and investigative cost and so on. They may even take equity for debt or they may resort to the combination of all these three possible ways. Other scenarios may include continued operations. This process generally yields them a greater return that they would have received in formal bankruptcy liquidation. In certain cases. The meeting is often arranged and conducted by an adjustment bureau that is associated with and run by local credit manager's association. the creditors should have more faith than the debtor firm will able to solve the problems. One such scenario may be the firm going out of business. it may take a year or even more than a year. They are also relatively cheap because the legal and the administrative expenses that are associated with it are limited to the minimum amount as a result of which the voluntary procedures normally result in the maximum return to the creditors. the creditors receive the cash and the new securities that have a combined market value that is less than the amounts owed to them. administrative cost. So a bank that is facing distress with its regulators over weak capital ratios may even agree to extend further loans that may be used to pay the interest on the earlier loans in order to keep the bank from having to write down the values of the earlier loans. In comparison to this. The firm may even take help of an appraiser who can appraise the value of the firm's property that can be used as a basis for ascertaining the value of the firm in different scenarios. Because of the sacrifices that are involved. legal fees. It has been frequently observed that the debt capacity of the firm exceeds its liquidation value and it is further observed that the legal fees and the other costs that are associated with the formal liquidation process under the bankruptcy lowers the proceeds available to the creditors. creditors offer extension because that promises them their full payment at some point of time. frequently with some improvements in the capital equipments. the creditors agree to reduce their claims. marketing and perhaps some management changes. The first step involves drawing up a list of creditors with the amount of debt that is owed to each. and may some times have to accept an amount that is lower than that owed to them. Restructuring process also enjoys the benefit of avoiding the loss that is incurred by the creditors. Added to this. the creditors voluntarily reduce their claims on the debt by accepting a lower principal amount or by reducing the interest rate on the debt. The process of voluntary settlement is both informal as well as simple. the feasibility of the assignments finds its significance only when the firm is small and the affairs of the firm are not that complex. This may be perhaps in exchange for a pledge of collateral. As an example. they generally recover more money and sooner than in case the firm were to file a bankruptcy. This reduces the present value of the proceeds to much lower level. In a similar way. Assignment is an informal procedure for the purpose of liquidating a firm. Assignments enjoy certain advantages over the process 141 . Although the creditors do not receive the payments immediately. the process of resolving the case through formal procedure is also very time consuming. it may resort to informal procedures to liquidate the firm. While framing the reorganization plan. However. selling off its assets and then distributing the proceeds to the various creditors as per the importance of the claim that is associated with each of them with the surplus going to the common stock holders. Causes and Effects of Financial Distress Before going in for a detailed analysis of the causes and effects of financial distress.of liquidation in the American bankruptcy Courts. and expense. financial distress and recession for both the consumer and firms. If a tender does not build a reputation for pressing his claims the borrowers will have an incentive to become more of illiquid so as to force an improvement in terms. the fall in the current level of income. selling of the T-bills has a contractionary effect. they try to avoid it by retaining considerable amount of liquid assets so as to meet their fixed expenses. increases the uncertainty about the future liquidity needs. Bernanke (1981) made some key findings on the relationship among liquidity. Here we try to focus more on the causes and effects of the financial distress that is encountered by firms around the globe. Formal liquidation in bankruptcy can help in solving both these problems. His suggestion is somewhat based on moral hazard. the fall in the current income reduces the expenditure on illiquid. There is also the general demand to bring solvency which consequently results in a reduced demand for consumer and producer durables. With a low level of internal liquidity. borrowing at unfavorable terms. so as to have an effect on its liquidity on either ways. in turn. coupled with many fixed expenses. These questions basically revolve round the primary reasons for a firm experiencing financial distress. Macro Level factors affecting the Financial Distress. But. firms must bring together and balance the long-term spending plans with the need for having the cash flow so as to meet the short-term obligations. The short-term interest rates fall when the Fed is pursuing an expansionary policy and rises when the contractionary policy is followed. for the level of durables holding consistent with maintenance of solvency in the long run. economic growth and financial distress. Bernanke has also stated the cause of bankruptcy. The operation of the Fed is under the assumption that inflation and real economic growth is positively correlated. the distress rate of assets. MONETARY POLICY Bernanke's study on the liquidity takes us back to the critical role of the monetary policy on the overall liquidity of a nation. postponement of capital expenditures is a proper defence mechanism of the balance sheet. so that the flow constraint has to be satisfied through expensive means. as a result of which almost all the agents try to avoid the consequence of bankruptcy costs. Say for example. the banks and the tenders try to avoid it by being selective as far as their borrowers are concerned and by limiting the size of the loan with recession creeping into any system. So an action can be taken much faster when the inventory becomes obsolete or the machine rusts. against any expected fall in the current income. It is to be borne in mind that the concept of financial distress is nothing new in the area of corporate finance.. The assignee has more flexibility in disposing a property than does a federal bankruptcy trustee. The overall liquidity of the US is governed by the Federal Reserve Board through its open market transactions. The first will speak more about the macroeconomic growth and the government policies and the regulations that center around the financial distress rates. if the 142 . let us answer these questions using a top-down approach. the bankruptcy of the firm. that bankruptcy leads to social costs. which again may generate further income reduction. Two reasons can be attributed for this. Liquidity and Recession In his study. From the viewpoint of the consumers. The primary duty of the Fed is protecting the purchasing power of the dollar. reflects a hazy implication for the estimate by the consumer of the future income flows and thus too. This. He postulates. for at least they raise the cost of new financing. At the same time. as an expansionary mechanism. long lived assets. severe reduction in the current standards of living or even the last possible resort. The other reason being. legal formality. there is the possibility of increase in the level of financial embarrassment. The discussion will be dealt in two separate sections. These operations may include the Fed's buying and selling of the US treasury bills out of its considerable inventory. the lower level of current income enhances the short run probability. the effects of the distressed firms etc. that the nation's banks can use in creation of new loans on a multiplied basis. it adds on to the legal reserves to the banking industry. When the Fed buys the bills. The second section will deal with the ways by which the financial distress can be related to the industrial factors. It must be remembered that. that recession leads to the creation of financial distress by bridging the gap of margin between cash flow and debt service. there is the reduction in the cash flow income that is available to meet the current obligation. while at the same time ensuring a sustainable level of real growth in the economy. His argument stressed on the fact that the existence of bankruptcy risk plays a role in the propagation of recession for both the firms as well as individuals. When there is a constrained flow. On the other hand. It is not possible for the tenders to perceive the objective conditions on which borrowers base their portfolio decisions. in terms of time. He says. let us first try to find an answer to the following questions. Bernanke's study focused on the critical relationship among the changes in liquidity. At the same time it is to be remembered that the assignment does not automatically result in a full and legal discharge of all the debtors liabilities and neither does it protect the creditors against fraud. The first being. and entail a much tighter limit on the availability of the short-term loans. iii. It is the contractionary policy to bring down the level of inflation. ii. One may be the contagion effect. particularly those firms that are relatively weak in financial terms or those that are highly levered. the economies of scope have been reversed in the 1980s.real economic growth is weak. the Fed can pursue an expansionary policy without concerning much about inflation. They may include i. leads to an increase in the financial distress of all firms. it was found that when the changes to the corporate focus began to take shape. The five forces that are included in it are a. This particular view is a deviation from the steady increase in diversification since the 1950s. Long and Srulz (1992) examined the effect of bankruptcy announcements by one firm on the values of other firms in the industry. The author further states that a highly leveraged firm will commit to riskier projects as well as aggressive product market strategies so as to prevent other firms from entry. negative information about the status of the industry as a whole. d. within the industry. In a separate study. changes in input costs of innovations in financial technology that brings about changes in the industry structures. e. deregulation. The shocks include. The weakest of the firms are forced into bankruptcy or they must consider being taken over by a stronger firm in the industry. Financial distress is likely to be more in case of larger firms than that of the smaller ones as per conclusions drawn from Williams analysis. The market may pull down the values of other firms within the industry because of the fact that the bankruptcy announcement brings new. the interest rates also rise. industry shocks and deregulation. the Fed steps in to make corrections. where the economy is growing at a high and presumably at a rate that is unsustainable. These events. b. and they are more likely to rationalize mergers and growth strategies. especially over a period of time. Industry Level Causes of Financial Distress The industry level causes of financial distress can be said to be a three tier system. On the other hand. It has been found out that the balance between these contrary views is dependent on the financial characteristics of the firm. in one instance. One of the possible implications of the stated factors is that the firms in the different industries display different level of competition as well as different profit sensitivities to the changes in the macroeconomic and industry conditions over time. one can resort to Michael Porter's five forces model. Industry Shocks Any negative shock to the demand of the product or its cost. Each of the above stated factors is associated with the financial distress of an individual firm that operates within the industry. Managers of today tend to focus more on the core business. Industry Deregulation 143 . Managerial economies of scale Economies of scope in production and marketing Financial synergies. At the same time. In situations. many of the inefficient conglomerates that were facing keener competition became financially distressed. as a result of such monetary policies. the market may also raise the value of other firms in the industry because one of their rival firms has failed. as a reflection of a strategy for specialization. along with the subsequent slow down of the economy itself. and from the several theoretical justifications for diversification that have since been evolved. The traditional thinking says that. Reversal Fortune: From Diversification to Focus The effect of the reversal on financial distress can be viewed from many angles. as well as divestitures and restructuring. c. Let us now discuss each of these factors in detail. They tested for two contradicting effects. Competition For identifying the possible industry level causes of financial distress. eventually forces a shakeout of firms in the industry. Studies conducted by Mitchell & Mulherin (1996) tested the proposition that industry shocks contribute to the frequency of takeover and restructuring activities. Barriers to entry Bargaining power of suppliers Bargaining power of buyers Threat of substitute products Rivalry among the competing firms. it is to be remembered that. They are competition. that deregulation within the industry brings forth a change in the economic structure of the industry. In another study. Kote and Lehn (1999) examined the effects of the Airlines Deregulation Act of 1978. Chen and Mercrilte studied the forced break up of AT&T. The authors also made predictions regarding the increase in the level of executive compensation for the airline executives. 144 . which are proportional to his equity stake. The other effect being. the outside shareholder will engage in monitoring only if his private benefits. and continued for almost two years. whereas it would be more sensitive towards the stock's price after the process of deregulation. no transfer of wealth from the bondholders to stockholders took place during the deregulation process. They were able to develop several hypotheses about the expected effects based on the agency theory. on airline firm's governance structures. along with the associated increase in competition. At the same time. The findings of their studies showed that economically significant events took place during the deregulation process. The first being. They stated that deregulation may bring in the concentration of equity ownership. in order to internalize the agency problems that are associated with higher monitoring costs. exceed the cost of monitoring. The authors concentrated on the issue on whether the break up resulted in wealth transfers among the security claimants of AT&T and other stakeholders as well. Deregulation may also lead to the increase in the costs of monitoring managers. it was also observed that. the executives pay would relatively be more sensitive towards the firm's earnings. Let us now try to focus on some of the studies that reveal the effects of financial position of a firm due to deregulation creeping in. This is mainly because of the fact. They also put forth the argument that before the process of deregulation. that was initiated by Court Order on first of January 1984. which resulted in the transfer of funds from third parties to the operating company shareholders. the managers themselves may own larger stakes so that they can have a larger proportion of wealth associated with their decisions. This can have a dual effect. In their studies conducted in 1986. and also involving a change in the form of the compensation provided.The process of deregulation in an industry can bring in financial distress in many firms. most firms employ several types of capital. EVA is the difference between net operating profit after-taxes (NOPAT) and a charge for capital. Most firms set target percentages for the different financing sources. a large telecommunications company in the United Kingdom. In both cases.cided to publish this textbook. due to differences in risk. As these examples illustrate. it is called a "capital budgeting decision. or WACC.cisions. Therefore. preferred. in 1999. All capital components have one feature in common: The investors who provided the funds expect to receive a return on their investment. If a firm's only investors were common stockholders. The second. with common and preferred stock.S.Chapter 7 Valuation Most important business decisions require capital. and probably more important. Vodafone estimated the in. When evaluating a potential acquisition. Microsoft had to make a I similar decision with Windows 2000. no more and no less.pensation plans based on the concept of Economic Value Added (EVA). The cost of capital is also a key factor in decisions relating the use of debt versus equity capital. a company may decide that now is a good time to issue common stock. later made a $124 billion I offer for Mannesmann. the cost of capital is a critical element in business de. these different securities have different required rates of return. a German company. National Computer Corporation (NCC) plans to raise 30 percent of its required capital as debt. if the stock market is extremely strong. telecommunications com. along with debt. These utilities are natural monopolies in the sense that one firm can supply service at a lower cost than could two or more firms. Although NCC and other firms try to stay close to their target capital structures. It is also important for a company to de. the weighted average cost of capital. spent I £60 billion to acquire Air7buch Communications. I Vodafone Group. First.pany. market conditions may be more favorable in one market than another at a particular time. and the cost of capital used to ana-lyze capital budgeting decisions should be a weighted average of the various components' costs. 10 percent as preferred stock. and 60 percent as common equity. Flotation costs are addressed in detail later in the chapter. it is vital to have a reliable estimate of the company's value. The Weighted Average Cost of Capital What precisely do the terms "cost of capital" and "weighted average cost of capital" mean? To begin. For example. being the three most frequently used types. then the cost of capital used in capital budgeting would be the required rate of return on equity. Recent survey evidence indicates that almost half of all large companies use com. Because it has a monopoly. and telephone companies. the cost of capital is an important factor in the regulation of electric. so they become prohibitively high 145 ." Companies that consistently make wise capital budgeting choices create value for their investors. then discounted those cash flows at the estimated cost of capital. This is its target capital structure. Such a model provides insights into the sources of the company's value. the cost of capital is an increasingly important component of compensation plans. most firms employ different types of capital. gas. reason for deviations relates to flotation costs. The expected rate of return exceeded the cost of the capital. called capital components. which are the costs that a firm must incur to issue securities. Mergers and acquisitions often require enormous amounts of capital. but for now simply accept NCC's 30/10/60 debt. and common percentages as given. and Harcourt when it de. The resulting company. We call this weighted average just that. However. The required rate of return on each capital component is called its component cost. if it were unregulated. Finally. When the decision involves a single project. Daimler had to estimate the total investment that would be re quired and the cost of the required capital. The cost of capital is also necessary to estimate the value of an entire company. However. Thus. Pfizer with Viagra. so Vodafone made the offers. where the capital charge is calculated by multiplying the amount of capital by the cost of capital. For example. they frequently deviate in the short run for several reasons.cremental cash flows that would result from the acquisition. Vodafone AirTouch. and. your electric or telephone company could. but note that these costs are to a large extent fixed. hence it is important for managers to understand the capital budgeting process. so Daimler went ahead with the project. For example. when Daimler-Ben decided to develop the Mercedes ML 320 sports utility vehicle and to build a plat is Alabama to produce it. a U. For example. regulators (1) determine the cost of the capital investors have provided the utility and (2) then set rates designed to permit the company to earn its cost of capital. note that it is possible to finance a firm entirely with common equity.. and it can be used to guide managers when they evaluate alternative courses of action. exploit you. The resulting values were greater than the I targets' market prices.velop a corporate valuation model for itself. this entire capital budgeting process would be incorrect. rate. Assume that NCC's bankers state that a new 30-year. it has new projects available that yield 13 percent. However. The following sections discuss each of the component costs in more detail. This situation can cause managers to make a serious error in their capital budgeting. well above the return on the 2002 projects. and it will probably not be the same as the average rate on NCC's previously issued debt. capital. Therefore. However. and NCC's treasurer is estimating the WACC for the coming year. to finance projects that yield 10 percent. and preferred the following year. Cost of Debt. However. it would have reversed its capital budgeting decisions. and calculate their costs of capital as weighted averages of the various types of fonds they use. debt in the next couple of years. Since the WACC is used primarily in capital budgeting. preferred stock. regardless of the specific source of financing employed in a particular year.if small amounts of capital are raised. but not both. non-callable. In 2003. thus fluctuating around its target capital structure rather than staying right on it all the time.3 percent. raising equity in 2002 and debt in 2003. using up its debt capacity in the process. the average cost of all the capital raised in the past and still outstanding is used by regulators when they determine the rate of return a public utility should be allowed to earn. and each form has a somewhat different cost. it will move away from its target capital structure. To illustrate. it is inefficient and expensive to issue relatively small amounts of debt.T) The first step in estimating the cost of debt is to determine the rate of return debtholders require. Then. assume that NCC is currently at its target capital structure. rejecting all projects in 2 002 and accepting them all in 2 003. for our purposes. kd is equal to 11 percent. some problems arise in practice. For example. and its bonds are publicly traded. straight bond issue would require an 11 percent coupon rate with semiannual payments. or kd. and then we show how to combine them to calculate the weighted average cost of capital. in financial management the WACC is used primarily to make investment decisions. it will at some point find it necessary to raise additional equity. It is unlikely that the financial manager will know at the start of a planning period the exact types and amounts of debt that will be used during the period: The type or types used will depend on the specific assets to be financed and on capital market conditions as they develop over time. but to minimize flotation costs it will raise either debt or equity. as expansion occurs in the future. or marginal. at a cost of 8 percent. debt. The financial staff could use the market price of the bonds to find their yield to maturity (or yield to call if the bonds sell at a premium and are 146 . managers should view companies as ongoing concerns. Thus. this is incorrect. which costs 15. Assume that it is January 2002. and it issues 30-year bonds to raise long-term debt used to finance its capital budgeting projects. and these decisions hinge on projects' returns versus the cost of new. Now suppose NCC borrows heavily at 8 percent during 2 002. which is called the historical. To avoid such errors. because only debt at 8 percent will be used. Thus. How should she calculate the component cost of debt? Most financial managers would begin by discussing current and prospective interest rates with their investment bankers. and that it would be offered to the public at its $1. For example. or embedded. The argument is sometimes made that the cost of capital this year is 8 percent. and debt with and without sinking funds. kd (1 . the relevant cost is the marginal cost of new debt To be raised during the planning period.000 par value. Does it make sense to accept or reject projects just because of the more or less arbitrary sequence in which capital is raised? The answer is no. Although estimating kd is conceptually straightforward. Therefore.3 percent money. because it used up its debt capacity in 2002. or marginal. a company might issue common stock one year. If NCC finances this year's projects with debt. and common stock. NCC could raise a combination of debt and equity. NCC typically issues commercial paper to raise short-terrn money to finance working capital. the company might reject these 13 percent projects because they would have to be financed with 15. Note that the 11 percent is the cost of new. it must issue equity. Even so. straight and convertible debt. the financial manager does know what types of debt are typical for his or her firm. Let's suppose it decides to issue debt. The embedded cost is important for some decisions but not for others. Why should a company accept 10 percent projects one year and then reject 13 percent projects the next? Note also that if NCC had reversed the order of its financing. NCC's treasurer uses the cost of 30-year bonds in her WACC estimate. However. Therefore. and it is now considering how to raise capital to finance next year's projects. Suppose NCC had issued debt in the past. Companies use both fixed and floating rate debt. and it is the interest rate on debt.T) Therefore.6 percent: kd(l -T) . (2) they will find it difficult to raise additional funds in the capital markets. it would incur an underwriting (or flotation) cost of 2. we saw that investors require a return of ks.5 percent. the company bears their full cost.50 = 10. because otherwise (1) they cannot pay dividends on their common stock. although it is not mandatory that preferred dividends be paid. where T is the firm's marginal tax rate:" After –tax component cost of debt = Interest rate – Tax savings = kd .3%. when a firm issues new equity. hence they are incorporated into the formula for preferred stocks' costs. kps. divided by the net issuing price. the cost of debt to the firm is less than the rate of return required by debtholders. Cost of Common Stock. Cost of Preferred Stock. The component cost of preferred stock used to calculate the weighted average cost of capital. is used to calculate the weighted average cost of capital. The YTM (or YTC) is the rate of return the existing bondholders expect to receive. If new shares are issued. 147 . since interest payments are deductible. is the preferred dividend. less the tax savings-that result because interest is deductible.50 per share. Therefore. This too should provide a reasonable estimate of kd The required return to debtholders. kd. To illustrate the calculation. As a result. kps A number of firms. If NCC issued new shares of preferred. and it is also a good estimate of kj.4) . the rate of return that new bondholders would require.3 percent: kps. called flotation costs. use preferred stock as part of their permanent financing mix.4 In fact.$10/$97. is not equal to the company's cost of debt because. if NCC can borrow at an interest rate of 11 percent. If NCC had no publicly traded debt.11%(1. Pm which is the price the firm receives after deducting flotation costs: Component cost of preferred stock = kps = D ps Pn Flotation costs are higher for preferred stock than for debt. a company must earn more than ks on new external equity to provide this rate of return to investors because there are commissions and fees. including NCC. NCC's cost of preferred stock is 10. There are three reasons for this: 1. This is the same as kd multiplied by (1 — T). the government in effect pays part of the total cost.0. Therefore. assume that NCC has preferred stock that pays a $10 dividend per share and sells for $100 per share. then its after-tax cost of debt is 6. what rate of return must the company earn to satisfy the new stockholders? In Chapter 6.6) = 6-6%. today most have a sinking fund that effectively limits their life. firms generally have every intention of doing so. and if it has a marginal federal-plus-state tax rate of 40 percent. The after-tax cost of debt. or $2. ks Companies can raise common equity in two ways: (1) by issuing new shares and (2) by I retaining earnings.T). kd(1 .11% (0. However.likely to be called). Note too that while some preferreds are issued without a stated maturity date. Preferred dividends are not tax deductible. and (3) in some cases preferred stockholders can take control of the firm.kdT = kd (1 . Few mature firms issue new shares of common stock. and no tax adjustment is used -when calculating the cost of preferrd stock. Dps.50 per share. its staff could look at yields on publicly traded debt of similar firms. Flotation costs can be quite high. less than 2 percent of all new corporate funds come from the external equity market. as we show later in this chapter. so it would net $97.0 . Finally. kd. 2. Thus. but nonindexed long-term T-bonds will suffer capital losses if interest rates rise.. because they expect to earn that return by simply buying the stock of the firm in question or that of a similar firm. economy. Estimate the stock's beta coefficient. Estimating the Risk-Free Rate The starting point for the CAPM cost of equity estimate is kRF. it is more difficult to estimate ks. we proceed as follows: Step 1. real estate. However. Whereas debt and preferred stock are contractual obligations that have easily determined costs. What rate of return can stockholders expect to earn on equivalent-risk investments? The answer is ksp. Since we cannot in practice find a truly riskless rate upon which to base the CAPM. Therefore. and a portfolio of short-term T-bills will provide a volatile earnings stream because the rate earned on T-bills varies over time.S. this typically causes its stock price to decline. Treasury securities are essentially free of default risk. if a mature company announces plans to issue additional shares. and (3) the bond-yield-plus-risk-premium approach. However. RPM. 3. we can employ the principles described in Chapters 6 and 10 to produce reasonably good cost of equity estimates. and all are subject to error when used in practice. we generally use all three methods and then choose among them on the basis of our confidence in the data used for each in the specific case at hand. I scaled up or down to reflect the particular stock's risk as measured by its beta coefficient. then it should pass those earnings on to its stockholders and let them invest the money themselves in assets that do provide ks. (2) the discounted cash flow (DCF) method. These methods are not mutually exclusive—no method dominates the others. Therefore. The i signifies the ith company's beta. ks is the cost of common equity raised internally by retaining earnings. for the most part we assume that the companies in our examples. Therefore. Estimate the current expected market risk premium. and so on. like most. There is really no such thing as a truly riskless asset in the U. the firm should earn on its reinvested earnings at least as much as its stockholders themselves could earn on alternative investments of equivalent risk. what rate should we use? A recent survey of highly regarded companies shows that about two-thirds of the companies use the rate on long-term Treasury bonds. the risk-free rate. Three methods typically are used: (1) the Capital Asset Pricing Model (CAPM). The CAPM Approach To estimate the cost of common stock using the Capital Asset Pricing Model (CAPM) as discussed in Chapter 6. Estimate the risk-free rate. An increase in the supply of stock will put pressure on the stock's price. Does new equity capital raised by retaining earnings have a cost? The answer is a resounding yes. b. in which case stockholders could then have reinvested the money in stocks. kRF. There are times when companies should issue stock in spite of these problems.. Investors perceive issuing equity as a negative signal with respect to the true value of the company's stock. If a company cannot earn at least ks on reinvested earnings.. We agree with their choice. when faced with the task of estimating a company's cost of equity. and use it as an index of the stock's risk. forcing the company to sell the new stock at a lower price than existed before the new issue was announced. If some of its earnings are retained. then stockholders will incur an opportunity cost—the earnings could have been paid out as dividends (or used to repurchase stock). do not plan to issue new shares. Step 4. hence we discuss stock issues later in the chapter. Substitute the preceding values into the CAPM equation to estimate the required rate of return on the stock in Question: ks = kRF + (RPM)bF Equation 11-3 shows that the CAPM estimate of ks begins with the risk-free rate. Investors believe that managers have superior knowledge about companies' future prospects. kRfh I to which is added a risk premium set equal to the risk premium on the market. bonds. and that managers are most likely to issue new stock when they think the current stock price is higher than the true value. Step 2. RPM-' Step 3. and here are our reasons: 148 . The following sections explain how to implement the four-step process. T-bond rates can. "Beware of academicians bearing gifts" 149 . their results would have been very different.8 percent over the last 74 years. 1926-1999 Arithmetic Mean Geometric Mean Average Rates of Return Common stocks Long-term corporate bonds Long-term government bonds Treasury bills inflation rate Implied Risk Premiums Common stocks over T-bills Common stocks over T-bonds 13. Note that the risk premium of stocks over long-term T-bonds is about 7. over many periods the Ibbotson data would indicate negative risk premiums.2 Note that common stocks provided the highest average return over the 74-year period.6 5. For example. it is reasonable to think that stock returns embody long-term inflation expectations similar to those reflected in bonds rather than the short-term expectations in bills.1 summarizes some results from their 2000 study. we believe that the cost of common equity is more closely related to Treasury bond rates than to T-bill rates. the geometric average is a better predictor of the risk premium over a longer future interval.8 11. In theory. who examine market data over long periods of time to find the average annual rates of return on stocks. or kRF. T-bills barely covered inflation. 2. This leads us to favor T-bonds as the base rate. That. Table 71 also reports the implied risk premiums. the holding period for the CAPM also should be long. the theoretically correct holding period is the life of the project. In fact. T-bonds.5% 6. which is quite different than the 7. Table 7.5% "7. Indeed.2 percent when using the geometric average. while common stock provided a substantial real return. then the annual arithmetic average is the theoretically correct predictor for next year's risk premium. For example. the next 20 years. is available from Ibbotson Associates. Generally.8 3. the arithmetic average market risk premium has ranged from 5 to 6 percent.1 3.3% 5. the choice of the beginning and ending periods can have a major effect on the calculated risk premiums.. we use the yield on a 10-year T-bond as the proxy for the risk-free rate. Keep in mind that the logic behind using historical risk premiums to estimate the current risk premium is the basic assumption that the future will resemble the past. is contrary to both financial theory and common sense. Note too that using periods as short as 5 to 10 years can lead to bizarre results. the CAPM is supposed to measure the expected return over a particular holding period.5 3. TABLE 7. On the other hand. the | rate on a long-term T-bond is a logical choice for the risk-free rate. which covers the period 1926-1999. However.8 3. updated annually. between stocks and Treasury securities. Common stocks are long-term securities. or differences. If this assumption is reasonable. In light of the preceding discussion. while Treasury bills gave the lowest. but had their data begun some years earlier or later. Ibbotson Associates used the longest period available to them.1 Selected Ibbotson Associates Data. or ended earlier. it is not at all clear that the future will be like die past. say. most experts agree. using data for the past 3 0 or 40 years. Therefore.1.. Since many projects have long lives. of course. most stockholders do invest on a long-term basis. which would lead to the conclusion that Treasury securities have a higher required return than common stocks. When it is used to estimate the cost of equity for a project. be found in The Wall Street Journal or the Federal Reserve Bulletin.8 percent when using the arithmetic average and about 6. All this suggests that historical risk premiums should be approached with caution. It can be estimated on the basis of (1) historical data or (2) forward-looking data.1 7. This leads to the question of which average to use. Historical Risk Premium A very complete and accurate historical risk premium study. As one businessman muttered after listening to a professor give a lecture on the CAPM.2 9. in a CAPM cost of equity analysis. Therefore. RPM. kM — kRF. Treasury bill rates are more volatile than are Treasury bond rates and. and a set of high-grade corporate bonds. and although a particular stockholder may not have a long investment horizon. T-bills. is the expected market return minus the risk-free rate. 3.3% 5. Estimating the Market Risk Premium The market risk premium.9 5. more volatile than ks. The most common approach to forward-looking premiums is to use the discounted cash flow (DCF) model to estimate the expected market rate of return. to equal past results. many households have dual incomes. and since the current market value of the index (used for P 0}is I also known.3 percentage point from one another. However. what we really want is the marginal investor's expectations. the World War II years of the 1940s. which should make them less risk averse. The risk premium is driven primarily by investors' attitudes toward risk. The advent of pension plans. since the different approaches give different results. the estimation task is simplified because one can reasonably assume a constant long-term growth rate for a portfolio of mature stocks such as those in the S&P 500. though. one can use the Zacks or IBES aggregate growth rate forecast. This procedure recognizes that if markets are in equilibrium. to develop a consensus RP M forecast and thus avoid potential bias from the use of only one organization's estimate.2 and 7. and 11 percent use a premium in the range of 4 to 4. it appears that the market risk premium is somewhere in the area of 4. on average. when using the CAPM to estimate the cost of equity. To further muddy the waters. it appears that the market risk premium is somewhere between 6. since several studies have proved beyond much doubt that investors. Note. Several services (including Zacks and Institutional Brokers Estimate System. health insurance. it is best to use a current estimate of the ex ante RPM. a forecast based on DCF methodology for the expected rate of return on the market. that ex ante risk premiums are not stable: they vary over time. the previously cited survey indicates that 37 percent of responding companies use a market risk premium of 5 to 6 percent. and disability insurance means that people today can take more chances with their investments. RPMTwo potential problems arise when we attempt to use data from organizations such as Value Line. However. However. Here is our opinion. the estimated risk premium varies greatly depending on the period selected. so when we estimate kM) we are also estimating kM: Since Dj for the market as measured by the S&P 500 or some other index can be predicted quite accurately. all of which are included (and given equal weight with more recent results) in the bbotson data. The second problem is that there are a number of securities firms besides Value Line. and there are good reasons to believe that investors are less risk averse today than 50 years ago.forward-Looking Risk Premiums The historical approach to risk premiums used by Ibbotson Associates assumes that investors expect future results. at any given time. One can subtract the current T-bond rate from such a market forecast to obtain an estimate of the current market risk premium. the expected rate of return on the market is also its required rate of return. this is probably not a major problem. Moreover. Using the historical Ibbotson data over die last 74 years. Even here. the forward-looking risk premium has been in the range of 4. we have followed the forecasts of several of the larger organizations over a period of several years. on a regular basis. in the past 30 to 40 years. and finally to use this estimate of RPM in the Security Market Line. and. kM = kM. First. In recent years. or ex ante.5 percent. it has been toward the low end of the range when interest rates were high and toward the high end when rates were low. The questionable assumption that future expectations are equal to past realizations. not those of a security analyst.8 percent. 15 percent use a premium provided by their financial advisors (who typically make a recommendation of about 7 percent). then to calculate RPM as kM — kRF. Also. has led to a search for forward-looking. together with the sometimes nonsensical results obtained in historical risk I premium studies. and we have rarely found their kM estimates to differ by more than ±0. Social Security. Using the forward-looking approach. investors today probably expect results in the future to be different from those achieved during the Great Depression of the 1930s.5 percent. Therefore. along with an aggregate dividend yield.5 to 5. which 150 . Financial services companies such as Value Line publish. However. the average expected long-term growth rate for the market index. in any event. and the peaceful boom years of the 1950s. form their own expectations on the basis of professional analysts' forecasts. or IBES) publish data on the forecasts of essentially all widely followed analysts.5 to 6. kM. different analysts' forecasts of future market returns are somewhat different. Our View on the Market Risk Premium After reading the previous sections. This suggests that it would be most appropriate to obtain a number of forecasts of kM and then to use the average value to estimate RP M for use in the SML. on average. Therefore.5 percent. you might well be confused about the correct market risk premium. however. depending on whether you use an arithmetic average or a geometric average. the historical premium has been in the range of 5 to 6 percent. the major task is to estimate g. risk premiums. and. as we noted. but it is worthwhile to repeat some of them here. The average company has an estimated beta of 1. First.1. weekly. it is hard to know the correct estimates of the inputs required to make it operational because (1) it is hard to estimate the beta that investors expect the company to have in the future. For example. we conclude that the true risk premium in 2001 is almost certainly lower than the long-term historical average of more than 7 percent.4. the "true" beta may have changed during the sample period. We described these complications in detail in Chapter 7. Finally. but the 95 percent confidence interval ranges from about 0. you should always bear in mind that while the estimated beta is useful when calculating the required return on stock. we typically use a risk premium of 5 percent.4. called a fundamental beta. called an adjusted beta. The resulting beta is called the historical beta. even the best estimates of beta for an individual company are statistically imprecise.0. In practice. Another modification. Patting it all together. Fourth. With too few observations. But how much lower is the current premium? In our consulting. Even though these indexes are highly correlated with one another. In practice. One modification. the regression loses statistical power. such as changes in its product lines and capital structure.5 percent.. with the company's stock returns on the y-axis and market returns on the x-axis. since it is based on historical data. or monthly time periods. An Illustration of the CAPM Approach To illustrate the CAPM approach for NCC. hut we would have a hard time arguing with someone who used a risk premium in the range of 4.6 to 1. but with too many. if a firm's stockholders are not well diversified.also allows investors to take more chances. there is no theoretical guidance as to the correct holding period over which to measure returns. even if the CAPM method is valid. Beta is also sensitive to the number of observations used in the regression. assume that kRF = 8%. So. managers and financial analysts must learn to live with some uncertainty when estimating the cost of capital. Further. the historical average return on the market as Ibbotson measures it is probably too high due to a survivorship bias. and the resulting estimates of beta will differ. the market return should. First. where the true beta is the one that reflects the risk perceptions of the marginal investor. precise estimate of kg.0. although we are extremely doubtful that the premium market is less than 4 percent or greater than 6 percent. there are actually several problems with it.6 to 1. incorporates information about the company.0. and the CAPM procedure would understate the correct value of kj. The returns for a company can be calculated using daily. they may be concerned with stand-alone risk in addition to market risk. and (2) it is difficult to estimate the market risk premium. the firm's true investment risk would not be measured by its beta. Third. RPM = 6%. the NYSE Composite. some organizations modify the calculated historical beta in order to produce what they deem to be a more accurate estimate of the "true" beta. attempts to correct a possible statistical bias by adjusting the historical beta to make it closer to the average beta of 1. it is common to use either four to five years of monthly returns or one to two years of weekly returns.5 to 5. however. or the Wilshire 5000. then you can be 95 percent sure that the true beta is in the range of 0. Therefore. using different indexes in the regression will often result in different estimates of beta. even the human capital being built by students. reflect every asset. Estimating Beta Recall from Chapter 6 that beta is usually estimated as the slope coefficient in a regression. The bottom line is that there is no way to prove that a particular risk premium is either right or wrong. it is common to use only an index of common stocks such as the S&P 500.6 percent: It should be noted that although the CAPM approach appears to yield an accurate. Although this approach is conceptually straightforward. it is not absolutely correct. NCC's cost of equity is 14. Therefore. if your regression produces an estimated beta of 1. theoretically. complications quickly arise in practice. 151 . and bi = 1. In that case. Second. indicating that NCC is somewhat riskier than average. and (3) analysts' forecasts. G = b(r) Here r is the expected future return on equity (ROE). obtain a large number of quite different growth rates. = ∑(1+k t −1 )t Here PQ is the current price of the stock. and if investors expect these trends to continue. and ks is the required rate of return. the use of historical growth rates in a DCF analysis must be applied with judgment. the growth rate is by far the most difficult to estimate. We illustrate several different methods for estimating historical growth in the file Ch 11 Tool Kit.6 percent to 11.0 percent. and thus the retention rate. (2) the retention growth model. Therefore. then Equation 11-4 reduces to P0 = D1 k s −g We can solve for ks to obtain the required rate of return on common equity. Equation 11-7 produces a constant growth rate. r. b = 1 -Payout. This method of estimating the cost of equity is called the discounted cash flow. For NCC. with most estimates fairly close to 7 percent. then investors might base future expectations on past trends. the current dividend. we will assume that equilibrium exists. Dt is the dividend expected to be paid at the end of Year t. P0 Thus. making four important assumptions: (1) We expect the payout rate. g. Henceforth.xls on the textbook's CD-ROM. by implication. one can take a given set of historical data and. or DCF. unfortunately. we saw that both the price and the expected rate of return on a share of common stock depends on the dividends expected on the stock: P0 = − (1+ k s ) 1 (1+ k s ) 2 Dt s D1 + D2 +. Estimating inputs for the DCF Approach Three inputs are required to use the DCF approach: the current stock price. or Discounted Cash Flow (DCF). and the expected growth in dividends. . but. and b is the fraction or its earnings that a firm is expected to retain (1 — Payout ratio). we rarely find much historical stability. Historical Growth Rates First. Di/P0.xls shows. In equilibrium this expected return is also equal to the required return. Of these inputs. The following sections describe the most commonly used approaches for estimating the growth rate: (1) historical growth rates. and we reasoned that. to remain constant. . but when we use it we are. which for the marginal investor is also equal to the expected rate of return: Ks = ks = D1 + Expected g. depending on the years and the calculation method used. hence ks = ks. This is a reasonable proposition. ks. for a total expected return of ks. investors expect to receive a dividend yield. Approach In Chapter 10. if past growth rates have been stable. method. If dividends are expected to grow at a constant rate. then the past realized growth rate may be used as an estimate of the expected future growth rate. so we can use the terms ks and ks interchangeably. As the Ch 11 Tool Kit. if earnings and dividend growth rates have been relatively stable in the past. and also be used (if at all) in conjunction with ^-' ~r growth estimation methods as discussed next. these different methods produce estimates of historical growth ranging from 4. Now recall our purpose in making these calculations: We are seeking the future dividend growth rate that investors expect. (2) we expect the return on equity on new investment. plus a capital gain. Retention Growth Model Another method for estimating the growth rate is to use the retention growth model. to equal the firm's 152 .Dividend – Yield – plus –Growth – Rate. is also judgmental. and all of its new equity will come from retained earnings. However. its cost of preferred stock. These results arc unusually consistent.6) . and 60 percent common equity. and (4) future projects are expected to have the same degree of risk as the firm's existing assets. For example. are used to calculate the firm's-WACC. Because the 4 percent risk premium is a judgmental estimate. a riskier company. and common equity.6% + 14. The bond-yield-plus-risk-premium is used primarily by companies that are not publicly traded. The overall average of these three methods is (14. Composite." Comparison of the CAPM.3 percent. preferred. its cost of common equity. Therefore.12%. 10 percent preferred stock.. as follows: 153 . each firm has an optimal capital structure. However.current ROE. the DCF constant growth estimate is 14. its marginal tax rate is 40 percent.14. along with the component costs of capital. and common equity that causes its stock price to be maximized. Cost of Capital. have a yield of 10. its after-tax cost of debt is kd(l . For NCC. we expect this new stock to be sold at a price equal to its book value. kd. In this chapter. if an extremely strong firm such as BellSouth had bonds which yielded 8 percent. WACC.' This is in sharp contrast to a 1982 survey. People experienced in estimating equity capital costs recognize that both careful analysis and sound judgment are required. and 85 percent in the other.4%)/3 = 14. the CAPM estimate is 14. It is logical to think that firms with risky.T) = 11%(0.4 percent.5 percent. WACC As we shall see in Chapters 16 and 17.6%. We can calculate NCC's weighted average cost of capital. To illustrate. that it uses this optimum as the target. its cost of equity might be estimated as follows: ks = Bond yield + Risk premium = 8% 4. which implies that we expect the return on equity to remain constant.5% + 14. down from 31 percent in 1982. and the bond-yield-plus-riskpremium is 14. and the procedure of basing the cost of equity on a readily observable debt cost utilizes this logic. A 2000 research paper that reported the results of two surveys found that the CAPM approach is by far the most widely used method. suppose NCC has a target capital structure calling for 30 percent debt. or.4%. Bond – Yield-plus-Risk –Premium Approach Some analysts use a subjective.5%. kps. a value-maximizing firm will establish a target (optimal) capital structure and then raise new capital in a manner that will keep the actual capital structure on target over time. the estimated value of ks. if it does. Empirical work in recent years suggests that the risk premium over a firm's own bond yield has generally ranged from 3 to 5 percentage points. How the target is established will he examined in Chapters 16 and 17.5 percent. and consequently high-interest-rate debt will also have risky.4 percent. The bonds of NCC. precise way of determining the exact cost of equity capital. The target proportions of debt. preferred stock. so this method is not likely to produce a precise cost of equity.4% + 4% . if the methods produced widely varied estimates. we assume that the firm has identified its optimal capital structure. and that it finances so as to remain constantly on target.10.6. which found that only 30 percent of respondents used the CAPM. is 11 percent. (3) the firm is not expected to issue new common stock. used the CAPM. is 10.4% . so it would make little difference which one we used. and Bond-Yield-plus –Risk – Premium Methods We have discussed three methods for estimating the required return on common stock. DCF. ad hoc procedure to estimate a firm's cost of common equity: they simply add a judgmental risk premium of 3 to 5 percentage points to the interest rate on the firm's own long-term debt. is 14. then a financial analyst would have to use his or her judgment as to the relative merits of each estimate and then choose the estimate that seemed most reasonable under the circumstances. Its before-tax cost of debt. it can get us "into the right ballpark. Approximately 16 percent now use the DCF approach. or Weighted Average. Although most firms use more than one method. this is not possible—finance is in large part a matter of judgment. low-rated. defined as that mix of debt. making its estimated cost of equity 14-4 percent: ks . It would be nice to pretend that judgment is unnecessary and to specify an easy.6 percent. almost 74 percent of respondents in one survey. It. high-cost equity. and we simply must face that fact. Unfortunately. 6) + 0.WACC = wdkd(1 . preferred. which is presumably an estimate of the firm's optimal capital structure. some preferred. The determination of the right value of a business firm is crucial for the sustainable long-term success of the acquisition. (2) current market values of the capital components. First.3(11. Historically the comparable firms method and the adjusted book value method have been the more commonly used approaches to valuation of firms.o(14. However. etc. and wce are the weights used for debt.6 percent. Every dollar of new capital that NCC obtains will on average consist of 30 cents of debt with an after-tax cost of 6. dollar of capital—it is not the average cost of all dollars raised in the past. the percentages of each capital component. 10 cents of preferred stock with a cost of 10. the perceptions of value have to be backed up by reality.3 percent. every investor has to answer the question "Where will I be when the music stops?" Source: Damodaran on Valuation: Security Analysis for Investment and Corporate Finance by Aswath Damodaran DISCOUNTED CASH FLOW APPROACH The discounted cash flow model relates the value of the firm to the present value of its expected future cash flows. This is patently absurd. raise money in the future. Second. each of these new dollars will consist of some debt. However. The discounted cash flow approach to valuation relates the value of the firm to the present value of the expected future cash flows of the firm. Value and Pricing A postulate for sound investing is that an investor does not pay more for an asset than its worth. there is one point on which there can be no disagreement: pricing cannot be justified by merely using the argument mat there will be other buyers around willing to pay a higher price in the future. Two points should be noted. on average. On average. the comparable firms approach and the adjusted book value approach. in the recent years. which implies that the price paid for any asset should reflect the cash flow it is expected to generate. Some of the common approaches to valuation are the discounted cash flow approach. coupons and redemption value for bonds and the post-tax cash flows for a project.11. There are those who are disingenuous to argue that the value lies in the eyes of the beholder and that any price can be justified. and for this purpose the cost of the new money that will be invested is the relevant cost.7 percent. there is a marked shift towards the application of the discounted cash flow method. The reasons for its increasing popularity and acceptance is its conceptual soundness and its strong endorsement by leading investment bankers and consultancy firms. could be based on (1) accounting values as shown on the balance sheet (book values). if there are other investors willing to pay that price. book value.5%) . wps. including the actual estimates of the true value and the time taken for the prices to adjust to their true value. The comparable firms approach estimates the value of a firm in relation to the value of other similar firms based on various parameters like earnings. before playing. respectively. The average cost of each whole dollar. or marginal. There are many areas in valuation on which there is room to disagree. This statement may seem logical and obvious. sales. but investors do not (and should not) buy assets or firms for aesthetic or emotional reasons. Perceptions may be all that matters when the asset is a painting or a sculpture.3%) + u. is 11.0%)(0.7%. The nature of the cash flows will depend upon the asset: dividends for an equity share. This approach is based on the time value 154 .0.1(10. We are primarily interested in obtaining a cost of capital for use in capital budgeting. called weights. Consequently. Valuation of firm(s) as a going concern is the base for any merger and acquisition exercise.T) + wpskps + wceks . That is equivalent to playing a very expensive game of musical chairs in which. The adjusted book value approach to valuation involves estimation of the market value of the assets and liabilities of the firm as a going concern. the WACC is the weighted average cost of each new. There are various approaches and methodologies for valuation of a firm. the WACC. cash flows. They buy them for the cash flows they expect to receive. and common equity. Here w(]. since this is the best estimate of how the firm will. but it is forgotten and rediscovered at sometime in every generation and every market. and 60 cents of common equity with a cost of 14. The correct weights are those based on the firm's target capital structure. and some common equity. or (3) management's target capital structure.5 percent. The cost of capital is the rate to be used for discounting the free cash flows to their present values. The first step in the Discounted Cash Flow approach entails estimating the Free Cash Flow for the explicit forecast period.g. The Gross Cash Flow of the firm can be computed as follows: Earnings Before Interest and Taxes (EBIT) Less: Taxes on EBIT = Net Operating Profit Less Adjusted Taxes (NOPLAT**) Add: Add: ** Depreciation Non-Cash Charges Gross Cash Flow NOPLAT can also be computed as EBIT (1 .concept where the value of any asset is the present value of its expected future cash flows. One of the premises of this theory is that the firm is a going concern. Repayment of loans ana redemption/amortization of bonds. The free cash flow of a firm is the sum of its free cash flow from operations and its non-operating cash flows. This finite period (say 7 years) for which the free cash flows are computed is called as the explicit forecast period. Redemption/amortization of preference shares. Weightages based on market value is considered to be superior to assigning weights based on book value. This implies that the ROCE. reinvestment rate and the growth rate remain constant in perpetuity after the explicit forecast period. This is to ensure consistency in the approach. as the free cash flow is computed on post-tax basis. These include the equity holders. The second step in the DCF model involves computation of the cost of capital to the firm. Buy-back of equity shares. 155 . On the other hand. It is also important to obtain a historical perspective before forecasting the expected free cash flow of the firm. For e. • • • • • Interest payments (post-tax basis). The Gross Investment can be computed as follows: Increase in Net Working Capital Add: Capital Expenditure incurred Add: Increase in Other Assets Gross Investments Non-Operating Cash Flows represent the post-tax cash flows from items other than the regular operations of the firm. The historical analysis involves careful perusal of past financial statements. The free cash flow is used for the following purposes.tax terms. This is because book values represent the financial legacy rather than a current perspective. The explicit forecast period of the firm also needs to be determined. The implication of this assumption is that cash flows in perpetuity need be discounted to value the firm. weightages based on market value are taken to represent the economic claims of the various providers of capital. Hence the cash flows are explicitly computed for a finite period of time and the continuing value of the firm at the end of such period is computed. The weights assigned are based on the market value or each or the components of the capital. Equity and preference dividend. The cost of capital is to be computed as the weighted average of the costs of all sources of capital. Secondly the cost of capital is to be computed on post. The principal drivers which affect the free cash flow are the Return on Capital Employed (ROCE) and the Reinvestment Rate. The firm is expected to stabilize and reach a steady state at the end of the explicit forecast period. profit realized on sale of fixed assets.t) where t is the tax rate of the firm. analysis of the historical ROCE and reinvestement rates and assessing the sustainability of these rates over the explicit forecast period. This is. Normally the explicit forecast period is coterminous with the period during which the company enjoys competitive advantage. impossible in practice. The free cash flow from operations is the difference between the gross cash flow of the firm and its gross investments. however. the preference investors and the providers of debt to the firm. The free cash flow represents the cash flow available to all the suppliers of capital to the firm. The cost of capital is to be computed as follows: k o = kev + kpv + M1-') v where. The continuing value of the firm may be computed as follows: where. The premise of this method is that the free cash flow will grow at a constant rate after the explicit forecast period. Continuing value is also referred to as the horizon value. S + P + B is the tax rate applicable to the firm. The Book Value Method values the firm at its book value at the end of the explicit forecast period. Price Earnings Multiple (P/E) Method and the Replacement Cost Method. In addition to the above method. The advantage of this method is its familiarity as it is extensively used to value equity. the continuing value may be dominant component of the value of the firm. The 156 .e. In many cases. Some valuers use a variation of this method and values the firm as a multiple of its book value. The earnings are multiplied by an appropriate multiple (P/E ratio) to determine the continuing value. The third step in the DCF model involves computing the continuing value of the firm. There are a number of methods to compute the continuing value. Hence the impact of the same would have been reflected in the free cash flows which would have been understated to that extent. The non-cash flow based methods are the Book Value Method. kQ ke k_ kd S P B V t is the weightage average cost of capital is the cost of equity capital is the cost of preference capital is the cost of debt is the market value of equity capital is the market value of preference capital is the market value of debt is the sum of the market values of the equity capital. The Price Earnings Multiple Method involves valuing the firm based on its earnings of the first year after the explicit forecast period. Hence the valuer should be circumspect and realistic in computing the continuing value. The most common method is the Free Cash Flow method. preference capital and the debt i. Another drawback is that the book values are influenced by the accounting policies. there are a number of non-cash flow based methods. CV FCFn+1 k g is the continuing value of the firm at the end of the year n is the expected free cash flow for the year n + 1 is the weighted average cost of capital of the firm is the expected perpetual growth rate of the free cash flow. The main drawback of this method is that it does not take into account the increase in the book value due to inflation. This is because the cost of extending credit would have been factored in by the seller in pricing of the goods/services. The continuing value represents the value of the free cash flows beyond the explicit forecast period. It is to be noted that non-interest bearing debt like sundry creditors and bills payable are to be excluded in the above computation. 80 crore.1 Swagat Enterprises is engaged in the construction business. loans.g.main drawback is that this method uses earnings. Infosys Technology). some of these aspects are the principal factors responsible for the success of a firm. The last step in the DCF model involves determination of the value of the firm. However. in some instances. Valuation: A Science or An Art Valuing a company is neither an art nor a science but an odd combination of both. The value of non-operating assets like investments should be added to it. the net current assets will remain at 10% of the net fixed assets.l0 crore. etc. The sales of the firm are expected to grow at the rate of 10% per year for the next 5 years. The market value of all claims (bonds issued. Depreciation is to be charged @ 10% of the net fixed assets at the beginning of the year. Swagat Enterprises will be making the following investments: Year Investment in fixed assets (Rs. To finance this expansion. Illustration 7. failure is assured.g. All the investments will be made at the beginning of the respective years.) on the firm should be deducted to arrive at the ownership value of the firm. reputation of the firm for its ethical practices (e. There is enough science that appraisers are not left to rely solely on experience but there is enough art that without experience and judgments. Secondly. During the same period. due to the high degree of subjectivity involved in its computation. In such an eventuality. crore) 20 0 10 15 0 1 2 3 4 5 Throughout the five-year period. Ignoring these factors as non-replaceable grossly understates the value of the firm. 157 . Secondly. the valuation process becomes inconsistent due to use of cash flows in valuing the firm in the explicit forecast period and the use of earnings thereafter. The main drawback of this method is that only certain assets can be replaced. the replacement cost exceeds the value of the firm as a going concern. The corresponding level of net current assets stands at Rs. the operating expenses are expected to increase at the rate of 8% per annum. cannot be replaced. it may be simply uneconomical to replace some of its assets. Some non-tangible factors like relationships with customers (e. etc. which is vulnerable to distortion. Goldman Sachs relationship with their clients). The replacement cost method determines the continuing value based on the replacement cost of its assets. Its current financials are as follows: Rs. employee loyalty. (in crore) 100 40 60 10 50 20 Sales Operating expenses EBDIT Depreciation EBIT Tax (@ 40%) The current level of its net fixed assets is Rs. The free cash flow projections and the continuing value of the firm should be discounted by the cost of capital to arrive at the present value of the cash flows. From the sixth year onwards.40 crore. Investment in Net Current Assets Year Total Net Current Assets Net current assets at the end of previous year Investment in net current assets Investment Gross investment 1 10 10 0 20 20 2 9 10 -1 0 —1 3 4 9 10 9 9 0 1 5 9 10 —1 0 -1 10 15 10 16 158 . the free cash flow is expected to grow @ 10% per annum. The cost of equity is 15%.ll0 crore. crore) 10 5 20 1 3 4 The post-tax cost of debt is 8% for the firm. Solution Step 1 Calculating the Gross Cash Flow for the explicit forecast period Year Sales Operating Expenses EBDIT depreciation** EBIT Taxes NOPLAT Gross Cash Row ** Depreciation is calculated as follows: Year Net fixed assets at the end of previous year Additions at the beginning of the year Total Depreciation for the year 1 80 20 2 3 4 5 1 110 43 67 10 57 23 34 44 2 121 47 74 9 65 26 39 48 3 133 50 83 9 74 29 44 53 4 146 54 92 10 82 33 49 59 5 161 59 102 9 94 37 56 65 90 81 82 87 0 10 15 0 100 90 91 97 87 10 9 9 10 9 81 82 87 78 Net fixed assets at the 90 end of the year Step 2 Calculating the gross investment a. The market value of debt is Rs. and the market value of equity is Rs. The post-tax non-operating cash flows will be as follows: Year — Non-operating cash flows (Rs. Calculate the value of Swagat Enterprises. b.The tax rate will continue to be at 40%. 6906 0.12 38.7813 0.5396 Present value 30. The firm may have some assets which do not produce any cash flows.26 38.45 33.(2495 .g. the expected cash flows can be reliably estimated and there exists a proxy for risk which is required in computation of discount rates. The limitations of the DCF approach become apparent in the following cases. staff quarters. surplus land. unutilized floor space in factory buildings. The value of such assets will not be reflected in the DCF valuation. in a real life situation.75 35. However.495 cr Market value of debt Value of equity = = = Limitations of DCF Approach The DCF approach is the ideal model to be used when a firm has positive future cash flows.2. the valuer faces some practical challenges.08 x 40/150) + (0. The 159 Rs.10 (0.6104 0.40) cr Rs.15 x 110/150) 13.10 + 2319 = Rs. . For e.52 176.8839 0. etc.13% 1 44 20 24 10 34 2 48 -1 49 0 49 3 53 10 43 5 48 4 59 16 43 20 63 5 65 -1 66 0 66 Value of the firm = Discounted free cash flows + Discounted continuing value = 176.Step 3 Calculating the Free Cash Flow Year Gross cash flow Gross investment Free cash flow from operations Non-operating cash flow Free cash flow Step 4 Ascertaining the cost of capital Cost of capital = Step 5 Determine the present value of the free cash flow Year 1 2 3 4 5 Total Step 6 Calculating the discounted continuing value Free cash flow 34 49 48 63 66 PV factor 0. Asset Rich Firms: DCF valuation reflects the value of all the assets which produce cash flows.40 cr Rs. 1.2455 cr. Reliance Industries plays a dominant role in the petrochemical industry in India and commands a valuation multiple than IPCL. Analysis of the Firm The valuer is required to make an indepth analysis of the firm to get rich insights into the financial and operational aspects. one of the factors due to which Infosys Technologies commands high valuation is the market perception of its exemplary corporate governance. Further such firms have a high probability of going into bankruptcy. The second challenge involves estimating the effect of the resultant change in management (due to the merger or the takeover) on the discount rates due to the change in the risk profile of the firm. The profitability of the firm may be analyzed by looking at the operating profit margins and the net profit margins. The qualitative analysis includes assessing the position of the firm in the industry.g. The efficiency of the operations can be captured from ratios like inventory turnover. The present value of such firms will be a negative figure under the DCF method. Firms with Product Options: Firms often have unutilized product options which do not generate any current cash flows. market share. This limitation is more pronounced when the transaction involves a hostile takeover. debtors turnover. COMPARABLE FIRMS APPROACH This approach is also called as the relative approach. The challenge involved in such a valuation exercise is understanding the nature and form of the synergy and estimating its value in financial terms to compute its impact on the expected cash flows. Similarly firms may also have unutilized intellectual property rights like patents and copyrights. 160 . as their values will be understated in the DCF model. for companies involved in oil exploration. Firms in Distress: Firms in financial distress may have negative current and future cash flows. Mergers/Takeovers: A key driver in several merger/takeover transactions is the expected synergy between the two firms. 2. the value of any firm is derived from the value of comparable firms. Further analysis may be made by analyzing the return on capital employed and return on net worth. to a lesser extent. The valuation process applying this approach is a four staged exercise. For e. the firm will be grossly undervalued. The comparable firms model is essentially a top-down approach. The liquidity position may be analyzed from the current ratio and quick ratio. 5. to underutilized assets. sales. The valuations can be misleading if the explicit forecast period does not cover the entire economic cycle.g. This violates the basic premise of the DCF approach which views a firm as a going concern. 4. For e. winning the right to drill oil and gas in a particular region represents a product option. The most common manifestation of the comparable approach is in the use of the industry average PriceEarnings multiple (P/E ratio) for valuation of equity. The managerial evaluation is also important as the competence and integrity of the management have a greater bearing on the valuation. 3. In this approach. etc. etc. The earnings and cash flows are high during the boom periods and are low during recessionary periods. Some practitioners have overcome this limitation either by obtaining the market value of such options or by applying the option pricing model for its valuation. fixed assets turnover. The capital structure of the firm also needs to be analyzed.same limitation also applies. The cash flows of the firm need to be carefully studied and a sensitivity analysis may be conducted.g. If DCF model is applied for such valuations. book value. However this is an onerous task and the resulting valuation can be highly subjective depending on the valuer's assumptions about the timing and the duration of the phases of the economic cycle. competitive advantage (if any) etc. Another commonly used tool for valuing equity is the PriceBook Value multiple (P/BV ratio). based on a set of common variables like earnings. For e. The resultant value of the option is added to the value obtained from DCF valuation to arrive at the true value of the firm. cash flows. The ownership pattern plays its part as historically MNC firms have been given higher valuation vis-a-vis domestic firms as they are considered to be better managed. Cyclical Firms: The cash flows of cyclical firms tend to shadow the performance of the economy. The interest coverage and the debt service coverage would provide pointers to the solvency position. The identification process generally involves delineating a list of firms which bear some resemblance to the firm being valued. The valuer is to carefully assess the general profile of the industry.00 Beta 1.) (Rs. in cr. 1. Buildings are normally valued at replacement cost. ADJUSTED BOOK VALUE APPROACH The adjusted book value approach to valuation involves estimation of the market value of the assets and liabilities of the firm as a going concern.. etc. It is. etc. technology. Valuation of Tangible Assets The approach begins with valuation of all the assets of the firm.31 2. competitive structure. using the comparable firms approach. 2 and 1 respectively. the finished goods at the current realizable sale value after deducting provisions for 161 . availability of inputs. Land is valued at its current market price.65 Price/Book 2. however. debtors and cash. which can match the subject firm on all or even most of the parameters. The inventory is valued depending upon its nature. Solution The valuation multiples of the comparable firms are as follows: Particulars Price/Sales Ratio Price/Earnings Ratio Price/Book Value Ratio Alpha 1. Thus the weighted average value will be = Rs. The value of Sigma Ltd. markets served.35 60 141. Similarly plant & machinery.60 9. P/E ratio and the P/BV ratio are 1. Fixed assets constitute substantial portion of the asset side of the balance sheet in capital intensive companies.32 cr. The next step involves identification of firms with comparable profile. The other major block on the asset side of the balance sheet is current assets. are selected.45 9.) Price/Sales 1. fixtures. demand-supply position.45 100 145. From the universe identified as above three to five specific firms which bear similarity.25 8. An alternative method of valuing plant & machinery involves estimation of the prevailing market price of similar used (second-hand) machinery and adding the cost of transportation and erection.50 10.00 3.40 Avg.32 cr.60 2. to the firm being valued.Identification of Comparable Firms The next stage involves identification of comparable firms. is Rs. The principal components of current assets are inventory. capital equipments. etc. Once a universe of potentially comparable firms is identified.35 Applying the above multiples. are to be valued at fixed costs net of depreciation and allowances for deterioration in conditions. furniture.31 15 139. each of the firms is analyzed based on the predetermined parameters.00 Value The weightages to P/S ratio. pricing system.33 1.141.141. The conventional approach relies on the historical book value of the assets and liabilities as against the valuation of the assets and liabilities at their fair market value in this method. in cr. government policies and regulatory framework. cost structures. scale of operations.00 Price/Earnings 9. It is a pointer to the liquidation value of the firm. distinct from the conventional book value method. it is virtually impossible to find truly similar firms. However appropriate allowances are to be made for depreciation and deterioration in its conditions. as close as possible. This process begins with a thorough analysis of the industry in which the firm operates. the value of Sigma is as follows: Particulars Multiple Parameter Value (Rs.66 Gamma 1. long-term trends. the raw materials are to be valued at the rates of the latest orders. geographical location. installed capacities. In practice. The parameters used for identification of such firms include product profile. sale price of the finished product less cost incurred to convert the work-in-process into sales. are to be valued at their present value using the standard bond valuation model. etc. Normally such current liabilities and provisions are taken at their book value. distribution channel. As intangibles have significant financial value. However. The work-in-process can be valued either based on the cost i. etc. since it did not take into account the company's strong brands. allowances should be made for any doubtful debts. RHM issued a defense document that mentioned that GFW bid significantly undervalued RHM's true worth.e.packing. However. Debtors are generally valued at their book value. transportation.170 cr to acquire the soft drinks brands of Parle). Valuation of cash (including balances with bank) does not need any great expertise. failing which the intangible asset may be overvalued. Valuation of Intangible Assets The valuation of intangible assets like brands. All long-term debt like loans. The two popular methods of valuing intangibles are given below. are generally valued at their fair market value. etc. In the late eighties. provision for taxes. It must be noted that share capital.g. staff quarters. cost of materials plus processing costs incurred or based on the sales price i. The idea of intangibles as financial assets emerged in the mid-eighties. are to be taken at their book value. deposits made etc. etc. Non-operating assets like investments. RHM engaged the services of a professional consultancy firm to do a brand valuation. etc. The value of an intangible like any other asset is equal to the present value of the future earnings attributable to it. Only liabilities owed to outsiders are to be considered. goodwill. Cost Method: This method involves stating the value of the intangible asset at its cost to the company. Coca Cola paid Rs. This involves computing the present value of the debt servicing (both principal and interest payments) by applying an appropriate discount rate. their absence from the valuation distorts the true financial position of a company. accrued expenses. (For e. selling costs. The process of identification of the the costs incurred is characterized by a great degree of subjectivity. applying an appropriate multiplier to determine its present value. It said "These valuable assets are not included in the balance sheet. 162 . the Australian group. Hence in order to ensure that the valuation of a company is reflective of its true intrinsic worth it has become necessary for companies to determine the values of their brands. there is a large element of subjectivity in the process of valuation of intangibles. It is more difficult to value the brand when the intangible asset has been developed in-house by the company. Further the process of determining the multiplier is highly subjective. Earnings Valuation Method: This method of valuation is widely accepted in most markets around the world. the consultants valued the business at 900 million Pounds. but they have helped RHM build profits in the past and provide a sound base for future growth". Due care has to be taken for the above factors. The main drawback of this approach is that the future projections of the earnings may be optimistic. Once they published that information. Goodman Fielder Wattie (GFW) mounted a hostile bid on a British company Ranks Hovis McDougall (RHM). The methodology involves determining the cost incurred in developing the intangible asset. patents. reserves and surpluses are not included in the valuation. Viewing brands as assets. significantly higher than GFW bid of 600 million Pounds. This may have a significant impact on the final valuation. prepaid expenses. short-term borrowings. advance payment received. is a controversial area of valuation. This is relatively easy when the intangible asset is acquired. The money paid to buy the brands can be directly stated.e. Unscrupulous companies may possibly overvalue the intangibles and use brand values as a tool for window dressing. bonds. Current liabilities include amount due to creditors. it was clear that GFW's bid undervalued the business and the bid finally drifted away. Valuation of Liabilities The valuation of liabilities is relatively simple. This is a two-staged process involving • • determining the future earnings attributable to the intangible asset. surplus land. Several major companies (consumer goods in particular) believe that brands are its most valuable assets. Miscellaneous current assets like income accrued but not due. trademarks & copyrights. However. it is impractical to determine the variance in the first place. Hence a discount factor may be applied. Normally no premium is added for control as assets and liabilities are taken at their economic values. CONTEMPORARY DEVELOPMENTS IN VALUATION THEORIES A significant portion of the current research in the area of valuations is devoted to the application of option theory to value firms. The principle of limited liability eliminates the downside risk for the equity holders. A contingent claim (option) is an asset that pays off under certain contingencies. the maximum loss to the equity holders cannot exceed the amount of their investment. the inputs required for such models are again difficult to determine. Secondly. The market for some of the assets may be illiquid or may fetch a slightly lesser price if the buyer does not perceive as much value of the asset to his business. The contingent claims model values the firm by valuing its equity using the option-pricing models. preference shareholders. the equity holders can lay their claims to the cash flows (in the form of dividends) of the firm only after all the claims of other stakeholders (creditors'. The validity of this assumption to the value of the firm is doubtful. commodity or a currency. a discount may be necessary to factor in the marketability element. the average magnitude and the variance. However. if the value of the underlying variable exceeds a predetermined amount. the practical application of this model in the real world has not been very significant. if the firm is liquidated. is built on the premise that a replicating portfolio can be created using the underlying asset and riskless borrowing and lending. Experts opine that a possible solution is to use an option pricing model that explicitly allows for price jumps (discrete instead of continuous price process). which is the basis of the option pricing models. 163 • • . While the contingent claim model stands the test of conceptual soundness. even if such variance were to be measured. then for a call option has a value and if it is less than the predetermined value the put option has a value. The equity in a firm is a residual claim. The Black-Scholes Model is built on the assumption that the underlying asset's price process is continuous. Some of the issues which need to be further addressed before this model gets acceptability in the corporate world are as follows: • One of the basic assumption of the Black-Scholes Model is that the variance in the price of the underlying asset is known and remains constant over the life of the option. etc. In case of the contingent claim model where the underlying variable is the value of the firm.) have been satisfied. The principle of limited liability provides immunity to the equity holders if the value of the firm is less than the outstanding financial claims. the business (not the equity share) which is being valued is not traded in the market and the probability of building a replicating portfolio appears remote. V C is the value of the firm represents all the claims on the firm. the value of the claims can be taken as the exercise price (strike price). debt providers. On the other hand. Jump process models are based on poisson distribution and require inputs on the probability of the price jumps. Similarly. In other words. Option pricing theory. Hence no possibility of arbitrage exists. the equity holders receive the entire balance portion after all the financial claims on the firm have been paid off. This is leading to the emergence of a new model to value firms or businesses called as the contingent claims model. The contingent claims model is based on the premise that equity can be viewed as call option on the firm. as in both the Binomial Model and the Black-Scholes Model. Thus the pay-off to the equity holders in the event of liquidation is V .Valuation of the Firm The ownership value of a firm is the difference between the value of the assets (both tangible and intangible) and the value of the liabilities. the maturity of the claims measuring the life of the option and the original investment representing the option premium. it is unlikely that it will remain constant over extended periods. Thus an analogy can be drawn between equity and options wherein the equity shares are treated as call options on the value of the underlying firm.C if V > C or zero if V<C where. This is a reasonably defensible assumption when the underlying variable is a security. 5. _The_ estimation of the_future cash flows depend -upon the aggressiveness or the conservatism of the assumptions made. product design and development to interrelated manufacturing methods and obtaining feedback from consumers. an ideal strategy is to move into a diversification program from a base or core of existing capabilities or organizational strengths. 3. wants. Hence the focus should not be exclusively on the outcome in the form of a definitive value figure. In this dynamic changing world managements must relate to missions.VALUATION: SOME MISCONCEPTIONS 1. When the value estimated is significantly different from the market valuation. This has to be kept in mind even before the carryover of capabilities in pure conglomerate mergers. The value estimated is important. correctness of the assumptions and the application of the right valuation model. It is generally observed that in case of takeovers the value of the target firm as estimated by their investment bankers is higher than the valuation estimates by the investment bankers of the predator company. defined in terms of customer needs. A well-done valuation is a timeless treasure: Any valuation exercise is time specific and is reflective of the information available to the valuer at that specific point of time. In such cases it is prudent to give the benefit of doubt to the market as the collective wisdom of the market as a whole is generally superior to the judgement of the valuer. 4. Valuation Models give an exact estimate of value: The appropriateness of the valuation depends upon the quality of the data. If the firm does not possess a sufficient breadth of capability to use as a basis for moving into other areas. Another important dimension of the concept of industries is a range of capabilities. The technological capabilities include all processes from the basic research. there can be two conclusions: the valuer is right and the market has substantially undervalued/ overvalued the firm or that the market is right and the valuation is incorrect. the flow of new information begins. The opinions and the biases of the valuer"get reflected in the valuation. 164 . marketing. if the valuer is able to convincingly prove the wisdom of his valuation. the nature of the firms and the boundaries of industries have become much more dynamic and flexible. The firm should be clear on both its strengths and weaknesses and should clearly define the specific new capabilities it is seeking to obtain. the process does not matter: The valuation exercise depends on the robustness of the valuation process. The valuation process is informative and provides valuable insights about the firm. directing. Most of the data pertaining to projected cash flows is futuristic and is thus characterized by uncertainty. DIVERSIFICATION STRATEGY All other things being constant. and controlling as well as specific management functions of research. In recent years. Managerial capabilities include competence in the generic management functions of planning. As time passes by. It is observed that very often. The valuation process gives us at best a value anchor. the instantaneous conclusion drawn is that the market is wrong. The market is always wrong: The benchmark for comparison of a valuation exercise is the market valuation of the firm. Valuation is a totally objective exercise: The models used in valuation may be quantitative but the inputs leave plenty of room for subjective judgements. organizing. The process reveals a great deal about the determinants of value and the user should make an effort to understand the valuation process. 2. an alternative strategy may be employed. This makes valuation an inexact and imprecise exercise. The information may be firm specific. Thus the valuation done in the past becomes increasingly obsolete and the same needs to be updated to reflect the current information. However. industry specific or pertain to the market as a whole. only then the same may be accepted and not otherwise. A value range may be determined based on the margin of error which in turn is a function of the degree of uncertainty of the cash flows. Further there is also a certain degree of subjectivity in determination of discounting rates. or problems to be solved. finance and personnel. Characteristics of a Successful Diversification Strategy Some of the characteristics of a successful diversification strategy are: PLATFORM OF EXISTING CAPABILITIES Any diversification strategy should be built on the foundation of existing competencies. The key for small companies is to identify markets where their capabilities can be profitably leveraged to create customer value. CHOICE OF NEW MARKETS The markets earmarked for expansion should be growth markets with low gestation periods. On the other hand. The private operators in most circles are yet to make profits. for instance. These could be decisions related to investment or downsizing. It should not be open to duplication by competitors. The telecom sector. Strong and visionary leadership is required to ensure successful implementation. LEAN AND TENACIOUS Companies that can maintain a lean management structure can avoid high overhead margins. Diversifying to new markets can be a risky proposition. distribution channels or adding marketing muscle. M&As will be considered first. MANAGEMENT SKILLS AND LEADERSHIP Implementation of the strategy will require strong and aggressive management. Growth and diversification can be achieved both internally and externally. EXTERNAL GROWTH Internal growth and mergers are not mutually exclusive activities. decisive measures during the diversification effort. They are mutually supportive and reinforcing. companies should acquire new ones to augment the existing strengths. Employees are more productive if given autonomy. The changing environments and the new forms of competition have created new opportunities and threats for business firms. the software boom saw many companies diversify into the Info Tech arena with substantial rewards. Firms must adjust to new forces of competition from all directions. Internal development is more advantageous for some activities and for some other external diversification is more beneficial. EMPLOYEE SKILLS AND PRODUCTIVITY A skilled and autonomous workforce is a must for the diversification strategy to succeed. The risk can be minimized if companies can identify their strengths and evaluate market opportunities accordingly. This facilitates entry into new markets. The success of the diversification ultimately hinges upon the tenacity of the personnel to see it through. but it should be understood that they represent only one set of the many adjustment and restructuring responses. They could make an effort to acquire new technologies. but a capability qualifies as a core competence if it fulfills the following criteria: • • • It should be applicable across all the product categories. They have been forced to adopt many forms of restructuring activity. These decisions may be risky and face resistance from employees. A company can have multiple capabilities. The characteristics and competitive structure of an industry will influence the strategies employed. NEW CAPABILITIES Though the strategy is based on existing capabilities. A small company cannot afford to operate in markets where the 'gestation period is high. was opened up in the year 1994. 165 . Successful growing firms use many forms of M&As and restructuring based on opportunities and limitations. It should result in significant value addition to the consumer. The new markets should also offer room for companies to operate in a niche. INTERNAL Vs. The owner/manager may have to take swift. Box 1: Diversification and Growth Through Acquisitions GE Capital is the product of dozens of acquisitions that have been blended to form one of the world's largest financial services organizations. These factors have made it beneficial to spread these abilities over a greater number of activities. the company has grown to become a major financial services conglomerate with 27 separate businesses and more than 50. Sometimes the acquisition moves into a new territory. it is consolidating acquisition in which a company is purchased and then consolidated into an existing GE Capital business like it happened when GE Capital Vendor Financial Services bought Chase Manhattan Bank's leasing business. Sometimes the acquisition is a hybrid. in shorter time and at lower cost. The prospects of economic profits from the supply of advanced technological capabilities to industries and firms which need them provide an increased incentive to diversify. the diversifying firms will develop industry specific managerial experience and firm specific organization capital overtime.The factors which support the external growth and diversification through mergers and acquisitions include the following: Faster achievement of goals and objectives through an external acquisition. GE Capital was founded in 1933 as a subsidiary of the General Electric Company to provide consumers with credit to purchase GE appliances. Moreover. Increased Technological Change The opportunities for diversification have increased along with the demands to change. Tax advantages. The expertise of technology is spread unequally among various business firms and industries. More than half of these businesses have become part of GE Capital through acquisitions. The primary reason for acquiring or merging with another business is to produce improved cash flow or to reduce the risk faster or at a lower cost than achieving the same goal internally. Internal development is favored when the above given advantages are minimal. Complementary capabilities. Four factors have contributed to the increased diversification by business firms: Advances in Managerial Technology Important changes in the management technology include issues like development in theory and practice of planning. the acquisition is a portfolio or asset purchase that adds volume to a particular business without adding people. Sometimes. the development and use of formalized decision models. there is an expectation that in the process of interacting with the generic management activities. Since then. than the cost of an acquisition. The acquisitions come in different forms and shapes. increased role of management functions in the firm's operations. as when GE Capital bought Travelers Corporation's business. parts of which fit into one or more existing businesses while the other parts stand alone or become joint ventures. When the firms which are available for acquisition do not provide attractive opportunities for achieving the goals that have been set. The external growth contributes to opportunities for effective alignment to the firm's changing environments. 166 . Greater cost of building an organization internally. the goal of any acquisition is to create a strategic advantage by paying a price for the target that is lower than the total resources required for internal development of a similar strategic position. Attainment of feasible market share with less risk. Conversely. DIVERSIFICATION PLANNING. Sometimes. internal development is more feasible from an economic perspective. These businesses include private label credit card services to commercial real estate financing to rail car and aircraft leasing. Thus. MERGERS AND THE CARRY OVER OF MANAGERIAL CAPABILITIES Growth through mergers and diversification represents a very good alternative to be taken into account in business planning. these management capabilities are not evenly distributed throughout industries giving an opportunity for firms to extend their capabilities to other firms and to new areas in order to increase the returns on investments in both management and physical assets. generate an entirely new GE Capital business. Another reason is the expectation on the part of the diversifying or acquiring firm that it has or will have excess capacity of general managerial capabilities in relation to its existing product market activities. Inefficiently managed target. increased recognition of quality and continuity of the firm's management organization as an important economic variable etc.000 employees worldwide. The search for product markets with growth opportunities intensified. In a rapidly changing world. The most remarkable examples of growth and often the largest increases in stock prices are a result of mergers and acquisitions. M&As are expected to increase value and efficiency and thereby increase shareholders' value. In the equity markets stock which had a potential for growth in earnings and dividends. From the viewpoint of the buyer. Corporate restructuring is a broad umbrella that covers many things. FORMS OF CORPORATE RESTRUCTURING Business firms in their pursuit of growth. Investments in managerial organizations have always resulted in economies of scale rather than investment in physical assets. rearrangements. 167 . were highly valued. operations. when a firm's existing divisions grow through normal capital budgeting activities. Generally. Financial restructuring refers to the actions taken by the firm to change its total debt and equity structure. and contests for corporate control. Severe competition. M&As is a generic term used to represent different types of corporate restructuring exercises. rapid technological change. the economies derived from spreading the fixed costs for managerial staff functions over a wide range of activities have increased. Hence. Neverthless. companies are facing unprecedented turmoil in global markets. growth stocks had higher P/E ratio.Large Fixed Costs and Staff Services Fixed cost of business firms have increased due to the need to maintain an affective competitive position in the world economy and the resultant larger management capabilities. Growth opportunities come in a variety of other forms and a great deal of energy and resources may be wasted if an entrepreneur does not wait long enough to identify the various dynamics which are already in place. and ownership reformulation. and non-strategic facilities. and rising stock market volatility have increased the burden on managers to deliver superior performance and value for their shareholders. and contractual relationships with shareholders. In addition to mergers. customers. engage in a broad range of restructuring activities. an increasing number of companies around the world are dramatically restructuring their assets. Development of Equity Markets The trends in the equity markets have strengthened the influence of the above mentioned factors in encouraging diversification by external diversification. Hence. In response to these pressures. Actions taken to expand or contract a firm's basic operations or fundamentally change its asset or financial structure are referred to as corporate restructuring activities. M&A represent expansion and from the perspective of the seller it represents a change in ownership that may or may not be voluntary. One of them is the merger or takeover. and competitors that do business with restructured firms. and other financial stakeholders. M&As is a strategy for growth and expansion. most of the corporate growth occurs by internal expansion. if the goals are easily achieved within the firm. creditors. M&As offer tremendous opportunities for companies to grow and add value to shareholders wealth. This increased interest in the growth stimulated mergers in various ways. Operational restructuring refers to outright or partial purchase or sale of companies or product lines or downsizing by closing unprofitable. takeovers. there are other types of corporate restructuring like divestitures. Corporate restructuring has facilitated thousands of organizations to re-establish their competitive advantage and respond more quickly and effectively to new opportunities and unexpected challenges. Corporate restructuring has had an equally profound impact on the many more thousands of suppliers. These corporate restructuring activities can be divided into two broad categories -operational and functional. it may mean that the goals are too small. is shown in a summarized form in Table 1. acquisition. In such acquisitions.825 per share. asset acquisition or a joint venture. Example: The acquisition of the cement division of Tata Steel by Laffarge of France. 168 . Example: (1) Flextronics International giving an open market offer at Rs. A new firm that is hitherto.An overview of all these restructuring activities. announced an open offer to acquire 8. Absorption This type of merger involves fusion of a small company with a large company. This form is generally applied to combinations of firms of equal size. MERGER Merger is defined as a combination of two or more companies into a single company. The grouping is a bit random but indicates the direction of the emphasis in these various practices.7 million tonne cement plant and its related assets from Tata Steel. After the merger. Amalgamation This type of merger involves fusion of two or more companies. After the amalgamation. Laffarge acquired only the 1. not in existence comes into being.4% stake in Astra Zenca Pharma India at a floor price of Rs. It can take place in the form of a merger. ASSET ACQUISITION Asset acquisitions involve buying the assets of another company. These assets may be tangible assets like a manufacturing unit or intangible assets like brands. Example: The merger of Brooke Bond India Ltd with Lipton India Ltd resulted in the formation of a new company Brooke Bond Lipton India Ltd. TENDER OFFER Tender offer involves making a public offer for acquiring the shares of the target company with a view to acquire management control in that company.548 for 20% of paid-up capital in Hughes Software Systems. tender offer. which results in an increase in the size of the firm. Example: The recent merger of Oriental Bank of Commerce with Global Trust Bank. (2) AstraZenca Pharmaceuticals AB. A merger can take place either as an amalgamation or absorption. After the merger the smaller company ceases to exist. a Swedish firm. GTB ceased to exist while the Oriental Bank of Commerce expanded and continued. Table 1: Forms of Restructuring Business Firms Expansion Mergers and Acquisitions Tender offers Asset acquisition Joint ventures Contraction Spin offs Split offs Divestitures Equity carve outs Assets sale Corporate Control Anti takeover defenses Share repurchases Exchange offers Proxy contests Changes in Ownership Structures Leveraged buyout Junk bonds Going private ESOPs and MLPs Each type of activity mentioned in the above Table is briefly explained below: Expansion Expansion is a form of restructuring. the acquirer company can limit its acquisitions to those parts of the firm that coincide with the acquirer's needs. the two companies lose their individual identity and a new company comes into existence. as can be interpreted from the following definitions: Acquisition or Takeover: The purchase of a controlling interest by a company in the voting share capita! of another company. The economic environment has shifted dramatically and in order to prosper or even to survive in such an environment. A company will seek to acquire the other company only when it has arrived at its own developmental plan to expand its operations after a thorough analysis of its own internal strength. Markets. For example. The economies of scale is obtained by the elimination of duplication of facilities and operations and broadening the product line. secure additional financial facilities. and (iii) Conglomerate mergers. eliminate competition and strengthen its market position. the strategy formulation has become very important. While the motives or influences leading to mergers are multiple. reduction in investment in working capital. The distinction between a merger and an acquisition is not very clear. the combination may take the form of acquisition (takeover) or a merger (amalgamation). idealistic view of what should be done and how it should be done. The methods used for mergers are often the same as the methods used to make takeovers. TYPES OF MERGERS Merger or acquisition depends upon the purpose for which the target company is acquired. Horizontal mergers result in decrease in the number of firms in an industry and hence such type of mergers make it easier for the industry members to join together for monopoly profits. etc. theoretically there can be a subtle difference between the two. etc. AT&T and Tata (BATATA) in Idea Cellular Ltd. and in which no party to the combination obtains control over the other. In this chapter we shall discuss in detail the various types of mergers and the process undergone by firms to accomplish a merger or an acquisition. usually by buying the majority of the voting shares is called an acquisition or a takeover.. exercise of better control on market. restrictive business practices legislation enforce strict regulations on the integration of competitors. Hence. the potential for concentration of economic power is inherent in the phenomenon of mergers. Horizontal mergers of even small enterprises may create conditions triggering concentration of economic power and oligopoly. Gold Spot. mergers can be divided into three categories: (i) Horizontal mergers (ii) Vertical mergers. A company involved in a vertical merger usually seeks to merge with another company or would like to takeover another company mainly to 169 . in which the shareholders of the combining entities come together in a partnership for the mutual sharing of the risks and the benefits of the combined entity. Coca-Cola paid Rs. However. The main purpose of such mergers is to obtain economies of scale of production. The alliance between Birla. is an example of a horizontal merger. financing and relationships have transformed to become exceedingly complex. This increase usually comes from the effects of synergy. in many countries. Horizontal mergers also have a potential to create monopoly power on the part of the combined firm enabling it to engage in anticompetitive practices. When two businesses combine their activities. elimination of competition in a product. Based on the reason why firms combine. Vertical Mergers A vertical merger involves merger between firms that are in different stages of production or value chain. An example of a merger is Daimler-Benz and Chrysler. Horizontal Merger A horizontal merger involves a merger between two firms operating and competing in the same kind of business activity. Merger: A business combination that results in the creation of a new reporting entity formed from the combining parties. The business world has changed drastically. The main reason for any business organization to combine is to increase the shareholder wealth. Idea Cellular acquiring Escotel is an example of an acquisition. varied and complex. reduction in advertising costs. Limca. instruments. It has to aim at a suitable combination where it could have opportunities to supplement its funds. It is no longer possible to take a simple. They are combination of companies that usually have buyer-seller relationships. and acquisitions.The asset being purchased may also be intangible in nature. This phenomenon is becoming part of the strategic planning of many corporate bodies seeking not only to exploit existing core competencies but also to build new ones for the future. The pursuit of growth and the need to access new markets are driving companies all over the world to undertake mergers. increase in market share. 170 crore to Parle to acquire its soft drinks brands like Thums Up. ix. exercise control and are the final financial risk takers. iii. Conduct the post-closing evaluation of acquisition (Evaluation). The basic purpose of such combination is utilization of financial resources. in vertical combination. Anticompetitive effects have also been observed as both the motivation and the result of these mergers. By providing managerial guidance and interactions on decisions. Within the broader category of conglomerate mergers two types of conglomerate firms can be distinguished. the merging company would be either a supplier or a buyer using its product as an intermediary material for final production. the process of acquisition can be summarized in the following steps: i. Refine valuation. Such type of merger enhances the overall stability of the acquirer company and creates balance in the company's total portfolio of diverse products and production processes and thereby reduces the risk of instability in the firm's cash flows. contacting the target. Product extension mergers are mergers between firms in related business activities and may also be called concentric mergers. Obtain all the necessary approvals. In other words. perform due diligence. Develop a strategic plan for the business (Business plan). Initiate contact with the target (First contact). Firms integrate vertically between various stages due to reasons like technological economies. Search companies for acquisitions (Search). iv. THE MERGER AND ACQUISITION PROCESS The acquisition process can be divided into a planning stage and an implementation stage. etc. Screen and prioritize potential companies (Screen). a merger or an acquisition decision is a strategic choice. They undertake strategic planning but do not participate in operating decisions. Pure conglomerate mergers involve merger between two firms with unrelated business activities. Conglomerate Mergers Conglomerate mergers involve merger between firms engaged in unrelated types of business activity. reconciliation of divergent interests of parties to a transaction. elimination of transaction costs. viii. Conglomerate mergers can be distinguished into three types: product extension mergers. Managerial Conglomerates: Managerial conglomerates transmit the attributes of financial conglomerates still further. managerial conglomerates increase the potential for improving performance. The implementation stage consists of the search. ii. geographic market extension mergers and pure conglomerate mergers. resolve post-closing issues and implement closing (Closing). They not only assume financial responsibility and control. vii. Geographic market extension mergers involve a merger between two firms operating in two different geographic areas. The acquisition strategy should fit the company's strategic goals of increasing the net cash flows and reduce risk. negotiation. and develop financing plan (Negotiation). The planning stage consists of the development of the business and the acquisition plans. implements its production plans as per objectives and economizes on working capital investments. The acquiring company through merger of another unit attempts to reduce inventories of raw material and finished goods. vi. 170 . structure the deal. These mergers broaden the product lines of the firms. Develop an acquisition plan related to the strategic plan (Acquisition plan). integration and the evaluation activities. Implement post-closing integration (Integration). x.expand its operations by backward or forward integration. but also play a role in operating decisions and provide staff expertise and staff services to the operating entities. In short. Developing the Business Plan As discussed earlier. Examples: Nirma's bid for Gujarat Heavy Chemical (backward integration) or Hindalco bidding for Pennar Aluminium (forward integration). Financial Conglomerates: Financial conglomerates provide a flow of funds to each segment of their operations. Develop plan for integrating the acquired business (Integration plan). improved planning for inventory and production. v. They do not come under product extension or market extension mergers. screening. It furnishes a proper guidance to those responsible for successfully completing the transaction by providing valuable inputs to all the later phases of the acquisition process. The acquisition plan defines the key management objectives for the takeover. The financial objectives include a minimum rate of return or operating profit. the industry or the market in which the firm desires to compete. 171 . resources should also include funds which the combined firm can raise by issuing equity or by increasing leverage. v. Financial Risk It refers to the acquirer's willingness and the ability to leverage a transaction as well as the willingness of shareholders to accept near-term earnings per share dilution. This information is useful in the selection of the right candidate for the merger or the acquisition. This plan focuses on the tactical rather than the strategic issues. appropriate tactics for implementing the proposed transactions and the schedule or a time table for completing the acquisition. Setting objectives by developing quantitative measures of performance. Self-assessment of the firm by conducting an internal analysis of the firm's strengths and.A business plan communicates a mission or vision for the firm and a strategy for achieving that mission. An external industry or the market analysis can be made to determine how the firm can most effectively compete in its chosen market(s).e. weaknesses relative to the competition. Determining how to compete. Building the Acquisition Plan After a proper analysis of the various available options if it is determined that a merger or an acquisition process is appropriate to implement the business strategy then an acquisition plan is prepared. resource constraints. revenue and cash flow targets to be achieved within a specified time period. The strategic planning process identifies the company's competitive position and sets objectives to exploit its relative strengths while minimizing the effects of its weaknesses. A wellstructured business plan consists of the following activities: i. The risk is higher in conglomerate mergers. If the target is identified. Defining the mission statement by summarizing where and how the firm has chosen to compete and the basic operating beliefs of the management.. iv. The acquiring company tries to maintain certain level of financial ratios such as the debt to equity and interest coverage ratio to retain a specific credit rating. MANAGEMENT OBJECTIVES Management objectives are both financial and non-financial. Selecting the strategy most likely to achieve the objectives within a reasonable time period subject to constraints identified in the self-assessment. Determining where to compete i. ii. RESOURCE ASSESSMENT The assessment of the resources involves the determination of the maximum amount of resources available to assign to the merger or acquisition. vi. The limited understanding of the business operations of the newly acquired firm may negatively impact the integration effort and the ongoing management of the combined companies. The firm's Mergers and Acquisitions strategy should complement this process. iii. These risks may be: Operating Risk It refers to the ability of the acquirer to manage the acquired company. targeting only those industries and companies that improve the acquirer's strengths or lessen the weaknesses. Nonfinancial objectives address the motivations for making the acquisition that support the achievement of the financial returns predetermined in the business plan. The resources available generally include the financial resources like the internal cash flows in excess of the normal operating requirements plus funds from equity and the debt markets. It is the management's perception about the likely risks that it would be exposed to by virtue of acquisition that determines the financial implications. lender or an investment banker. The first stage of the search process involves establishing a primary screening process. The size of the transaction is best defined in terms of the maximum purchase price a firm is willing to pay. Contact is made through an intermediary for a medium sized company. The schedule should also include the names of the individuals who will be responsible for ensuring that the set objectives are achieved. secondary selection criteria include a specific market segment within the industry or a specific product line within the market segment.The incremental debt capacity of the firm can be estimated by comparing the relevant financial ratios to those of comparable firms in the industry. The Search Process After the firm has developed a viable business plan that requires an acquisition to realize the firm's strategic direction and an acquisition plan the search for the right candidate for acquisition begins. TIME TABLE A time table or a schedule that recognizes all the key events that should take place in the acquisition process is the final component of a properly structured acquisition plan. It could run through several distinctively identifiable phases that need a little more elaboration. A conservative valuation can result in collapse of the deal while an aggressive valuation may create perpetual problems for the acquiring company. a letter expressing interest in a joint venture or marketing alliance is enough. book. First Contact The contact phase of the process involves meeting the acquisition candidate and putting forward the proposal of acquisition. It should be both realistic and aggressive to motivate all the participants in the process to work as fast as possible to achieve the management objectives established in the acquisition plan. The second stage involves developing the search strategy. The commonly used valuation methods are: 172 . The primary criteria based on which the search process is based include factors like the industry. Other measures like the firm's profitability. The search for a potential acquisition candidate generally takes place in two stages. Overpayment Risk It refers to the possibility of dilution in the earnings per share or reduction in the growth of the firm because of paying more than the economic value of the acquired firm. For a large sized company contact is made through an intermediary but it is important that the contact is made with the highest level of the management of the target firm. Investment banks. It can be expressed as the maximum purchase price to earnings. cash flow or revenue ratio or a maximum purchase price stated in terms of rupees. ALTERNATIVE APPROACH STRATEGIES The approach employed for contacting the target depends on the size of the company and whether it is publicly or privately held. DISCUSSING VALUE Valuation of the target company is the most critical part of a deal. degree of leverage and the market share are also used in the screening process. Law. accounting firm. The difference represents the amount of money that the firm can borrow without making the current credit rating vulnerable. Thorough preparation before the first contact is essential for that alone enables the acquirer to identify the company's strengths and weaknesses and be able to explain the benefit of the proposal to the client convincingly. The intermediaries might include members of the acquirer's board of directors. brokers. In addition to the primary criteria employed. Such strategies generally involve using computerized database and directory services to identify the prospective candidates. The Screening Process The screening process starts with the reduction of the initial list of potential candidates identified by using the primary criteria such as the size and the type of the industry. and leveraged buyout firms are also useful sources although they are likely to require an advisory fee. For small companies in which the buyer has no direct contacts. banking and accounting firms also form valuable sources from which information can be obtained. size of the transaction and the geographic location. A face to face meeting is then arranged when the target is willing to entertain the idea of an acquisition. the announcement of divestiture can be seen as a change in investment strategy or in operating efficiency. information effects. TYPES OF SELL OFFS Divestitures Definition A divestiture is the sale of portion of the firm to an outside party generally resulting in cash infusion to the parent. A particular business may be more valuable to someone for generating cash flows and that someone will be paying a higher price for the business than its present value. The most common form of divestiture involves sale of a division of the parent company to another firm. This may be taken in a positive sense and boost share price. If the total value of the firm remains unchanged. The competitive advantage that a company has may change over time due to changing market conditions. Book Value Method: This method attempts to discover the worth of the target company based on its Net Asset Value. the target company is valued vis-a-vis its competitors on several parameters. valuation represents the present value of the expected stream of future cash flow discounted for time and risk. iii. In this method. They are generally the least complex of the exit restructuring activities to understand. divestures can result in reverse synergy. Whether the divestiture is seen as a good or a bad signal depends on the circumstances.i. Information Effects The information that a divestiture conveys to investors is another reason for divestiture. Most of the sell offs are simply divestitures. and as a result. making it necessary for the company to refocus its core competencies. When there is increased leverage due to restructuring. Wealth Transfers Divestiture results in the transfer of wealth from debtholders to stockholders. if the divestiture announcement is perceived as the firms' attempt to dispose off a marketable subsidiary to deal with adversities in other businesses. If the information given by management is not known to investors. iv. a firm can have a tax shield advantage due to interest payments being tax deductible. it is very subjective due to the need to make several assumptions during the computations. The process is a form of contraction for the selling company and a means of expansion for the purchasing corporation. This transfer takes place when a company divests a particular division and distributes the resulting proceeds of the sale among. ii. a company may have to divest a particular business. A divestiture helps a company to refocus on its core competencies. However. However. it will send a wrong signal to investors. The stock market quotations provide the basis to estimate the market capitalization of the company. As a result of this transaction there is less likelihood of repayment and it will have lesser value. Market Value Method: This method is used to value listed companies. In some cases. its equity value is expected to rise. 173 . stockholders. divestitures also provide a considerable tax advantage. Discounted Cash Flow Method: In this method. and tax reasons. Efficiency Gains and Refocus While Mergers and Acquisitions lead to synergy. the past diversification programs of a company may have lost value. it is better to divest wholly or in part to realize a tax benefit. When a company is losing money and is unable to use a tax-loss carry forward. efficiency gains and refocus. Divestiture is also taken to enable a company to make certain strategic changes. wealth transfers. Comparable Companies Method: This method is based on the premise that companies in the same industry provide benchmark for valuation. EXPLANATION AND RATIONALE FOR GAINS TO SELL OFFS Some of the main reasons why firms are forced to divest are. Tax Reasons As in the case of mergers. This is the most valid methodology from the theoretical standpoint. 2000). The 20% limit is usually observed in the first step in order to preserve the tax-free status of the transaction. where parent firms first sell up to 20% of the shares in the subsidiary in an initial public offering. The shares of the new company are listed and traded separately on the stock exchanges. which was in turn due to the lack of knowledge on the part of investors. both the parent and the subsidiary initially share the same shareholder base. Why firms choose to pursue a two-step spin-off instead of a 100% pure spinoff is unclear. Kudla and Mclnish (1983) showed a positive market reaction in the parents' stock 15 to 40 weeks before the distribution took place . thus providing an exit route for the investors. Spin-offs also have smaller underwriting discounts and fees than transactions such as carve-outs. Spin off has emerged as a popular form of corporate downsizing in the nineties. When the second step of the spin-off takes place. 174 . Previous research generally focuses on pure spin-offs. A possible reason for a two-step spin-off is to avoid the dip in the stock price that the spun-off subsidiary usually experiences in the first few months following the distribution. For example. In the US spin-offs have become increasingly popular in the last decade. Cusatis.an indication that the market correctly predicted the spin-off well ahead of the actual event. Spin-offs are often tax-free to the parent company and to the shareholders receiving stock in the spin-off. whether due to third-party negotiations or to market conditions. Also. so this question has yet to be addressed. in the form of a dividend. Also. This initial stock price decline is usually associated with the portfolio rebalancing activities of large institutional investors who may not wish to hold the shares of the subsidiary given away by the parent in a spin-off transaction. as in the case of a pure spin-off (Lament and Thaler. the market is then better positioned to support the portfolio rebalancing activities highlighted above. followed shortly by a distribution of the remaining shares to its shareholders. the parent and the spin-off-parent combination for a period of up to three years after the spin-off announcement date. Hence a spin-off results in the creation of a new public company with the same proportional equity ownership as the parent company. The shares of the new unit are distributed on a pro rata basis among the existing shareholders. even though the operations and management of the two entities are now separate and independent of each other. In other words. with firms seeking to divest a part of their businesses. Miles and Woolridge (1993) were among the first researchers to focus on the performance of the subsidiary post-spin-off. They also found that the abnormal returns were attributable to increased takeover activity. the minority carve-out enables the parent firm to create an orderly market for the new issue. This result has been supported by many other studies for periods that date back as early as 1963 to 1981. In a study of 6 major spin-offs in the 1970s.a feature that is also conspicuously absent in a pure spin-off transaction. since the carve-out takes the form of an IPO. as opposed to the less direct benefits of the parent company receiving the proceeds of a negotiated sale. Hence. so as to avoid flooding the market with a large number of shares. the manager of an index fund may be required to sell the shares of the spun-off subsidiary if that subsidiary does not form part of the index. Spin-off does not result in cash inflow to the parent company. investment banks are often committed to help support and market the new issue . which was not folly anticipated by the market at the time of the spin-off announcement. a spin-off can be an effective method for minimizing the execution risk of a divestiture. They examined 815 spin-offs from 1965 to 1988 and found significantly positive abnormal returns for the spun-off subsidiary. there has been a noticeable trend towards two-step spin off transactions. Moreover. Recently. There is a wealth of research on the effects of spin-offs on both parent and subsidiary firms. J P Morgan attributed this to underpricing by the market. A new legal entity is created to takeover the operations of a particular division or unit of the company. Another important feature of a spin-off that sets it apart from other types of corporate divestitures is that it does not provide the parent with any cash infusion. they concluded that earlier event studies underestimated the value created by spin-offs. In a two-step spin-off. Most of these spin-offs involve a pro rata distribution of shares in a wholly owned subsidiary to the shareholders of the firm. A 1997 study done by J P Morgan provided evidence that the positive stockholder wealth effects continued well into the 1990s. In addition. After the distribution. it was found that smaller spin-offs (with an initial market capitalization of less than $200 million) significantly outperformed their larger counterparts. the shareholders of the parent company receive a direct benefit by obtaining the stock of the spun-off subsidiary. the shareholding in the new company at the time of spin-off will reflect the shareholding pattern of the parent company.SPIN OFFS It is a transaction in which a company distributes to its own shareholders on a pro rata basis all of the shares it owns in a subsidiary. Early research efforts focused mainly on the changes in parent company share prices at the time of the spin-off announcement. This will have a downward pressure on the stock price in the short-term. Thereafter. Abarbanell et al. and this was consistent with a decrease in mean level of institutional ownership. If this is the case. The main goal is to maintain the market value of the shares that may be obtained through the conversion of the employee stock options. Tax Consideration Spin offs consist of multiple spin offs not taxable to shareholders. The spin-off may cause the common stock in the parent company to be less valuable if the deal is structured for the gain through the distribution of the proceeds in the form of special dividend. Servicing the shareholders will lead to duplication of the activities in parent and the spun off company. they noted that the overall returns to subsidiaries were significantly negative within 10 trading days of the distribution date. Likewise.An interesting phenomenon reflected in the graphs showing the post-distribution stock returns of the spun-off subsidiary. As shares are distributed primarily to existing shareholders. Unlike spin-offs. And parent has to distribute the shares in the subsidiary without a prearranged plan for these securities to be resold. 175 . The new company formed by the spin off has to incur expenses for issuing new shares. The adjustment is designed to leave the market value of the shares that could be obtained after the spin-off at the same level. a negative abnormal return of. The stock price of the parent company may fall because it will be less likely that the price will rise high to enable the securities to be converted. ECOs have become increasingly popular in the last several years. ECOs generate a capital infusion because the parent offers shares in the subsidiary to the public through an IPO. This pricing anomaly. However. the conversion prices may not need to be adjusted as part of the terms of the deal. had already been picked up by the press and documented by other researchers such as Brown and Brooke (1993) and Abarbanell. Treatment of Warrants and Convertibles Securities When the parent company has issued the warrants and the securities the conversion ratio may have to be adjusted. The parent company does not gain monetarily through the spin off. and concluded that the sudden and substantial sell-off of subsidiary shares by institutional investors as part of their portfolio rebalancing activities explained the downward pressures on price and consequently returns. A spin off is often perceived as a method for getting rid of a sub-par asset by the parent. spin-off lack liquidity. found empirical evidence supporting the initial decline in the stock returns of the spun-off subsidiary. Like spin-offs. the downward trend is reversed and returns become positive three months after the spin-off date. did not find any reliable evidence that led them to conclude that this decline was associated with institutional sell-offs. Brown and Brooke reported price declines of approximately 4% in spunoff subsidiaries that coincided with substantial reductions in institutional holdings in these firms. however. To avoid ordinary income taxes the parent and the subsidiary must have been engaged in business for 5 years prior to the spin-off. Bushee and Raedy (1998). From the disposition proceeds the parent does not get anything. EQUITY CARVE-OUTS An Equity Carve-out (ECO) is a partial public offering of a wholly owned subsidiary. Employee Stock Option Plans Employee's shares are held under an employee stock option plan. Its growth was partly fueled by investors' preferences to release the internal values in the company's stock prices. but not investigated by J P Morgan. In fact. although it usually retains a controlling interest in the subsidiary.4. It has grown its popularity since 1992. The subsidiary should be at least 80% owned by the parent. The number of the shares obtained also need to be adjusted after the spin-off. Abarbanell et al.12% was observed for a 35-day trading period (similar to the finding by Brown and Brooke) and it took another 25 trading days for this trend to completely reverse. Disadvantages of Spin-offs • • • • • • • There will be considerable selling pressure from institutions and index funds immediately after the spin-off. Warrant and security holders may not participate in this gain. In a study of 179 spin-offs between 1980 and 1996. is the initial decline in returns experienced by the spin-offs in approximately the first 30 trading days after the distribution. neither the parent nor the carve-out incurs a tax liability. increases the subsidiary's visibility as well as analyst and investor awareness. it must recognize the difference between the IPO proceeds and its basis as a gain or loss for tax purposes. The research indicates that the initial stock market reaction to an ECO announcement is more favorable if the subsidiary retains the funds. In secondary offerings. The parent typically continues to perform certain corporate services. and 20 percent pay to creditors. When the ECO sells the shares. especially for a subsidiary that is not involved in the parent's primary business or industry. Over 70 percent of the companies in the researchers' sample reported handling the ECO in this manner. 50 percent of the parents ECOs retain the proceeds. A study has found that 50 percent of the ECOs used for the proceedings of primary offerings to repay loans to the parent. two years of audited balance sheets. and offering marketing — normally takes up to six months. A part of the stake in this subsidiary is sold to outsiders. and amendments. After the IPO. Either the parent or the carve-out (or both) can receive the IPO proceeds. human resources. the IPO represents a primary offering. 176 . If the subsidiary sells the shares.An equity carve-out involves conversion of an existing division or unit into a wholly owned subsidiary. Investors also like ECO pure plays because separating the parent and subsidiary minimizes cross-subsidies and other potentially inefficient uses of capital. An equity carve-out is different from a spin-off because of the induction of outsiders as new shareholders in the firm. companies must file an S-l registration statement with the SEC. The potential benefits of equity carve-out include: "Pure play" Investment Opportunity: Pure plays have been in much demand by investors in recent years. Correspondingly. The shares of the subsidiary are listed and traded separately on the stock exchange. visible scorecard can boost performance by spurring managers to make timely strategic decisions and concentrate on the factors that contribute to better shareholder value. Process of Equity Carve-out A typical carve-out scenario in the US begins with the parent publicly announcing its intention to offer securities in a subsidiary or division through an ECO. The parent company may or may not retain controlling stake in the new entity. on a contractual basis. either listing the spin-off on an exchange or providing for trading over the counter. This enhances its overall value. A relatively small number of ECOs are handled as joint offerings of the parent and subsidiary. An ECO. Characteristics of ECO candidate Strong potential ECO candidates have some or all of the following characteristics. managers are also more likely to be rewarded for improved results. it often uses some of the proceeds to repay loans to the parent or pay a special dividend. Registration requires three years of audited income statements. and identity of an independent company will be able to generate additional financing sources and borrowing capacity after the carve-out. This immediate. Management Scorecard and Rewards: Management is evaluated on a daily basis through the company's stock price. If the subsidiary sells the shares in the IPO. Secondly equity carve-outs require higher levels of disclosure and are more expensive to implement. Capital Market Access: An ECO typically improves access to capital markets for both the parent and the subsidiary. If the parent sells the shares (known as secondary shares). Since an ECO is a type of IPO. SEC review. legal and tax services. and banking services. The ensuing process — including the preparation of financial and registration statements. data processing. Independent Borrowing Capacity: A subsidiary that has achieved the size. it will likely sell at a higher price/earnings multiple once it has been partially carved out of the parent. responses. Once the SEC reviews and declares it effective. Strong Growth Prospects: If the subsidiary is in an industry with better growth prospects than the parent. the parent can sell the offering. 30 percent to be retained. Equity carve-outs result in a positive cash flow to the parent company. asset base. and five years of selected historic financial data. all transactions between the parent and the subsidiary must be conducted on an arm's-length basis and disclosed in the registration statement. such as investor relations. earnings and growth potential. while 50 percent pay to creditors. a section of the shareholders will be allotted shares in the new company by redeeming their existing shares. researchers found important increases in sales. ECOs clearly seem to lead to better operating performance (on average) and greater increases in shareholder value. An analysis of returns for these companies suggests that ECOs that are taken over perform better than average. As a restructuring device. Note that ECOs.Unique Corporate Culture: Subsidiaries whose corporate culture differs from that of the parent may be good ECO candidates because the carve-out can offer management the freedom to run the company as an independent entity. Post carve-out. The logic of split-off is that the equity base of the parent company should be reduced reflecting the downsizing of the firm. This is because the relative growth rates were not positive or statistically significant. earn negative stock returns. Just . which may allow management to respond more quickly to changes in technology. on average. Nonetheless. This sale may not necessarily leave the parent in control of the subsidiary. and regulation. Equity carve outs involve the sale of an equity interest in a subsidiary to outsiders. and Rewards: Subsidiaries that compete in industries where management retention is an issue and targeted reward systems are required can benefit from an ECO. operating income before depreciation.as in spinoff. This indicates that lack of separation between the two entities prevents the carved-out entity from reaching its potential. on the other hand. while those that are not perform worse than average. Disadvantages of Equity Carve-Outs The biggest disadvantage of carve-outs is the scope for conflict between the two companies as operation level conflict occurs because of the creation of a new group of financial stakeholders by the mangers of the carvedout company. a new company is created to takeover the operations of an existing division or unit. As with spin-offs. 177 . The requirements of these stakeholders differ from those of the original stakeholders. Split-Up Split-up results in the complete break up of a company into two or more new companies. while carve-out firms without spin-off announcements under performed the market by 3%. Overall. A portion of the shares of the parent company are exchanged for the shares of the new company. they believe these improvements owe less to newly gained efficiencies than to the carve-out's growth after going public. in other types of firms. like spin-offs. Hence the shareholding of the new entity does not reflect the shareholding of the parent firm. Parents. All the division or units are converted into separate companies and the parent firm ceases to exist. these higher-than-normal stock returns are associated with better operating performance and corporate restructuring activity. even the latter outperform. In a study of equity carve-outs by J P Morgan. The shares of the new companies are distributed among the existing shareholders of the firm. Special Industry Characteristics: Subsidiaries with unusual characteristics are often better suited to decentralized management decision-making. This conflict can hinder the performance of both firms. the partially divested subsidiary is operated and managed as a separate firm. In the sample. and capital expenditures. The term "split-up" is defined as the division of a company into two or more publicly traded comparatively substantial entities through one or more transactions. competition. Retention. total assets. Companies that require entrepreneurial cultures for success can especially benefit from this transaction. However. it is clear that ECOs earn significantly positive abnormal stock returns for up to three years after the carve-out. outperformed the market by 11% for a period of 18 months after the initial public offering. Split-Off In a split-off. a split-off does not result in any cash inflow to the parent company. it was found that carve-out firms in which the parent firm announced that a spin-off would follow at a later date. In other words. After the Equity Carve-Out While analyzing a sample of ECOs. 50% of the ECOs were acquired within three years. are subject to a great deal of takeover activity. Management Performance. The stock performance of a company that has carved out 70 to 100 percent is better than that of a company that has carved-out less than 70 percent. Activity drivers represent the event that causes costs within an activity. These steps are discussed in more detail below. 1. ordering materials. An activity driver is chosen for each cost pool. and controlling quality. The judicious use of more activity drivers increase the accuracy of product costs. and perhaps inspection. First. ordering. the consumption of the activity implied by the activity driver should be highly correlated with the actual consumption of the activity. 3. scheduling their arrival. If two cost pools use the same cost driver. Cooper has developed several criteria for choosing activity drivers. activity drivers for the purchasing activity include negotiations with vendors. Typical activities used in ABC are designing. A cost pool is an account to record the costs of an activity with a specific cost driver. More than one cost pool can be established for each activity. which in turn can affect individual performance measures. 178 . Ostrenga concludes that there is a preferred sequence for accurate product costs. material-handling operations. To facilitate this tracing. 5. Activity drivers determine the application of costs. costs must be traced to the cost pools for different activities. 2. These cost drivers are often called resource drivers. and the number of steps in a manufacturing process. the data on the cost driver must be easy to obtain. multiple activities are identified in the production process that are associated with costs. Second. then the cost pools could be combined for product-costing purposes. Trace Costs to Activities Once the activities have been chosen.Chapter 8 Financial Engineering ACTIVITY BASED COSTING Applying overhead costs to each product or service based on the extent to which that product or service causes overhead cost to be incurred is the primary objective of accounting for overhead costs. The following five steps are used to apply costs to products under an ABC system. Examples of overhead cost drivers are machine set-ups. moving materials. These activities do not necessarily coincide with existing departments but rather represent a group of transactions that support the production process. Each of these activities is composed of transactions that result in costs. Each of these activity drivers represents costly procedures that are performed in the purchasing activity. the number of take-offs and landing for an airline. controlling inventory. For example. The cost drivers are used to apply overhead to products and services when using ABC. scheduling. Choose Appropriate Activities The first step of ABC is to choose the activities that result in incurring of overhead costs. overhead is applied to products using a single predetermined overhead rate based on a single activity measure. The events within these activities that cause work (costs) are called cost drivers. With Activity-Based Costing (ABC). cost drivers are chosen to act as vehicles for distributing costs. In many production processes. Examples of cost drivers in non-manufacturing organizations are hospital beds occupied. and the number of rooms occupied in a hotel. Determine Cost Drivers for Activities Cost drivers for activities are sometimes called activity drivers. Choose appropriate activities Trace costs to activities Determine cost drivers for each activity Estimate the application rate for each cost driver Apply costs to products. A predetermined rate is estimated for each resource driver. 4. The third criterion to consider is the behavioral effects induced by the choice of the activity driver. Consumption of the resource driver in combination with the predetermined rate determines the distribution of the resource costs to the activities. 000 10.00. activities are chosen and the overhead costs are distributed to cost pools within these activities through resource drivers.10.10.2.00.000 of direct labor Standard Motors Rs. 10. ordering. ordering.000 Overhead to special-order motors = 500% of Rs.2. Estimate Application Rates for each Activity Driver An application rate must be estimated for each activity driver. Alpha Motors incurs the following costs during the month of January: Traditional cost accounting would apply the overhead costs based on a single measure of activity.000 30.60.000 3.000 10. and marketing.00.00.00.35. Alpha Motors performs the following activities: designing. or 500% of direct labor. which is less accurate.00. The application of overhead costs through cost drivers is the next most accurate process.00. then the overhead rate would be Rs. machinery.00.00. The costs of activities are then applied to products through activity drivers.00.10. If direct labor was used.000 + Rs. produces electric motors. The company has four essential activities: design. and marketing.00.2. Each activity has one cost pool. Standard costs.00. Any remaining overhead costs must be allocated in a somewhat arbitrary manner.00.000 60.000 of direct labor = Rs. Hence: Overhead to standard motors ~ 500% of Rs.000 Special Order Motors Rs.00. A predetermined rate is estimated by dividing the cost pool by the estimated level of activity of the activity driver.000).50. machining. Alternatively.000 10. The overhead costs are distributed to the cost pools of the activities using the following resource drivers: Overhead Account Resource Driver Indirect labor Labor hours Depreciation of building Area of building Depreciation of equipment Machine time Maintenance Area of building Utilities Amps used 179 .Direct costs are the most accurate in applying costs to products.000/(Rs.00.000 2.000 Rs. could also be used to calculate a predetermined rate. Examples of Activity Based Costing Alpha Motors Inc. The company makes a standard electric-starter motor for a major auto manufacturer and also produces electric motors that are specially ordered. Applying Costs to Products The application of costs to products is calculated by multiplying the application rate times the usage of the activity driver in manufacturing a product or providing a service.00.000 Direct labor Direct materials Overhead: Indirect labor Depreciation of building Depreciation of equipment Maintenance Utilities =Rs.000 With ABC. an actual rate is determined by dividing the actual costs of the cost pool by the actual level of activity of the activity driver.00. 000 13.00. overhead costs can be allocated to the different activities.00.000 30.00.000 1.00.25. 20/hr.50/orders Rs.00.2000/hours Rs.00.000 20. 10/Labor hour Re.000 30.12.000 30.000 labour-hours Area of 2. 1/sq.000 30.000 contracts Application Rate Rs.00.000 Amps 2.00.250 changes 6.000 sq. the cost of the indirect labor allocated to the designing activity is Rs.50. of building 50. Rs.000 14.000 sp. ft.00.25.000 1.00.000 75.000 45.000 35. The ABC method applied a much higher amount of the overhead cost to the special-order electric motors than when all overhead was applied by direct-labor basis.000 3. 10. 3.5 hours 7.ft.50/amps By multiplying the application rate times the resource usage of each activity.000 20.000 1.000 30.000 1.000 20. activity drivers must be chosen to apply the costs to the products. Rs.00. Suppose the following activity drivers are chosen: Activity Designing Ordering Machining Marketing Activity Driver Design changes Number of orders Machine time Number of contracts with customer Alpha Motors uses actual costs and activity levels to determine the application rates shown below: Activity Driver Design changes Number of orders Machine time Number of contracts Costs of Activity Rs.00.00.00.00.000 20.000 Sq.000 20.000 Machine time 0 0 10.000 2.000 2.00.000 50.000.25.000 1.ft. The reason for the greater overhead application to the special-order electric motors is the greater usage of the activities that enhance the manufacturing of the electric 180 . 10.000 3.00.000 3. For example.000 16.000 10.000 1.30.000 Total Driver Usage 12. Rs.00.500 orders 152.00.50.000 1.l0/labor hour i.000 2.l.000 60.200/contract The application rates are then multiplied by the cost driver usage for each product to determine-the costs applied.ft 0.000 hrs.00.000 10. Rs. time Area of 3.00.00.00.000 Indirect labor Depreciation of building Depreciation of equipment Maintenance Utilities Totals Once the overhead costs have been distributed to the activity cost pools.000 2.000 14.00. 35.000 50.000 50.000 8.000 amps Application Rate Rs.The usages of the resource drivers by activity are: Designing Ordering Machining Marketing Totals Labor hours 1.000 The resource driver application rates are calculated by dividing overhead costs by total resource driver usage: Overhead Account Indirect labor Depreciation of Building Depreciation of Machinery Maintenance Utilities Resource Cost of Total Driver Driver Overhead Usage Labour hours Rs.000 Totals Rs.00. building Machine 10. Rs.00.SO/sq.000 3.000 12.00.00.00.00. building Amps used 10.25.000 50.e.50. Designing Ordering Machining Marketing Rs.000 1.00.00.000 20.l00/change Rs. Rs.000 10.50.00.000 0 10.50.ft.00.00.00.000 10. the greater the need for an ABC system. Weaknesses of Activity Based Costing First. The greater the diversity of requirements of products on over head-related services and other overhead costs. ABC highlights the causes of costs. companies should always ask the question as to whether the incremental benefit is justifiable in terms of the incremental cost incurred. At higher management levels. it is important to identify variable costs. Second. the following factors can be considered: – Purpose of the system • The objectives of the system will determine how many cost drivers are needed • The greater the number of cost drivers. the greater will be the cost of designing and maintaining the system – Resources availability • Cost benefit analysis can be applied. they may be reduced. ABC does not partition variable and fixed costs. The distribution and application of costs becomes an arbitrary allocation process when the cost drivers are not associated with the factors that are causing costs. – Company complexity • Product as the cost object: – Number of production processes – Total indirect costs – Product diversity • Customer as the cost object: – Number of distribution channels – Steps in distribution system – Variety in items – Customer diversity • 181 . Use of direct-labor hours to allocate overhead does not recognize the extra overhead requirements of the special-order electric motors. An analysis of these causes can identify activities that do not add to the value of the product. For planning decisions. The ultimate question is whether the company can afford the best system available given its requirements. Workers on the line often understand activities better than costs and can be evaluated accordingly.e. Managers would be responsible for the costs of the activities associated with their responsibility centers. These activities include moving materials and accounting for transactions. For many short run decisions. i. ABC tends to be more expensive than the more traditional methods of applying costs to products. And finally. Organizational Base Costing – It is a traditional costing that considers the cost of a product to be its direct costs for materials and labor. An analysis of activities can also lead to better performance measurement. ABC is based on historical costs.motors during their production. Misapplication of overhead could lead to inappropriate product line decisions. future costs are generally the relevant costs. the activities can be aggregated to be in line with responsibility centers. overhead rates are allocated to products using a plant-wide or departmental overhead rates. because the establishment of an ABC system requires a careful study of the total manufacturing or service process of an organization. Third. A recognition of how various activities affect costs can lead to modifications in the planning of factory layouts and increased efforts in the design process stage to reduce future manufacturing costs. Although these activities cannot be completely eliminated. Other Benefits of Activity Based Costing ABC is" valuable for planning. In OBC. ABC is only as accurate as the quality of the cost drivers. plus some allocated portion of manufacturing overhead. Product Costing Continuum Organizational-Based Costing (OBC) Activity-Based Costing (ABC)* Plant-Wide Departmental Two-Stage Models Multiple Stage Models Overhead Overhead Rate Methods *Also varies in number of cost drivers at each level Deciding the number of cost drivers To decide on the number of cost drivers. cost assignment follows the organization chart. 15%).25. .00. provision expenses and preferred stock dividends. let X be an independent financial variable and Y its dependent variable.62.000 9.00.000 2. shareholders have received a total economic return on their investment in excess of their required rate of return.00. LEVERAGE. calculate net operating profit after tax (NOPAT) by adjusting net income. The key difference between the IRR and CFROI is that cash flows and investment are stated in constant monetary units in CFROI which overcome deficiencies of the traditional return on investment methods. Interest on Debt (I) Profit Before Tax (PBT) Less:Tax @ 50% (T) 182 Amount (Rs.000 6. securities gains and losses. Numerous studies have shown EVA to have a higher correlation to stock valuation than accounting based measures. When leverage is measured between two financial variables it explains how the dependent variable responds to a particular change in the independent variable.000 75. First. Common adjustments include extraordinary gains and losses. Cost of capital equals the minimum required rate of return for investors {e.000 5. EVA = Net Operating Profit after Tax .ECONOMIC VALUE ADDED (EVA) Economic Value Added or EVA is the economic profit generated after the cost of invested capital. Item Total Revenue Less: Variable Expenses (V) Fixed Expenses (F) Earnings Before Interest & Tax (EBIT) Less. EVA incorporates the opportunity cost of invested capital that is not realized by traditional accounting measures. and certain adjustments for cumulative non-operating gains and losses. To explain further. where LY/LX AX AY A X/X AY/Y measure of the leverage which dependent Y has with independent X change in X change in Y percentage change in X percentage change in Y - Measures of Leverage To better understand the importance of leverage in financial analysis. Invested capital includes book value of common and preferred equity. Whenever EVA is positive. Given below is the Income Statement of XYZ Company Ltd. CASH FLOW RETURNS ON INVESTMENT (CFROI) CFROI is defined as the return on investment expected over the average life of the firm's existing assets.500 .(Invested Capital x Cost of Capital) There are two steps required to convert GAAP net income to EVA.. Second.Leverage in the general sense means influence of power i. These three measures of leverage depend to a large extent on the various income statement items and the relationship that exists between them.00.g. it is imperative to understand the three measures of leverage. CFROI is nothing but another form of IRR measure. then the leverage which Y has with X can be assessed by the percentage change in Y to a percentage change in X. calculate invested capital and apply cost of capital. • Operating Leverage • Financial Leverage • Combined/ Total Leverage. utilizing the existing resources to attain something else.) 25.e.000 10. after-tax allowance for loan losses. and the relationship that exits between the various items of the statement: Income Statement of XYZ Company Ltd. Leverage in terms of financial analysis is the influence which an independent financial variable has over a dependent/related financial variable. . given the following additional information: Quantity produced Variable cost per unit Selling price per unit Fixed asset DOL of XYZ Company Ltd..0 00 4.(iv) When the value of Q is 3000 the EBIT of the company is zero and this is the operating break-even point.000(500 ..5 -2.200 Rs.200)]/[5.F Substituting for EBIT.00.62.. Thus.50 Application and Utility of the Operating Leverage It is important to know how the operating leverage is measured. of Equity Shareholders 2. EBIT EPS = QxS-QxV-F = Q(S-V)-F = r(EBIT-I)(l-T)-DJ/N .9.000 .0 2. DOL = Percentage change in EBJT/Percentage change in Output From Eq(i) EBIT = Q(S .500 50. = [5.(i) .00... To understand the application of DOL one has to understand the behavior of DOL visa-vis the changes in the output by calculating the DOL at the various levels of Q.V) . OPERATING LEVERAGE Operating leverage examines the effect of the change in the quantity produced on the EBIT of the company and is measured by calculating the Degree of Operating Leverage (DOL).500 The above three equations [(i).9.5 5.500 Rs.(iii) where N = No.000] = 2.Profit After Tax (PAT) Less: Preference dividend (Dp) Equity Earnings Total Revenue = Quantity Sold (Q) x Selling Price (S) Hence...200) . (ii) and (iii)] which establish the relationship between the various items of the Income Statement form the base for the measurement of the different leverages.1 Calculate the DOL for XYZ Company Ltd. Following are the different DOL for the various levels of Q for XYZ Company Ltd. but equally essential is to understand its application and utility in financial analysis.(ii) . 183 .000 Rs..12.: Quantity Produced 1000 2000 3000 4000 5000 Degree of Operating Leverage -0.000 2.000(500 . we get DOL = [Q(S-V)]/[Q(S-V)-F] Illustration 8. 000 2.000 (90. IMPLICATIONS Determining Behavior of EBIT DOL helps in ascertaining change in operating income for a given change in output (quantity produced and sold). An interesting point we notice is that at an output of 50.000) 40. This brings us to the conclusion that the DOL of Fibre Glass Limited is greater than the DOL of Bell Metal Works.000 8. then DOL will be negative (which does not imply that an increase in Q leads to a decrease in EBIT).50.00.5)] / [50.00.000 4.000 10..40.10 .e.1. Units Produced & Sold Q Bell Metal Works Total Sales Operating Cost PQ Fibre Glass Limited EBIT (In Rupees) (60.5) .40.40.10 Operating Fixed Costs (F) = Rs.000 units. Table 8.000 70. Rs.000.000 3. The selling price per unit (P) of both firms is the same. A large DOL indicates that small fluctuations in the level of output will produce large fluctuations in the level of operating income.00.000) 20.000 5.00.000 3.000 4.00. two firms with different cost structures are compared.000 50. the EBIT of Bell Metal Works fluctuates for less than the EBIT of Fibre Glass Limited.000 3. 2.90.000 5.90.000 6.000 60.000 2.00.000 80.000 6.000 4.40.7 EBIT Break-even Point = 30.40.1.00.00.60.000 4.000 30.50.000 Units Produced & Sold Q Sales PQ Total Operating Cost EBIT 10.000) 30.000 3. where the EBIT is zero.000 6.000 Unit Selling Price (P) = Rs.1.000 (10 .000 Unit Variable Operating Cost (V) = Rs.000 60. However. then a 10% increase in the level of output will increase operating income by 20%. For Bell Metal Works: DOL = [50.: Q After measuring the DOL for a particular company at varying levels of output the following observations can be made: • • • • Each level of output has a distinct DOL..000 1.00. If Q is less than the operating break-even point.60.000 2.70.20.000 Unit Selling Price (P) = Rs.1. the DOL will start to decline as the level of output increases and will reach a limit of 1. Operating Fixed Costs (F) = Rs.00.10.1 Cost and Profit Schedules for Bell Metal Works and Fibre Glass Ltd.000(10 .90.00.000 (1.000] = DOL 2.00.000 2.000 Unit Variable Operating Cost (V) = Rs.000 1.000 1. Let us compute the DOL of these two firms at an output of 50. If Q is greater than the operating break-even point.000 2.00.10.000 3.000 80.000 .000 8.000 60.000 5.7) . 90.000 4. In Table 8.00.90.000 7. viz.000 20.000 (10 .000 1.90.000 70.000 For XYZ Company Ltd.000 5.10. However.000 (40.000' 50.00.1.000 5.200) = 3.5 For Fibre Glass Limited: = [50.000 1.000) 0 30. we can see that Bell Metal Works has lower fixed costs and higher variable cost per unit when compared to Fibre Glass Limited.5 EBIT Break-even Point = 38.000 7. the quantity produced can be calculated as follows: Q = F/(S .V) 9.at operating break-even point.10.000 units From table 8.00.000 units (In Rupees} 10.80. If the DOL of a firm is say.60.000 (10 .0007(500 .40.000 60.000 2.90.000) (30.000 units both firms have the same profit i. Rs.30.000 3.90. as sales fluctuate.00.000 90. then the DOL will be positive.00. DOL is undefined at the operating break-even point.7)] / [50.000 40.000 1.000] 184 .000 5. ) DFL 50. • Measurement of Business Risk: We know that the greater the DOL. Taking the example of XYZ Company Ltd.00. Any method of production which increases DOL is justified only if it is highly probable that sales will be high so that the firm can enjoy the increased earnings of increased DOL.000 at 5.75.000 5. EBIT (Rs.000 Corporate Tax (T) = 50% 6.40 185 50.00.17 The figures prove our conclusion to be right. to measure DFL for varying levels of EBIT.00. a higher DOL means higher business risk and vice-versa.5 Application and Utility of the Financial Leverage Financial leverage when measured for various levels of EBIT will aid in understanding the behavior of DFL and also explain its utility in financial decision making. which has an EBIT of Rs. DOL is therefore a measure of the firm's business risk.6.100 Total Let us now calculate the DFL of XYZ Company Ltd.000 .000 -0.e. thereby reducing variable labor overhead while increasing the fixed costs.000 level of production.6.00.00. the firm may have the opportunity to change its cost structure by introducing labor-saving machinery. 10 each 15% Debentures 10% Preference Shares 5000 Preference Shares @ Rs. For instance. Business risk refers to the uncertainty or variability of the firm's EBIT. Production Planning: DOL is also important in production planning.50. every thing else being equal.000 60. Earnings Before Interest and Tax = Rs. Such a situation will increase DOL. the financial leverage measures the effect of the change in EBIT on the EPS of the company.00.000 (ERIT) Interest on Long-term Debt (I) = Rs.000 Preference Dividend (Dp) = Rs.000-75. Financial leverage also refers to the mix of debt and equity in the capital structure of the company.. Consider the case of XYZ Company Ltd. The measure of financial leverage is the Degree of Financial Leverage (DFL) and it can be calculated as follows: DFL DFL = = (percentage change in EPS)/ (percentage change in EBIT) (AEPS/EPS)/(AEBTT/EBIT) Substituting Eq (ii) for EPS we get. the capital structure of the company is as follows: Capital Structure Authorized Issued and Paid-up Capital 500000 Equity Shares @ Rs.000 Amount (Rs.000 DFL 6.000 1-0. the more sensitive is EBIT to a given change in unit sales.= 4. the greater is the risk of exceptional losses if sales become depressed. • FINANCIAL LEVERAGE While operating leverage measures the change in the EB1T of a company to a particular change in the output.00.00. So.) 50. i.000 5. 3. as interest is a tax deductible expense. the company is not financially leveraged and would have the following balance sheet. Rs. to the extent of interest (1 . By assessing the DFL one can understand the impact of a change in EBLT on the EPS of the company. a part of this money may also be brought in through debt financing. increased use of debt financing will lead to increased financial risk which leads to: • • Increased fluctuations in the return on equity.000 7.30 The DFL at EBIT level of 175000 is undefined and this point is the Financial Break-even Point.00.00. i.00. how financial leverage affects return on equity.e. This will however start to decline as EBIT increases and will reach a limit of 1. The greater the tax rate.1. a company may increase the return on equity by the use of debt i. the company's operations have been able to generate more than 15% which is being transferred to the owners. The use of debt in the company's capital structure has caused the net profit to decline from Rs. Impact of Financial Leverage on Investor's Rate of Return Let us see with the help of a very simple example.000).000 1. the use of financial leverage.. DFL will be negative when the EBTT level goes below the Financial Break-even Point DFL will be positive for all values of EBIT that are above the Financial Break-even Point. By increasing the proportion of debt in the pattern of financing i. by increasing the debt-equity ratio.000 7. Increase in the interest rate on debts.500. 1.000. as.000 to operate.500 to Rs.e.000. DFL is undefined at the financial Break-even Point.1. What happens to return on equity? The income statements for the financially unleveraged and leveraged firms will appear as follows: Leveraged Finn Unleveraged Firm (Debt-Equity Ratio (zero Debt) 2 : 1) 186 . expenses remaining the same. What were the factors which contributed to this additional return? We can trace out two sources of this additional return: • • though the company has to pay interest at 15% on borrowed capital.41 1.. This money may be brought in by the shareholders of the company. the reduction in PBT has brought about a reduction in the amount of tax paid. 1.. Financial Leverage and Risk If increased financial leverage leads to increased return on equity. it becomes riskier.000 to Rs. why do companies not resort to ever increasing amounts of debt financing? Why do financial and other term lending institutions insist on norms for Debt-Equity Ratio? The answer is that as the company becomes more financially leveraged. 10. If the management raises Rs. In addition to this it also helps in assessing the financial risk of the firm. the owners have invested only Rs. Alternatively.75. let us assume that sales decline by 10% (from Rs. 10.9. • • • • Each level of EBIT has a distinct DFL. As was seen in the above example.33 00 1.e.tax rate) i. Increased Fluctuations in Returns In the previous example.333 now which earned them Rs. A company needs a capital of Rs. It can be defined as: EBIT = I + Dp/(l-T) The following observations can also be made from studying the behavior of DFL.000 from shareholders.50.33 1.e. 10. the company should be able to increase the return on equity. But has the return on owner's capital declined? Return on Equity now works out to 30%. the more is the tax shield available to a company which is financially leveraged.000 -1.000 6.. 000 2.000 Leveraged [Liabilities Assets 10. 10.000 1.000 2.000 10.000 1. the return on equity decreases.667 10. 10. the greater the use of financial leverage.000 Sales Expenses EBIT Interest PBT Tax @ 50% Net Profit The Degree of Financial Leverage (DFL) in each case is calculated as: 187 .000 1.000 (6667x0.000 2. in which case financial leverage would still be favorable. even though the rate of return diminishes.000 9.000 3. the company was unleveraged.15) 1.000 7.000 Equity 3.333 Cash Capital Debt Debt 6. Balance Sheets Liabilities Equity Capital Unleveraged Assets 10.000 7.000 1. IMPLICATIONS Let us again refer to our earlier example.000 3.9.000 3. In the first situation.500 Leveraged 10.000 Cash 10.000 500 500 1000 30% 15% We see that a 10% decline in sales produces substantial declines in earnings and the rates of return on owner's equity in both cases. However.000 1.000 1. interest payments become obligatory and hence fixed in nature.500 1. But the decline is greater for the financially leveraged firm than for the financially unleveraged firm. The balance sheet and income statements are reproduced below.000 10. 10.000 7. Creditors may refuse to lend to a highly leveraged firm or may do so only at higher rates of interest or more stringent loan conditions.500 15% 10% 9. Hence. INCREASE IN INTEREST RATES Firms that are highly financially leveraged are perceived by lenders of debt as risky.000 10.000 ROE at Sales of Rs.000 Income Statements Unleveraged 10.000 is now the cause for its more than proportional decline with a decline in sales. the greater the potential fluctuation in return on equity. in the second situation the debt-equity ratio was 2:1. it might still exceed the rate of return obtained when no debt was used.000 1.Sales Expenses EBIT Interest Charges PBT Tax @5Q% Net Profit Net Profit at Sales of Rs.000 1. The same interest payment which was the cause for increase in owner's equity when sales were Rs.000 2. As the interest rate increases.000 7.000 ROE at Sales of Rs. Why is this so? The reason can be traced to the fact that once a firm borrows capital. 000 Rs. EPS will also change by 1%. TOTAL LEVERAGE A combination of the operating and financial leverages is the total or combined leverage.00.000 = 50% = - 3.V) .5% when it uses debt in the ratio of 2:1 (66.000 = Rs. when the output is 5.41 -3.5% change in EPS. Thus. EPS changes by 1. Applications and Utility of Total Leverage 188 .000 units.V) .75. the degree of total leverage (DTL) is the measure of the output and EPS of the company.200 = Rs.53 = DOL x DFL Thus.F .[Dp/1 . Through an EBIT-EPS analysis. a one percent change in Q will result in 3.What do these figures imply? They imply that if EBIT is changed by 1%. DTL is the product of DOL and DFL and can be calculated as follows.5x1.50. DTL DTL = = = % change in EPS / % change in output = DOL x DFL (AEPS/EPS)/(AQ/Q) {[Q(S-V)]/[Q(S-V)-F]}X {[Q(S . This is proof of what we have stated earlier: The greater the leverage.500 5000 Units = Rs.67% of total capital).500 5.9.F]/Q(S . we can evaluate various financing plans or degrees of financial leverage with respect to their effect on EPS.000 = Rs.53 DTL 2. Ltd.00.I . the wider are fluctuations in the return on equity and the greater is the financial risk the company is exposed to. the company uses no debt. However.62.T)]} Calculating the DTL for XYZ Co.1. given the following information: Equity Earnings Quantity Produced (Q) Variable Cost per unit (V) Selling Price per unit (S) Number of Equity Shareholders (N) Fixed Expenses (F) Interest (I) Preference Dividend (Dp) Corporate Tax (T) = Rs. Before understanding what application the total leverage has in the financial analysis of a company.67 -4. by measuring total risk. DTL decreases as Q increases and reaches a limit of 1.500.000) x Percent change in Q = 6x10% = 60% 2. Percentage change in EPS = DTL (Q = 3.000 . Calculating DTL for various levels of output with the given information: Q 1000 2000 2500 3000 5000 DTL -0. Thus.5)]/ (1. given the following information: F I Dp S V = = = = = Rs. Let us calculate the overall break-even point and the DTL for the various levels of Q. then the DTL will be negative. At the overall break-even point of output the DTL is undefined. the overall break-even point is at 2500 units. A number of criteria have been evolved for evaluating the financial desirability of a project.000 Rs. then the DTL will be positive. If the level of output is less than the overall break-even point. These criteria can be classified as follows: Figure 8. For example.00. it measures the variability of EPS for a given error in forecasting Q. the DTL has the following applications in analyzing the financial performance of a company: 1.000 + 60. Thus.00.0007(1. Measures Total Risk: DTL measures the total risk of the company since it is a measure of both operating risk and total risk.000 Rs.600 The overall break-even point is that level of output at which the DTL will be undefined and EPS is equal to zero.0. if DTL for Q of 3000 units is 6 and there is a 10% increase in Q.00 The following observations can be made from the above calculations: • • • • There is a unique DTL for every level of output.000 + 80.60. Measures changes in EPS: DTL measures the changes in EPS to a percentage change in Q. the percentage change in EPS can be easily assessed as the product of DTL and the percentage change in Q. 1. Thus.2 189 . If the level of output is greater than the overall break-even point.8. we are now ready to examine whether the project is financially desirable or not.000 Rs. the affect on EPS is 60%.000 Rs. Further.00 2. This level of output can be calculated as follows: = = [8. APPRAISAL CRITERIA Having defined the costs and the benefits associated with a project.80.00 QO 6. let us make a few more observations by studying its behavior.600) 2. 10 lakh.Payback Period The payback period measures the length of time required to recover the initial outlay in the project.n)-10 Assuming the cost of funds to be 12 percent..037 Therefore. the firm has to decide upon an appropriate cut-off period.4) = 3.4 lakh.. Projects with payback periods less than or equal to the cut-off period will be accepted and others will be rejected.(1) .6 lakh. say Rs. we find that PV1FA (32.5 From PVIFA Tables. and is expected to generate a net annual inflow of Rs. We find the discounted pay back period is longer than the undiscounted pay back period which will be 2.. these firms discount the cash flows before they compute the payback period. Equation (1) can be re-written as PVIFA(12.15 years.12 lakh and Rs. Consequently the firm may accept too many short-lived projects and too few long-lived ones. if a project with a life of 5 years involves an initial outlay of Rs. For example. The payback period criterion however suffers from the following serious shortcomings: It fails to consider the time value of money. the payback period of the project = 20/8 = 2. we find it to be a whisker better than the 190 .5 years in this case. the importance of which has already been discussed at length. Since the application of the payback criterion leads to discrimination against projects which generate substantial cash inflows in later years.8 lakh.402 PVIFA (12.20 lakh and is expected to generate a constant annual inflow of Rs. In order to use the payback period as a decision rule for accepting or rejecting the projects.4 lakh for the next 4 years.. 'n' lies between 3 and 4 years and is approximately equal to 3. Rs.. • The cut-off period is chosen rather arbitrarily and applied uniformly for evaluating projects regardless of their life spans. Evaluating the discounted pay back period as an appraisal criterion. the criterion cannot be considered as a measure of profitability. Rs.3) = 2. the discounted pay back will be that value of 'n' for which 4xPVIFA(12. Rs. It helps in weeding out risky projects by favoring only those projects which generate substantial inflows in earlier years. In other words. The payback period is a widely used investment appraisal criterion for the following reasons: • • It is simple in both concept and application. • To incorporate the time value of money in the calculation of payback period some firms compute what is called the "discounted payback period". n) = 2. For instance if a project involves an initial outlay of Rs.14 lakh over the 5 year period the payback period will be equal to 3 years because the sum of the cash inflows over the first three years is equal to the initial outlay.10 lakh. On the other hand if the project is expected to generate annual inflows of.5 years. In such cases if the current book return of a firm tends to be unusually high or low.2 191 . This criterion also depends on the choice of an arbitrary cut-off date and ignores all cash flows after that date. this criterion ignores the time value of money. the ARR depends on accounting income and not on the cash flows. But it still suffers from the other shortcomings of the pay back period. ARR is simple both in concept and application. Finally. the ARR of a project is compared with the ARR of the firm as a whole or against some external yard-stick like the average rate of return for the industry as a whole. The following illustration illustrates this point. Since cash flows and accounting income are often different and investment appraisal emphasizes cash flows. the immediate cash flow will be investment (cash outflow) and the net present value will be therefore equal to the present value of future cash inflows minus the initial investment. This criterion. It considers the returns over the entire life of the project and therefore serves as a measure of profitability (unlike the payback period which is only a measure of capital recovery). suffers from several serious defects. In practice. companies do not give much importance to the payback period as an appraisal criteria. Illustration 8. To use it as an appraisal criterion. Often firms use their current book-return as the yard-stick for comparison. As an investment appraisal criterion. a profitability measure based on accounting income cannot be used as a reliable investment appraisal criterion. ARR has the following merits: • • Like payback criterion. the firm using ARR as an appraisal criterion must decide on a yard-stick for judging a project and this decision is often arbitrary.undiscounted pay back period. Second. then the firm can end up rejecting good projects or accepting bad projects.) Year Investment Sales Revenue Operating expenses (excluding depreciation) depreciation Annual Income 0 (90000) 60000 30000 30000 1 120000 2 100000 50000 30000 20000 3 80000 40000 30000 10000 The firm will accept the project if its target average rate of return is lower than 44 percent. It considers the time value of money and thereby does not give an equal weight to all flows before the cut-off date. The net present value is equal to the present value of future cash flows and any immediate cash outflow. Net Present Value (NPV) We have already discussed the concept of present value and the method of computing the present value in the chapter on time value of money. it gives no allowance for the fact that immediate receipts are more valuable than the distant flows and results giving too much weight to the more distant flows. First. In the case of a project. Put differently. Accounting Rate of Return Trie accounting rate of return or the book rate of return is typically defined as follows: Accounting Rate of Return (ARR) = Average Profit After Tax/Average book value of the investment. It appeals to businessmen who find the concept of rate of return familiar and easy to work with rather than absolute quantities. however. To illustrate the computation of ARR consider a project with the following data: (Amount in Rs. Since net present value represents the contribution to the wealth of the shareholders. Rarely in real life situations. A project will be accepted if its NPV is positive and rejected if its NPV is negative.266 1 5100 0. But in practice.Consider the project described in illustration 8.) PVIF@k-12% Present value (Rs.34 -16.065 + 3. the decision-maker is supposed to be either indifferent in accepting or rejecting the project. NPV in the neighborhood of zero.4 will be: BCR NBCR = 4.. theoretically speaking. If it happens. (-12.500+ 16.766/12.500) + (4. we encounter a project with NPV exactly equal to zero. maximization of shareholders' wealth. The only problem in applying this criterion appears to be the difficulty in comprehending the concept per se. Compute the net present value of the project.893 4554 2 5100 0.(-12.266/12.631 f 4.636 4516 The decision rule based on the NPV criterion is obvious.516) = Rs.500 = 0. if the cost of funds to the firm is 12 percent. maximizing NPV is congruent with the objective of investment decision making viz.766) = Rs. The NPV is a conceptually sound criterion of investment appraisal because it takes into account the time value of money and considers the cash flow stream in its entirety.797 4065 3 5100 0.500 =1.34 The decision-rules based on the BCR (or alternatively the NBCR) criterion will be as follows: 192 .3. Most non-financial executives and businessmen find 'Return on Capital Employed' or 'Average Rate of Return' easy to interpret compared to absolute values like the NPV. calls for a close review of the projections made in respect of such parameters that are critical to the viability of the project because even minor adverse variations can mar the viability of such marginally viable projects. Benefit-Cost Ratio (BCR) The benefit-cost ratio (or the Profitability Index) is defined as follows: where BCR PV and = = = Benefit Cost Ratio Present Value of Future Cash Flows Initial Investment A variant of the benefit-cost ratio is the net benefit-cost ratio (NBCR) which is defined as: The BCR and NBCR for the project described in illustration 18.554 + 4.4. Solution The net cash flows of the project and their present values are as follows: Year Net cash flow (Rs.712 3631 4 7100 0.) Net present value . 75/20 = 5.433) -20 (1. C. First.433) -4.3 Zeta Limited is considering 4 projects .50 Rank II IV III I 25. this criterion cannot be used.5x3. it provides no means for aggregating several smaller projects into a package that can be compared with a large project. On the other hand NPVs of projects B.58/7 = 12.14 1.5 (2. Rank the 4 projects in terms of the NPV and BCR criteria. all 4 projects are acceptable because NPV is positive and BCR is greater than one for each project. But there are two serious limitations inhibiting the use of this criterion. C.02 The BCR of the 4 projects are: Project A B C D BCR 1.20 lakh and the cost of funds to the firm is 14 percent.3 2.5 1 S 1. Therefore the package comprising projects B. B. and D with the following characteristics: Initial Investment Annual Net Cash (Year 0) Flow (Years 1 to 5) A B C D (20) (4. C and D but not both. Second.8 Rank I IV III II A B C D = 5.02/8 = Based on the NPV and BCR criteria.25 which is more than NPV (A).65 + 1. and D can be aggregated and compared with the NPV of project A to arrive at a decision.433).65 = 1. Illustration 8.A.5x3.02-6.5) (7) (8) 7.5x3. Either Zeta has to accept project A or a package consisting of projects. NPV (B + C + D) = NPV (B) + NPV (C) + NPV (D) =0.433).5) NPV(Rs. when the investment outlay is spread over more than one period. it is considered to be a useful criterion for ranking a set of projects in the order of decreasingly efficient use of capital. In this sort of a decision-making situation.5xPVIFA(I4.58 -4.5 The funds available for investment are limited to Rs.5 3.58 + 4. C and D must be accepted.23 1. C and D.15/4.5x3.5 = 8. The decision will depend upon which option maximizes the shareholders' wealth. Internal Rate of Return 193 . The following illustration illustrates the first limitation. Which project(s) will you recommend given the limited supply of funds? Solution The NPVs of the 4 projects are: Project 7. the BCR becomes inapplicable because there is no way by which we can aggregate the BCRs of projects B.7 (3.75 = 0.27 1. B. But all 4 projects cannot be taken by the firm because of the limited availability of funds. in lakh) -20 =(7.If BCR > 1 (NBCR > 0) Decision Rule Accept the project BCR < 1 (NBCR < 0) Reject the project Since the BCR measures the present value per rupee of outlay. 08 x 0.833) + (5 x 0.20% will be equal to: -10 + (5 x 0.16% will be equal to: -10 + (5 x 0. or in other words.08 x 0..743) + (3. the duration of the project. it is a matter of indifference). we can use the following short-cut procedure: Step 1 Find the average annual net cash flow based on the given future net cash flows.20 x 0.e. While under NPV method the rate of discounting is known (the firm's cost of capital).84 NPV at r .20 x 0.870) + (5 x 0.482)-0 We find that at r .57 Step 2 Divide the initial outlay by the average annual net cash flow i. we can determine the approximate value of the IRR. the average annual net cash flow will be equal to: (5 + 5 + 3. this rate of interest will be equal to 15%. 194 .862) + (5 x 0.801 Step 3 From the PVIFA table find that interest rate at which the present value of an annuity of Re. 10/3.33 NPV at r . In our illustration.552)-0.719) + (3.08 + 1. To use IRR as an appraisal criterion..20)74 = 3. the NPV is zero and therefore the IRR of the project is 20%.658)+ (1.08x0.848) + (5 x 0.20%.516) -0.66 NPV at r = 18% will be equal to: -10 + (5+9/ x 0. we require information on the cost of capital or funds employed in the project.08 1.2x0. in lakh) (10) 5 5 3. (If r = k. we have to compute the NPV of the project for different rales of interest until we find that rale of interest at which the NPV of the project is equal to zero or sufficiently close to zero.08 x 0.756) + (3.694) + (3. the NPV at r 15% will be equal to: Cash flow (Rs.801 in 4 years i. then the decision rule based on IRR will be: Accept the project if 'r1 is greater than k and reject the project if r is less than k.57 = 2. We use 15% as the initial value for starting the trial and error process and keep trying at successively higher rates of interest until we get an interest rate at which the NPV is marginally above zero and an interest rate at which the NPV is marginally below zero. Now we know that IRR.609) + (1. To reduce the number of iterations involved in this trial and error process. In the case of our project. Illustration 8.572) -0.4 A project has the following pattern of cash flows: Year 0 1 2 3 4 What is the IRR of this project? Solution To determine the IRR. it is the rate which equates the present value of the cash inflows to the present value of the cash outflows. To illustrate this concept. If we define IRR as 'r' and cost of funds employed as 'k'.e. In our case. let us consider the following illustration.l will be nearly equal to 2. lies between the two rates of interest and using a linear approximation.2x0.The internal rate of return is that rate of interest at which the net present value of a project is equal to zero.20 -10 + (5 x 0.641) + (1. under IRR this rate which makes NPV zero has to be found out.579) '+(1. IRR cannot be a meaningful criterion of appraisal. The steps involved in computing the annual capital charge are as follows: Step 1 Determine the present value of the initial investment and operating costs using the cost of capital (k) as the discount rate. The IRR criterion can be misleading when the decision-maker has to choose between mutually exclusive projects that differ significantly in terms of outlays. in lakh) Project Cash Flow Stream (Rs. there can be multiple internal rates of return.g.. Financial Institutions insist that projects having substantial outlay specially in the medium and large scale sectors must show the computation of IRR in the Detailed Project Report. This criterion however suffers from the following limitations: IRR is uniquely defined only for a project whose cash flow pattern is characterized by cash outflow(s) followed by cash inflows (such projects are called simple investments). For such projects. • In spite of these defects. But projects C and D can have multiple internal rates of return because their cash inflows and outflows are interspersed. The quotient is defined as the annual capital charge or the equivalent annual cost.n) where n represents the life span of the project. it makes sense to businessmen who prefer to think in terms of rate of return on capital employed. e.IRR is a popular method of investment appraisal and has a number of merits like: • • • It takes into account the time value of money. choosing between fork-lift transportation and conveyor-belt transportation. IRR is still the best criterion today to appraise a project financially.1 (Rs. Step 2 Divide the present value by PVIFA (k. Once the annual capital charge for the various alternatives are defined. Annual Capital Charge This appraisal criterion is used for evaluating mutually exclusive projects or alternatives which provide similar service but have differing patterns of costs and often unequal life spans. 8. It considers the cash flow stream over the entire investment horizon.1 where four projects with different patterns of cash flows are given: Table: 8.) Year 0 Year 1 Year 2 Year3 A -20 5 10 15 B -10 -10 15 15 C -10 5 -10 20 D -10 15 10 -5 • Year 4 15 15 20 20 Projects A and B are simple investments and therefore will have unique IKK values. the alternative which has the minimum annual capital charge is selected. This point can be clarified with the help of the following table no. Illustration 8. If the cash flow stream has one or more cash outflows interspersed with cash inflows. which they appraise before sanctioning financial assistance. Like ARR.5 195 . 24.000 x 0.00. (You can assume that the net salvage values of the two systems at the end of their economic lives will be zero.00. system B is preferred to system A. well-defined. for internal transportation.26.000 x 0.000 x 0.00. system A has a life of 7 years and system B has a life of 5 years.17. the appraisal must be carried out in explicit.000 x 0.00.507) + (2.20.636) + (1.00.00.797) + (1.712) + (1.000 x 0.000 x 0.000 1. preferably standardized terms and should be based on sound economic logic.50.3.797) (1.25.00. A wide variety of measures are used in practice for appraising investments.00. 196 .000 Calculate the annual capital charge associated with these two systems.75. The initial outlay and operating costs (in Rs.000 x 0. But whatever method is used.00.40.) Solution Present value of costs associated with system A .000 1.50. While the two systems serve the same purpose.000 x 0. if the cost of capital is 12 percent.000 x 0.712) + (1.40.567) = Rs.00.000 75.l 1.000 1.000 2.636) + (2.452) = Rs.900 Annual capital charge associated with system A Present value of costs associated with system B = Rs.000 1.893) + (1.00.000 + (1.75.25.00.000 + (75.Hindustan Forge Limited is evaluating two alternative systems: A and B.000 B 8.855 Annual capital charge associated with system B = Rs.893) + (1.567) + (2.20.) associated with these systems are: Year 0 1 2 3 4 5 6 7 A 10.000 2.Rs.000 2.00.00.77.000 x 0.000 1.000 x 0.25.10.000 x 0.000 1.8.25.000 1.000 1.728 Since the annual capital charge associated with system B is lower than that of system A. once the most profitable investment banking firm. community. and they also conduct training programs designed to ensure that employees understand the correct behavior in different business situations. was implicated in a Treasury bond scandal that resulted in the firing of its chairman and other top officers. Many socially responsible firms have created enormous value for their owners. and independent government tests show no adverse effects. However. suppose a medical products company's own research indicates that one of its new products may cause problems. the results of a recent study indicate that the executives of most major firms in the United States do try to maintain high ethical standards in all of their business dealings. president. and possibly keep some patients who would benefit from the new product from using it. However. in recent years the employees of several prominent Wall Street investment banking houses have been sentenced to prison for illegally using insider information on pro-posed mergers for their own personal gain. and to produce safe products. customers. Social Responsibility Another issue that deserves consideration is social responsibility: Should businesses operate strictly in their stockholders' best interests. fair marketing and selling practices. but the amount of pollution is within. and illegal payments to obtain business. Furthermore. was sentenced to ten years in prison plus charged a huge fine for securities-law violations. fair employment practices." Michael Milken. A firm's commitment to business ethics can be measured by the tendency of the firm and its employees to adhere to laws and regulations relating to such factors as ! product safety and quality. Most firms today have in place strong codes of ethical behavior. Business Ethics The word ethics is defined in Webster's dictionary as "standards of conduct or moral behavior. Chase Bank suggested that ethical behavior has increased its profitability because such behavior helped it (1) avoid fines and legal expenses. lost its independence through a forced merger after it was convicted of cheating its banks out of millions of dollars in a check kiting scheme. and (5) support the economic viability of the communities in which it operates. For example. the evidence is relatively weak. who had earned $550 million in just one year. When conflicts arise between profits and ethics. the use of confidential information for personal gain. there is a positive correlation between ethics and long-run profitability. E Hutton. There are no obvious answers to questions such as these. bribery. However. and E.Chapter 9 Financial Ethics Business Ethics and Social Responsibility Is the goal of maximizing stock prices consistent or inconsistent with high standards of ethical behavior and social responsibility? It is most definitely consistent. Another investment bank. community involvement. a large brokerage firm. Should the company make the potential problem known to the public? If it does release the negative (but questionable) information. suppose Norfolk Southern's managers know that its trains are polluting the air along its routes. For example. to avoid polluting the air or water. sometimes the ethical considerations are so strong that they clearly dominate. directives. There are many instances of firms engaging in unethical behavior. and vice-presidents—be openly committed to ethical behavior. customers. Axe the managers ethically bound to reduce pollution? Similarly. However. and stockholders. but companies must deal with them on a regular basis. socially responsible 197 . and the communities in which they operate? Certainly firms have an ethical responsibility to provide a safe working environment. and many unethical firms now are bankrupt. or are firms also responsible for the welfare of their employees. and that they communicate this commitment through their own personal actions as well as through company policies. legal limits and preventive actions would be costly. (3) attract business from customers who appreciate and support its policies. and punishment/reward systems. it is imperative that top management—the chairman. High standards of ethical behavior demand that a firm treat each party that it deals with in a fair and honest manner. other evidence regarding benefits to patients is strong. Salomon Brothers. (4) attract and keep employees of the highest caliber. and they made people wonder about the ethics of business in general. For example." Business ethics can be thought of as a company's attitude and conduct to-1 ward its employees. and a failure to handle the situation properly can lead to huge product liability suits and even to bankruptcy. These cases received a lot of notoriety. went bankrupt. this will hurt sales and profits. (2) build public trust. and its "junk bond king. in many cases the choice between ethics and profits is not clear cut. Drexel Burnham Lambert. However. If other firms in its industry do not follow suit their costs and prices will be lower. Short-term creditors hold obligations that will soon mature and they are concerned with the firm's ability to pay its bills promptly. These persons are interested in liquidity. If two groups of people are interested in the valuation of the firm and they are creditors and shareholders. With poor policies. employee benefit programs. If some firms act in a socially responsible manner while others do not. Without profits. creditors are again divided into short-term creditors and long-term creditors. if not impossible. that is. the firm would not be able to declare dividends. it will have to raise prices to cover the added costs. suppose all firms in a given industry have close to "normal" profits and rates of return on investment. A ratio gives the mathematical relationship between one variable and another. The ratios like receivables turnover ratios and inventory turnover ratios indirectly measure the liquidity. To illustrate. publicly owned firms are constrained by capital market forces. the common stock would trade at low prices in the market. The usefulness of ratios ultimately depends on their intelligent and skillful interpretation. Long-term creditors hold bonds or mortgages against the firm and are interested in current payments of interest and eventual repayment of principal. If a firm has sufficient net working capital (excess of current assets over current liabilities) it is assumed to have enough liquidity. This ability can be measured by the use of liquidity ratios. These persons examine liquidity and profitability. and not ail businesses would voluntarily incur all such costs.actions have costs. which directly measure liquidity. close to the average for all firms and just sufficient to attract capital. What about oligopolistic firms with profits above normal levels—cannot such firms devote resources to social projects? Undoubtedly they can. The firm must be sufficiently liquid in the short-term and have adequate profits for the long-term. its interpretation is a difficult exercise. and the like to a greater degree than would appear to be called for by pure profit or weal™ maximization goals. Considering the above category of users financial ratios fall into three groups: • • • Liquidity ratios Profitability or efficiency ratios Ownership ratios Earnings ratio Dividend ratios . Thus. Short-term liquidity involves the relationship between current assets and current liabilities. Ratios are used by different people for various purposes. The analysis of a ratio can disclose relationships as well as bases of comparison that reveal conditions and trends that cannot be detected by going through the individual components of the ratio. RATIO ANALYSIS Ratios are well-known and most widely used tools of financial analysis. and it will be forced to abandon its efforts. Ratio analysis mainly helps in valuing the firm in quantitative terms. the amount of liquid assets determines the ability to clear off current liabilities. Current Ratio The liquidity ratio is denned as. In addition to liquidity and profitability. Though the computation of a ratio involves only a simple arithmetic operation. C urrent A ssets C urrent Liabilitie s 198 . any voluntary socially re sponsible acts that raise costs will be difficult. If one company attempts to exercise social responsibility.4 Furthermore. sue cessful firms do engage in community projects. the owners of the firm (shareholders) are concerned about the policies of the firm that affect the market price of the firm's stock. many such firms contribute large sums to chari-ties. The current ratio and the quick ratio are the two ratios. and many large. The socially responsible firm will not be able to compete. In the short run. Without liquidity. Still.Leverage ratios • • Capital structure ratios Coverage ratios LIQUIDITY RATIOS Liquidity implies a firm's ability to pay its debts in the short run. the firm cannot pay cash dividends. in industries that are subject to keen competition. then the socially responsible firms will be at a disadvantage in attracting capital. 31 is considered to be healthy by normal standards which is 2:1. debtors. Measuring and predicting the future fund flows. and pre-paid expenses. loans and advances. Quick ratio of Rainbow-chem Industries for the year 5 is calculated as: = 46. To overcome this a more stringent form of liquidity ratio referred to as quick ratio can be calculated. and provisions. Current liabilities include loans and advances taken.31 to 2. But in interpreting the current ratio care should be taken in looking into the composition of current assets. cash costs and expenses. The existing pool of net funds does not have a logical or causative relationship to the future funds that will flow through it. though both the firms may have the same current ratio.23%. we can infer that as the proportion of inventories in total current assets is 3S. higher the short-term liquidity.1 for the year 5. A firm which has a large amount of cash and accounts receivable is more liquid than a firm with a high amount of inventories in its current assets. the quick ratio for the industry (dyes and pigments) is 2.24 From the above figures. and the liquidity ratio of the firm decreased from 3. marketable securities.26. These flows depend importantly on elements not included in the ratio. Measuring the adequacy of future fund inflows in relation to outflows. Quick Ratio Quick-test (also known as acid-test ratio) is defined as: Quick Assets Current Liabilities Current Assets . As the quick ratio is below the industry average.85 + 23. 199 . we can conclude that the liquidity position is below average though the current ratio gives a different picture. which are least liquid of current assets. normally ratios are compared with the industry figures in the absence of predetermined standards. Yet it is the future flows that are the subject of our greatest interest in the assessment of liquidity. such as sales. Though there is no standard with which the ratio can be compared. a current ratio of 3. Inventories have to go through a two-step process of first being sold and converted into receivables and secondly collected. are excluded from the ratio. 2.6 As the current ratio measures the ability of the enterprise to meet its current obligations. profits. accrued expenses.10 32.04. This concept will be clear when the study of funds flow analysis is done.85 + 1.31: 1 implies that the firm has current assets which are 3.30 + 49. The ratio has limitations in the following aspects: 1. The quick test is so named because it gives the abilities of the firm to pay its liabilities without relying on the sale and recovery of its inventories. Limitations of the Current and Quick Ratios The current ratio is a static or stock concept of what resources are available at a given moment in time to meet the obligations at that moment. inventories. and changes in business conditions. So higher the current ratio. trade creditors.Inventotries Current Liabilities The quick ratio is a more stringent measure of liquidity because inventories. In the above case. A current ratio of 3.Current assets include cash.1 36.31 times the current liabilities. the current ratio for the year 5 can be calculated as: Current ratio = 121. From the balance sheet data given in table 6.36 + 4. In the operating cycle of the firm current assets are converted into cash to provide funds for the payment of current liabilities. Higher the receivables turnover ratio. Normally the receivables ratios are useful for internal analysis.31 35. They are: a. The sales figure in the numerator is only credit sales.Bank Finance to Working Capital Gap Ratio Where working capital gap is equal to current assets less current liabilities other than bank borrowings.28% more than the industry. b. care should be taken to see that to project higher receivables turnover ratio. Two ratios are used to measure the liquidity of a firm's account receivables. Accounts receivable turnover ratio Average collection period Accounts Receivable Turnover Ratio The average accounts receivable is obtained by adding the beginning receivables of the period and the ending receivable. may not disclose the credit sales details. As the publicly available information on the firm. Average Collection Period One can get a sense of the speed of collections from receivables turnover ratio and it is valuable for comparison purposes. we can say that the firm's liquidity of accounts receivables is on average 16.66 00.58 .99 00.85 Year 4 01. and dividing the sum by two. the firm may be having a policy of giving certain percent of discount if the debtor pays in certain period of time. Total Debtors Average accounts receivables 43.16 times. Here the measure of liquidity is concerned with the speed with which inventory is converted into sales and accounts receivables converted into cash. Turnover Ratios Receivables turnover ratios and inventory turnover ratios measure the liquidity of a firm in an indirect way.30 (49.99(6Approx. In our case. The turnover ratios give the speed of conversion of current assets (liquidity) into cash as shown above. However. greater the liquidity of the firm. how many times on an average the receivables are generated and collected during the year.19 45.85 + 37. For example. for doubtful debts. because firm cash sales don't give any receivables. The accounts receivables position of the Rainbow-chem Industries for two years is as follows: Sundry debtors more than 6 months Other debtors Prov.30)72 261/43. the firm does follow a strict credit policy. the average receivables turnover ratios of 6 indicates that on an average receivables are revolved 6 times during the year.) Turnover ratio gives. but we cannot directly compare it with the terms of trade usually given by the firm. This ratio shows us the degree of the firm's reliance on short-term bank finance for financing the working capital gap. Such comparison is best made by converting the turnover into days of sales tied up in 200 Year 5 04. When we compare this with the industry of 5.00 37. the analyst in the external environment has to assume that cash sales are insignificant.58 Average receivables turnover 5.00 49. 16 = 69. The ratio that gives the above comparison is average collection period. If the firm is having a credit policy of giving substantial discounts if the receivables are collected within 30 days.receivables. In spite of careful collection efforts difficulty in obtaining prompt payments. or stock turnover. Inventory Turnover The liquidity of a firm's inventory may be calculated by dividing the cost of goods sold by the firm's inventory. it could reflect the following: 1. low. because of high inventory (low turnover). First for getting the cost of goods sold. Average inventory can be obtained by adding the closing inventory (Year 5) and the opening inventory (Year 4) and dividing them by two. Inventory turnover can be defined as: Higher the ratio. 2. The first conclusion requires remedial managerial action. If the terms. The nature of the business should also be considered in analyzing the appropriateness of the size and turnover of the inventory. In this case. or normal.e. the firm is having above average collection period. In the case of Rainbow-chem Industries the inventory turnover could be calculated as follows. It can be obtained by dividing 360 by the average receivables turnover ratio calculated above. 2. For example. For Rainbow-chem Industries. it helps the analyst measure the adequacy of goods available to sell in comparison to the actual sales orders. Excessive carrying charges. high inventory is kept if the cost of imported raw materials because of depreciation is more than the cost of storage. One has to manage carefully between running out of goods to sell and investing in excessive inventory otherwise it will result in either a high or low ratio. In this regard. assuming that there is only one sundry debtor the average collection period is equal to 60 days (360/6). Customers facing financial problems. 360/5. which may be an indication of poor management. which is defined as the number of days it takes to collect accounts receivable. Collection job is poor. greater the efficiency of inventory management. for example say the average collection period is 30 days and the realized average collection period is 60 days.76 days). Evaluation Accounts receivable turnover rates or collection periods can be compared to industry averages or to the credit terms granted by the firm to find out whether customers are paying on time. That is. while the second and third conclusions convey the quality and liquidity of the accounts receivables. The inventory turnover. Running out of stock due to low inventory (high turnover) which may indicate future shortages. The importance of inventory turnover can also be looked from a different point of view i.e. we have to add all the expenses in the profit and loss account including depreciation charges and excluding interest expenses. the presence of inventory involves two risks: 1. The current turnover must be compared to previous periods or to some industry norms before it is designated as high. the debtor will not be able to avail the discounts. 201 . The analyst should keep in mind that high and low turnovers are relative in nature. a manufacturing firm which has to import its key raw materials is justified in keeping high inventory of raw materials if it finds out that its base currency has been depreciating against the exporting country's currency consistently. measures how fast the inventory is moving through the firm and generating sales. 3. If we compare the above with the industry figure (i. 79(31.64) 13.72 14.3 Growth Rates Items Sales (Rainbow-chera) Inventory (Rainbow-chem) Sales (Industry) Inventory (Industry) Year 5 21.58 (35. the liquidity position of the Rainbow-chem Industries Ltd.57) 12. it can be noticed that the Rainbow-chem's current and quick ratios are just below the average industry figures. 202 . Ind.2(100) 13. can be said to be above average.63 4.03 (33.2 Inventory turnover ratio Rainbow-chem Industries Ltd.28(31.52 -9.28 (30.86) 46.63 Average Inventory 4.22(34.26 Rainbow-chem Dyes & Pigm Ltd.08 12.33(32.42 6.18(17.87 (36.40 Year 3 4.14) 14.63 7. Table 9.42 23.39) 41.75) 14. Dyes & Pgrrt. A meaningful conclusion about the inventory turnover can be arrived after studying its composition. and receivables turnover ratios are above the industry averages to an extent.28 Year 2 3.1 Trend Analysis of Inventory Composition Inventory composition Raw materials Work-in-progress Finished goods Total Year 5 Year 4 Year 3 Year 2 Year 1 13.3 Overall Liquidity Position Ratios Liquidity or Current Ratio Quick Ratio Definition Current Assets Current Liabilities Current Assets .16 70 2.80) 12.99 (30. Industry Table 9. Inventory turnover is in a better position compared to the industry which is concluded in the overall analysis of inventory turnover in the respective section.31 From the above table. In conclusion.37 21.48 (100) 34.87 Year 3 16.53 (100) Table 9. its change over the years and comparing the turnover trends with the industry.53 Inventory Turnover Accounts Receivables /Turnover Cost of Goods Sold 5.30 (100) 40.22) 12.83 (33.73) 12.65 Year 4 Year 5 5.39) 17.93) 1632 (46.47) 12.69 4.04 2.25 4.37(35.The average industry inventory turnover is 4.67 Table 9.31 3.87 (100) 35.31 Year 4 5.3. 3.Inventory Current Liabilities Net Credit Sales Accounts Receivable Average Turnover Ratio Receviable Average Collection Period 360 Accounts 5.73) 11.14 18.26 16.80 17.99 60 5.42 (31.10 3.34) 6.04) 14.89 (38. If the firm cannot produce a satisfactory profit on its asset base. pricing. financing.39% In comparison with the industry net profit.6. Two popular ratios in this category are gross profit margin ratio. administration. GPM for Rainbow-chem Industries is calculated as: GPM for industry is 10. it would have indicated some mismanagement in the areas excluding production (as GPM is in line with the industry). Had this been below the industry average. It may be used as an indicator of the efficiency of the production operation and the relation between production costs and selling price. Pro/its in Relation to Assets: It is also important that profit be compared to the capital invested by owners and creditors. By achieving a high asset turnover. Specific area could have been investigated by taking all the aspects and analyzing respectively. Gross Profit Margin Ratio The gross profit margin ratio (GPM) is defined as: where net sales = Sales . Net Profit Margin Ratio The net profit margin ratio is defined as: This ratio shows the earnings left for shareholders (both equity and preference) as a percentage of net sales. Asset Turnover It highlights the amount of assets that the firm used to generate its total sales. and tax management. it might be misusing its assets. margin ratio is just above the average percentage figure. Jointly considered. 1.PROFITABILITY OR EFFICIENCY RATIOS These measure the efficiency of the firm's activities and its ability to generate profits. There are two types of profitability ratios. Profits in Relation to Sales: It is important from the profit standpoint that the firm be able to generate adequate profit on each unit of sales. Idle or improperly used assets increase the firm's need tor costly financing and the expenses for maintenance and upkeep. 2. a firm reduces costs and increases the eventual profit to its owners. the gross and net profit margin ratios provide the analyst available tool to identify the sources of business efficiency/inefficiency.60% which is less than GPM of Rainbow-chem Industries. . it is difficult for the firm to cover its fixed charges on debt and to earn a profit for shareholders.92% NPM for industry = 6. earning power and return on equity. If sales lack a sufficient margin of profit. It measures the overall efficiency of production. and net profit margin ratio. selling. They are also referred to as rate of return ratios and some of them are asset turnover ratio.Excise duty This ratio shows the profits relative to sales after the direct production costs are deducted. Asset turnover ratio is defined as: 203 . The ability to generate a large volume of sales on a small asset base is an important part of the firm's profit picture. 34% 13.26 1758 .29%.49 indicates the firm with an asset base of 1 unit could produce 1. Return on Equity The return on equity (ROE) is an important profit indicator to shareholders of the firm.76% 16. and tax rate. we can conclude that Rainbow-chem tops the industry with a percentage of 17. As it does not consider the effects of financial structure and tax rate it is well suited for inter-firm comparisons. average cost of debt funds.33% 16. Rainbow-chem is operationally very efficient in comparison to all the players in the industry. Asset turnover for Rainbow-chem Industry asset turnover is 1. debt-equity ratio. Earning Power Earning power is a measure of operating profitability and it is defined as: The earning power is a measure of the operating business performance which is not effected by interest charges and tax payments. It is influenced by several factors: earning power.18%. whereas the average is only 16.15. The return on equity measures the profitability of equity funds invested in the firm. It is regarded as a very important measure because it reflects the productivity of capital employed in the firm. An asset turnover ratio of 1. It is calculated by the formula: Net income denotes profit after tax (PAT) and average equity is obtained by taking the average equities of year 5 and year 4.29% From the table.17. The firm s healthiness in this respect also can be easily seen from 204 .82 175 .58%.58% 13. Return on equity for the industry is 13. This is a healthy both in absolute terms and also in comparison with the industry as the turnover of the industry is only 1.18% 17.Average assets is calculated by adding the opening stock of assets (previous year's closing stock of assets) and closing stock of assets of the present year. Rambow-chem s earning power = 30 .58 % Inter-firm comparisons earning power percentages Company Rainbow-chem Industries Atul Products Indian Dyestuff Mardia Chem Sudarshan Chem Industry (dyes & pigm (large)) Year 5 Earning power 17.15.49 units of sales. the earnings trend for the two firms is as follows: Firm Atul Products (EPS) Year 5 Year 4 5. 1. This indicates that some remedial measures have to be taken from the sales' point of view.12% As mentioned in the beginning of this section. whereas the industry is giving only 13.50 per share.68% return to the equity holders. and capitalization ratio. Ownership ratios compare the investment value with factors such as debt.69% 6. Dividend Ratios. it is calculated as follows: Earning per share (EPS) A cross-sectional and year-to-year analysis (will be discussed in later sections in detail) can be very informative to the analyst. Ratios Gross Profit Margin Net Profit Margin Asset Turnover Return on Equity Earning Power Rainbow-chem Ltd. The above table conveys that. EARNINGS PER SHARE (EPS) Shareholders are concerned about the earnings of the firm in two ways. They are.the differences in returns of equity. In the following paragraphs we will discuss the above ratios in detail. Mathematically. Overall Profitability (Efficiency) Analysis Rainbow-chem's profitability ratios are summarized in the following table against the industry. the analyst is able to assess the likely future value of the market.39% 1. One is availability of funds with the firm to pay their dividends and the other to expand their interest in the firm with the retained earnings. earnings. These earnings are expressed on a per share basis which is in short called EPS.18%. Earnings Ratios 2. price-earnings ratio (P/E ratio).15 7. (large) industries.80% 34. Assuming the market price of each stock as Rs. By understanding the liquidity and profitability ratios. Leverage Ratios Capital Structure Ratios Coverage Ratios 3.49% 20. 1. whereas by analyzing the ownership ratios. Rainbow-chem Industries is able to generate profits in relation to sales on an average scale.96 12. profitability is analyzed in two respects.58% Dyes & Pigm Ind. That is in relation to sales and in relation to assets.92% 1 . we can conclude that Rainbow-chem has employed it resources productively. OWNERSHIP RATIOS Ownership ratios will help the stockholder to analyze his present and future investment in a firm. As an example let us take two firms Atul Products and Rainbow-chem Industries in the Dyes & Pigm. one can gain insights into the soundness of the firm's business activities. Stockholders (owners) are interested to know how the value of their holdings are affected by certain variables.97 8.16 . 22. but in respect of efficient application of assets it performs well above the average. 10.60% 6.68% 17. Ownership ratios are divided into three main groups. Earnings Ratios The earnings ratios are earnings per share (EPS).'Thus. From earnings ratios we can get information on earnings of the firm and their effect on price of common stock.18 205 Year 3 Year 2 Year 1 5. Rainbow-chem is giving 20. EPS is calculated by dividing the net income by the number of shares outstanding. dividends and the stock's market price.25% 13. Atul Products started at a high EPS of Rs.e. We will get an even more clear picture if we compare all the players in the industry.12 EPS and sells for Rs. i. Rs.12 Year 3 130 8. it may be considered as an undervalued stock.68 12.70 5. the share capital of Atul products has increased without proportionate increase in the net income. (market price/EPS) gives this return.0279 Year 1 0.100. 12 percent.3 respectively and earning per shares of both the firms as Rs.24 per share but steadily progressed and nearly tripled its EPS in 5 years.98 6.Rainbow-chem (EPS) 13.97 per share.5. Leverage Ratios 206 .24 From the above table. For example. it can be easily understood that the Rainbow-chem Industries began at a low EPS of Rs. we can find that over the years. Market value of industry =7x3=21 Market value of firm A =5x3 = 15 Market value of firm B =9x3=27 THE CAPITALIZATION RATE The P/E ratio also may be used to calculate the rate of return investors expect before they purchase a stock. If the ratio is 80/1.12.81 8. 2. The P/E ratio method is useful as long as the firm is a viable business entity.06 450 12.069 Year 2 0. The reciprocal of the P/E ratio. This ratio gives the relationship between the market price of the stock and its earnings by revealing how earnings affect the market price of the firm's stock. If a stock has a low P/E multiple.028 Year 3 0. The trends of the two earnings streams appear to forecast a brighter future for Rainbow-chem Industries than for Atul Products.0655 For Rainbow-chem Industries. A 12 percent capitalization implies that the firm is required to earn 12 percent on the common stock value.5. if a stock has Rs.e.81 35. The P/E multiples for Rainbow-chem Industries is calculated as follows: Table 9. This is called the stock's capitalization rate.4 Year5 Year 4 Share price EPS P/E 425 13.68 31. It is the most popular financial ratio in the stock market for secondary market investors. i.24 15. and its real value is reflected in its profits.47 Year 2 Year 1 240 6. For example. for example 3/1.98 14.82 80 5.26 The main use of P/E ratio is it helps to determine the expected market value of a stock. rates are very low because of very high prices in comparison to earning per shares.16 per share but in 5 years declined up to Rs. the marketplace expects a return of 12/100. If the investors require less than 12% return they will pay more for the stock and capitalization rate would drop. PRICE-EARNINGS RATIO The price-earnings ratio (also P/E multiple) is calculated by taking the market price of the stock and dividing it by earnings per share.032 Year 4 0. If we assume the average industry P/E and EPS as 7/1. it may be viewed as overvalued. Year 5 Capitalization rate 0.70 35. If we go further into the reasons behind this performance of Atul Products. one firm A may be having a P/E of 5/1 and another firm B of 9/1. Whereas. we will get the following results.3. They are structural ratios and coverage ratios. results of operations and future prospects. which implies that the debt portion is more than equity. when the debt-equity ratio is less than 0.424. It is usually held that fixed and other long-term assets should not be financed by means of short-term loans.5:1 is considered to be healthy. This way. For Rainbow-chem Industries the debt-equity ratio is In the above case the debt-equity ratio stood as 1. Rainbow-chem's debt-asset ratio for the year 5 is: 207 . By normal standards and also the industry's the debt-equity ratio is within the limits. The denominator in the ratio is total of all assets as indicated in the balance sheet. CAPITAL STRUCTURE RATIOS Various capital structure ratios are: Debt-equity ratio. It is defined as: The composition of debt portion is same as in the debt-equity ratio. Debt-equity Ratio The debt-equity ratio which indicates the relative contributions of creditors and owners can be defined as: D ebt E quity Depending on the type of the business and the patterns of cash flows the components in debt to equity ratio will vary. It is used as a screening device in the financial analysis. It includes only the preference shares not redeemable in one year. While analyzing the financial condition of a firm. whereas coverage ratios are derived from the relationships between debt servicing commitments and sources of funds for meeting these obligations. The debt-equity ratio of the dyes & pigments industry on average is 1. In the manufacturing industry a debtequity ratio of 1. Structural ratios are based on the proportions of debt and equity in the capital structure of the firm. the analyst can go to other critical areas of analysis.33. But an analysis reveals that debt is a significant amount in the total capitalization if further investigation is undertaken which will throw light on firm's financial condition. analysis of debt-equity ratio has a very important position in the financial analysis of any firm. In fact. though financially very sound organization may go for debt finance. the higher the degree of protection felt by the lenders. the lower the debt-equity ratio. The ratio of long-term debt (total debt-current liabilities) to equity could also be used. airways the ratio may even go more than 3:1 as the capital outlays required are in very huge sums. In general.When we extend the analysis to the long-term solvency of a firm we have two types of leverage ratios. Debt-assets ratio. the most appropriate source of funds for investment in such kind of assets is equity capital. One of the limitations of the above ratio is that the computation of the ratios is based on book value. Normally the debt component includes all liabilities including current. The debt-equity ratio indicates the relative proportions of capital contribution by creditors and shareholders. a sick company whose equity is initially valued at book values may be a healthy one if its assets are valued at market prices if it has large land property in its books.50. At the time of mergers and acquisitions or rehabilitation operations the valuation of the equity and debt will be affected by the basis of computation. Debt-Asset Ratio The above ratio measures the extent to which borrowed funds support the firm's assets. infrastructure industries like railways. as it is sometimes useful to calculate these ratios using market values. The type of assets an organization employs in its operations should determine to some extent the sources of funds used to finance them. petroleum industries. For example. but what is important is that consistency is followed when comparisons are made. And the equity component consists of net worth and preference capital. In the heavy engineering industries. There are two major uses of capital structure ratios: 1. fixed charges coverage ratio and debt-service coverage ratio. principal repayment obligations. An interest coverage ratio of 4 means that the firm's earnings before interest and taxes are four times greater than its interest payments. 2. Important coverage ratios are interest coverage ratio.57 implies that 57% of the total assets are financed from debt sources. As the debt content increases most of firm's income will go for servicing the debt and net income will be reduced. 3.= 0. It is defined as: 208 .69). Funds available to meet an obligation Amount of that obligation COVERAGE RATIOS Interest Coveragerage Ratio One measure of a firm's ability to handle financial burdens is the interest coverage ratio. lease payments and preference dividends. This will affect the longterm earnings prospects of the company as less funds are reemployed because of increased debt servicing burden. FIXED CHARGES COVERAGE RATIO Interest coverage ratio considers the coverage of interest of pure debt only. the capital structure ratios offer an indication of whether debt funds could be used. Ratios Coverage ratios give the relationship between the financial charges of a firm and its ability to service them. This ratio shows how many times the pre-tax operating income covers all fixed financing charges. we find that the firm is having a lower leverage compared to the industry. When we compare this with the industry average debt-asset ratio of (0. To Measure Financial Risk: One measure of the degree of risk resulting from debt financing is provided by these ratios. To Identify Sources of Funds: The firm finances all its requirements either from debt or equity sources. the firm may not be able to borrow. Fixed charges coverage ratio measures debt servicing ability comprehensively because it considers all the interest.57 A debt-asset ratio of 0. To Forecast Borrowing Prospects: If the firm is considering expansion and needs to raise additional money. Depending on the risk of different types the amount of requirements from each source is shown by these ratios. This ratio tells us how many times the firm can cover or meet the interest payments associated with debt. also referred to as the times interest-coverage ratio. For Rainbow-chem Industries it is equal to The greater the interest coverage ratio. If the ratios are too high. the higher the ability of the firm to pay its interest expense. If the firm has been increasing the percentage of debt in its capital structure over a period of time. this may indicate an increase in risk for its long-term finance providers. The loan repayment has been assumed to be Rs. it may not be retaining adequate funds to finance future growth. without liquidity the firm cannot get cash to pay the dividends. But in both the cases. DEBT SERVICE COVERAGE RATIO Normally used by term-lending financial institutions in India.37 crore.92 times all fixed financial obligations. DIVIDEND YIELD This is the ratio of dividends per share (DPS) to market price of the share. This is done by increasing them by an amount equivalent to the sum that would be required to obtain an after-tax income sufficient to cover such fixed charges. If the firm is paying excessive dividends.Fixed charges that are not tax deductible must be tax adjusted. The firm must be liquid and profitable to pay consistent and adequate dividends. which is a post-tax coverage is defined as: For Rainbow-chem Industries the debt service coverage ratio for the year 1995-96 is: A DSCR of 1. For Rainbow-chem Industries the fixed charges coverage ratio is calculated for the year 5 as follows: For Rainbow-chem there are no lease rental payments and preference dividend payments. It indicates what percentage of total earnings are paid to shareholders.89 times the total obligations (interest and loan repayment) in the particular year to the financial institution. it has to be divided by the factor (1 . the firm will not have sufficient resources to give dividends. DIVIDEND PAY-OUT RATIO This is the ratio of dividend per share (DPS) to earnings per share (EPS). They are dividend pay-out ratio and dividend yield ratio. So depending on the shareholder's aspirations a firm must formulate its dividend policy in a balanced way.tax rate). 209 . 3.dividend pay-out) is retained for the firm's future needs. To get the gross amount of preference dividends. it might increase the dividends.92 indicates that its pre-tax operating income is 1. In the above ratio. Without profits. Dividend Ratios The common stockholder is very much concerned about the firm's policy regarding the payment of cash dividends. There is no guideline as to what percentage of earnings should be declared as dividends and it varies according to firm's fund requirements to support its operations. consistency of dividend payment is important to the shareholders. The percentage of the earnings that is not paid out (1 . In the above respects. If the firm is not paying enough dividends the stock may not be attractive to those who are interested in current income from their investment in the company. 3. If the firm is in need of funds. preference-stock dividend requirement is one example of such non-tax deductible fixed charges. two dividend ratios are important. the debt service coverage ratio.89 indicates the firm has post-tax earnings which are 1.7. then it may cut the dividends in relation to earnings and on the other hand if the firm finds that it lacks opportunities to use the firms generated. The fixed charges coverage ratio of 1. Being ethical would broadly include trying to be a good corporate citizen. The focus here is on the individuals rather than on the issues. It is more often between what is right and what is less right . honoring of contractual obligations. trust is extremely difficult to rebuild. It is based on broad principles of integrity and fairness and focuses in issues that a company or an individual can actually influence. This is mainly of interest to the investors who are desirous of getting income from dividends. the right over the wrong and the fair over the unfair in an increasingly competitive business where the choice is not always the simple one between what is right and what is wrong. not rules. customers. or its commitment to the honest conduct of business is in doubt. fairness. Ethical codes of conduct come into picture where regulations end. The economic function demands that the firms have to operate profitably in order to survive over the long-term while the social function stresses the obligations of the firm towards its employees. and trying to do the right thing. damaging the firm's reputation and ability to compete. This is particularly important for those activities that fall under the "grey areas" of regulations. avoidance of conflicts of interest. This basic fiduciary duty required is that the financial managers on behalf of the company serve the interests of the clients not as a by-product. integrity. the satisfaction of their self-interest is obtained as a by-product of a proper discharge of that responsibility. companies are entrusted with an extraordinary responsibility: managing other people's money. and e-business applications not only poses a particular threat to investment banks that manage ethics as a strategic element rather than a core business principle but also challenge even the most ethically vigilant and conservative firms. being perceived as trustworthy is essential because transactions involve the exchange of significant volumes of assets. To be engaged in questionable financial dealings is not merely a breach of ethics and the law it is poor business. often without a face-to-face meeting or the traditional handshake. And it will surely imperil many client relationships. and respect for the law. gaps exist. ethical behavior seeks to achieve compliance.This ratio gives current return on his investment. the driver of a company's culture.in other words between shades of grey. When an firm's ethical stance comes into question. Some of these include honesty in financial transactions. While being ethical may in simple words imply choosing the good over the bad. In other words. or on the continual potential of that conflict. No dividend yield exists for firms which do not declare dividends.can be made only at the expense of one or more of the groups to 210 . stockholders and the general public. However. The key challenge therefore lies in making ethics a core value and making values. The high-voltage. Investors base their trust on a firm's reputation for financial performance and ethical soundness. Cases of wrong doing in business are not confined to particular industries and occur almost across the board. convergence. but also to the spirit of law. respect for company property. Managers thus need to be ever more diligent to balance their entrepreneurial impulses with their fiduciary responsibilities and adhere to strong standards of professionalism that require that the interest of clients be placed ahead of self-interest at all times. And. consolidation. ethical conduct ensures avoidance of even apparent or perceived conflicts of interests. high-velocity financial environment that has emerged in the recent years as a result of globalization. not just to the letter of law. The management confronts an ethical dilemma when the improvements in economic performance namely. and the primary question deals with how individuals conduct themselves in fulfilling these ethical requirements. For the managers. MANAGERIAL ETHICS The ethical dilemma faced by the management centers on the continual conflict. the increase in profits or decrease in costs . clients. and along with them the future profitability of the firm. While regulations might aim at avoiding any actual unscrupulous activity or conflicts of interests. responsible citizenship and accountability. Ethics fill in the gaps where a specific regulation may not exist. but as an end in itself. trying as an organization to adhere to certain ethical values like honesty. Because regulations are often specific to events and activities. that exists between the economic and social performance of an organization. CONCEPT OF ETHICS Business ethics can he defined as an attempt to ascertain the responsibilities and ethical obligations of the business professionals. Financial Ethics Ethical conduct lies at the core of all businesses. or mergers and acquisitions. if not the spirit of it. An amoral management intervenes in the matters when the actions of the employees lead to external pressures. When companies are forced to downsize because of economic considerations. marketing policies. decline in the stock prices prompt the investment banks to layoffs in different business segments. Managers confront many ethical dilemmas while making the decisions because many of the times someone to whom the firm has some form of obligation is going to be hurt or harmed in some manner. it does not have a stance on issues relating. it never sacrifices the sense of fairness. But it does not and cannot embody the whole duty of man. while the company is going to profit. but within the purview of legal and moral compliance. to morality or ethical considerations. companies can cause extra pain to employees by bumbling their way through the process. it thinks that general ethical standards are not applicable to business. Types of Management Ethics Archie B. Such a management not only ignores ethical consideration in business operations. or helping the employees find new jobs firms can reduce the emotional impact of the downsizing. Amoral management is a middle path between moral and immoral. ROLE OF LAW IN ETHICS It is generally agreed that law cannot substitute either ethical standards or corporate governance. While being fired is always traumatic. and mere compliance with the law does not necessarily make a good citizen or a good company. premature and lacking integrity. Instances of such practices have been seen in the online brokerage industry where the advertising practices and the advertising content of the online brokers could color the expectations of the online investors. In this context. it is crucial to keep in mind the human impact. Managers face ethical dilemmas while taking decisions on aspects like downsizing. as the wave of consolidation. The surviving employees will often share perceptions about ethics of this decision with those who are being forced to leave. The employees who are forced to leave their jobs feel betrayed and the organization and its leadership may be thought to be impatient. Similarly shutting down a business segment that has not been profitable also leads to job cuts. it excludes ethical issues from the decision-making process. MARKETING STRATEGIES Marketing strategies is another area where the increasing competitive pressures prompt the corporations to engage in activities at the expense of consumer education about their products and services in order to generate sales. DOWNSIZING One of the most common ethical dilemmas faced by the management is layoffs or downsizing in the event of a market downturn or increasing competitive pressures. Immoral management is synonymous with the "unethical practices" in business.whom the firm has some form of obligation. nor do they seem to bother about them does it. justice and ethics. but also actively opposes ethical behavior. Managerial decisions have extended consequences impacting both the organization and the customers. it is left to the firm to follow judicious and ethical practices. law can support the cause by specifying the basic minimum standards to be followed. an eminent researcher in the field of corporate social responsibility. engage in subtle forms of deception. strictly confined to the letter of the law. The question for the management therefore lies in finding a balance between social performance and economic performance when faced by an ethical dilemma. broadly divided the managements into three types: (i) Moral management (ii) Amoral management (iii) Immoral management. Carroll. Moral management strives to follow ethical principles and precepts. or make claims about their services that are exaggerations or worse. While most of the commercial advertising is regulated there continue to be instances where the corporations stretch the truth. Even while fighting it tough for business success. They also feel tremendous pressure when asked to do more work or learn new tasks. Basically. Sluggish pace of activities in the capital markets that include decline in both equity and debt markets." 211 . The management must therefore demonstrate empathy for all of those affected by this decision. mergers and acquisitions sweeps through the financial services industry downsizing in order to avoid duplication of efforts has become a common practice. It does care about the letter of law. Therefore. However. The management must try to soften the blow as much as possible. It supports extreme pragmatism and displays short-term tendencies. For say. it is worthy to note the following: "The law states minimum standards of conduct. It does attach due weight to profits and financial results. Over and above the compliance. By granting generous packages to the fired employees. When the management is intentionally amoral. This way. identifies possible violations of the code. Top management commitment: Managers can prove their commitment and dedication to work by employing the other tools that would inject a sense of ethics in the staff. Misrepresentations in prospectuses are dealt with under both civil and criminal laws.Given the limitations of law in enforcing high ethical standards. not rules the drivers of a company's culture. reviews and update the code of ethics and reports activities of the committee to me board of directors. 2. appoint a formal ethical committee and. The evolution of technology has provided greater access to information to the companies. the firm can try to institutionalize ethical behavior. Disclosure practices ii. Maintaining confidentiality of client information The company law in any country can also govern the conduct and behavior of the management and accountability. This aspect is peculiar due to their historical adherence to the partnership form of business organization. there can be a set of guidelines acting as general tools and techniques to create an ethical climate. rewards ethical behavior and punishes those who violate corporate ethics. the management can incorporate ethical practices techniques in three steps: establish appropriate company policy or code of ethical conduct. Tools for Ethical Management Though there can be no hard and fast rules on the tools that would bring in ethical business practices. Transparency of operations iii. Ethics Committees: Codifying the ethical practices would alone not suffice if it is not supplemented by an exclusive body for monitoring and steering the operations. but also seem to be done. The tools include: 1. 3. people may conclude. Ethical practices mean "justice should not only be done." ENFORCING ETHICS Companies face the daunting task of promoting ethical behavior among all the employees and ethics programs seek to promote awareness of legal and ethical concerns and to encourage ethical behavior among the employees. The following are the areas that can be subjected to the purview of law with effective supervision: i. 212 . to the others within and outside the company. The role of the committee becomes significant when the firm faces situations of dilemma regarding policy matters. According to Theodore Parcell and James Weber. Investment banks also allowed the market to value them. The compensation policies in the industry are peculiar and highly subjected to multiple counting of transaction value that can be credited to each employee. is permitted" which is a dangerous assumption. Visionary and ethical managements resorted to corporatization as a means of communicating their commitment to greater transparency. This allows all the market participants to have equal access to the same market information and removes the disparity of information between the clients and brokers to a certain extent. between corporates and partnership firms. Regulations pertaining to conduct of meetings address the issue of management participation and also pave the way for shareholder activism. it still attempts to legally govern a few aspects of business and corporate functioning. enforces the code. communicate the code to all members of the organization. An ethics committee needs to be constituted with both the internal and external directors. This is because in a purely rule-driven culture. Code of Ethics: This is a formal document that states an organization's primary values and the ethical rules it expects employees to follow. "what is not forbidden. The limit on the maximum number of directorships attempts to define a span of attention and devotion for an individual. Information technology has enabled the exchanges to broadcast the trade and quotation information to all the market participants. The tools for enforcing ethics seek to promote awareness of legal and ethical concerns and to encourage ethical behavior among employees at work. TRANSPARENCY OF OPERATIONS There is a major difference in terms of transparency of operations. It is important to design a compensation determination policy that would instill a sense of confidence and fair play among the employees. responsibility and accountability. The key challenge for every financial managers lies in making ethics the core value and making values. impart education on ethics during management development programs. The ethics committee organizes regular meetings to discuss ethical issues. Audits attempt to identify and correct any deviations from the standards set. experiences. 213 . For example. An employee who comes to know of it can contact the region-head or the global corporate headquarters and complain about the matter. This requires the managers to develop a strong ethical culture that imbibes and reflects the values. a country head may resort to unethical practices by manipulating the equities market (underlying) to suit the derivatives operations of the firm. Ethics Training: The goal of ethics training is to encourage ethical behavior. Even a company with a long tradition of being committed to ethics has no assurance that it will remain so committed. While a commitment to ethics is among the most valuable assets a firm can possess. attitudes and beliefs. The hotline helps in gathering the information from the whistle-blower. The future growth and success of any company depends on its commitment to these values. 5. relating to the ethical validity of any of the firm's activity. problems and opinions. This can be conducted both during the induction of the employee as well as during the periodic employee/management development programs. thereby controlling the damage that adverse publicity can cause to the firm. 6.4. it is also among the most difficult of assets to acquire and maintain. Such a whistle-blower might even go public with the information. if he perceives that no remedial action might be available inside the firm. Ethics Hotline: Ethics Hotline enables employees to deviate from the normal chain of command and reach the top management with their observations. attitudes and beliefs and its ability to instill them in its employees. Ethics Audits: This involves scrutiny and assessment of activities and their conformance with the predetermined ethical guidelines. as well as among the easiest to lose. which have the single greatest influence on how the investment bank works'.