Assignment Topics

(Case study-based)
1. Ratio analysis using financial statements-1 (manufacturing company, also refer
Chapter-25, IM Pandey)
2. Ratio analysis using financial statements-2 (IT company, also refer Chapter-25,
IM Pandey))
3. Break-even analysis
4. Operating cycle/Working capital
5. Budgeting (discuss receipts and expenditure, industry specific)
6. Valuation of securities and warrants
7. Dividend policy of an IT company
8. Hybrid financing
9. Manufacturing economics (also discuss cost of production)
10. Dividend’s impact on share price (manufacturing company)
11. Convertibility

(Refer notes on SLE that has been circulated)

 Understanding the three basic elements of manufacturing costs

In the manufacturing industry, cost accounting is a fundamental requirement for

achieving success. To be competitive and profitable, a manufacturer must understand
and control the three basic elements of manufacturing costs – direct materials, direct
labor and factory overhead.

Direct materials consist of all of the materials that become an integral part of the
finished product. Direct materials should include the actual cost of the materials, as well
as freight in, import duties, purchasing costs, receiving costs, storage costs and other
directly attributable costs of acquiring the materials. Direct materials should be recorded
net of any trade, quantity or cash discounts attributed to the materials.

Direct labor consists of all of the personnel costs required to manufacture the finished
product. Direct labor should include wages, payroll taxes, and benefits associated with
personnel who are integral to manufacturing the finished product.

Factory overhead consists of all of the other costs required to manufacture the finished
product that do not fit into the direct material or direct labor elements. They consist
mainly of indirect material, indirect labor, depreciation, utilities, rent, repairs and
maintenance and insurance.

In the current economic conditions, companies have been searching for ways to improve
efficiencies, in order to maintain profitability and a competitive advantage. Phase one of
this effort should be to perform an operational assessment to identify the strengths and
key deficiencies within the manufacturing process. The assessment would include a
detailed review and analysis of manufacturing areas such as service and quality,
management and personnel abilities, reporting metrics and systems, inventory
management and plant physical layout. The assessment exposes areas within the
manufacturing process that can be used to initiate and concentrate improvement efforts
and cost reduction strategies. Cutting costs prior to performing an operational
assessment might not result in improved efficiency or profitability.

Phase two of this effort would be a cost reduction project. The first step of this phase
should begin with a comparison of the company’s profitability to the average profitability
within the industry. It’s important to consider multiple industry resources and publications
to obtain appropriate and comparable regional profitability averages. All fixed and
variable costs within the manufacturing process should be focused on the goals of
reduction, elimination, modification, substitution or innovation. Scrutinize direct material
purchases, freight, utilities, insurance, inventory carrying costs and other indirect
manufacturing costs.

During any process improvement or cost reduction project, it is critical to engage

employees from all levels in the process. Engaging employees in process improvement
initiatives keeps them focused on the company and its profitability, as well as their job.
Employee engagement will enhance the benefits of the project, since production
personnel possess the most hands-on experience in the manufacturing process, and
can provide invaluable insight.
Poor economic conditions tend to result in an increase in efficiency improvement and
profit improvement projects. However, don’t overlook the importance of considering
some level of one of these projects each year. When poor economic conditions occur, it
frequently pays to be the first company to react and position for the conditions. These
projects can also lead to better than average growth during good economic conditions.

Understanding and controlling manufacturing costs can be the difference between

making the sale or losing the sale. It can also be the difference between making a
profitable sale or making an unprofitable sale. Lost sales and unprofitable sales can both
result in a disastrous conclusion. Schneider Downs can help you achieve the profitability
and competitive advantage that is necessary to be successful in this or any economy.

Elements of cost
1. ELEMENTS OFCOST

2. The cost of a product consists of the following cost components or elements:Direct

MaterialDirect LabourDirect ExpensesFactory OverheadSelling and Distribution and
Administrative Overhead

3. Materials: Material indicates principal substances used in production. Examples are:

cotton,jute, iron-ore, and silicon. The cost ofmaterial is further divided in to direct andindirect
materials.

4. Direct Material: Direct materials refer to the cost of materials which become a major part of
the finished product. They are raw materials that become an integral part of the finished
product and are conveniently and economically traceable to specific units of output.Some
examples of direct materials are:raw cotton in textiles, crude oil to makediesel, steel to make
automobile bodies.

5. Indirect material:These are materials which are usedancillary to manufacture and cannot
betraced in to the finished product. Theseform a part of manufacturing overhead. Examples
are glue, thread, nails,consumable stores, printing and stationarymaterial

6. LABOUR: Labor is the physical or mental effortexpended on the production of an item. It

isthe active factor of production as againstmaterial which is a passive factor. The costof labor
further divided into direct andindirect labor.

7. Direct Labour:Direct labour is defined as the labourassociated with workers who are
engagedin the production process. It the labourcosts for specific work performed on aproduct
that is conveniently andeconomically traceable to end products.Direct labour is expended
directly uponthe materials comprising the finishedproduct. Examples are the labour
ofmachine operators and assemblers
8. Indirect labor: This includes wages paid for all labour which isnot directly engaged in
changing the shape orcomposition of raw materials. It cannot be traceddirectly to the product.
Lick indirect materials,indirect labour forms part of the manufacturingoverheads. Examples of
indirect labor cost arewages paid to foremen, supervisors, store-keepers, time-keepers,
salaries of officeexecutives and the commission payable to salesrepresentatives.

9. Direct Expenses:Direct expenses include any expenditure other thandirect material and
direct labor directly incurred on aspecific cost unit (product or job). Such specialnecessary
expenses can be identified with cost unitsand are charged directly to the product as part of
theprime cost.Some examples of direct expenses are: (a) Cost of special layout, designing or
drawings; (b) Hire of tools or equipment for a particularproduction or product; (c)
Maintenance costs of such equipments.

10. Indirect expenses: Indirect expenses are those incurred forthe business as a whole rather
than for aparticular order, job or product. Examplesof such expenses are rent,
lighting,insurance charges.

11. Overheads: Overheads may be defined as the aggregate of indirectmaterial, indirect

labor and indirect expenses. Thus, allindirect costs are overheads. These cannot be
associateddirectly with specific products. Hence, the amount ofoverhead has to be allocated
and apportioned to productsand services on some reasonable basis. The synonymous termis
“burden”. Overheads may be subdivided in to followinggroups: a)Factory overheads. b)
Administrative overheads. c) Selling and distribution overheads.

12. Factory Overhead:Factory overhead also calledmanufacturing expenses or factoryburden

may be defined as the cost ofindirect materials, indirect labor andindirect expenses.
Examples of such items arelubricants, cotton waste, handtools, works stationery.

13. Selling and Distribution andAdministrative Overhead: Selling and distribution overhead is
also known as marketing or selling overhead. Distribution expenses usually begin when the
factory costs end. Such expenses are generally incurred when the product is in saleable
condition. It covers the cost of making sales and delivering/dispatching products. These costs
include advertising, salesmen salaries and commissions, packing, storage, transportation,
and sales administrative costs. Administrative overhead includes costs of planning and
controlling the general policies and operations of business enterprises. Usually, all costs
which cannot be

14. Fixed cost:Fixed cost is the cost which does not changein total for a given time period
despite widefluctuations in output or volume of activity.Example: Rent, Property taxes,
Supervisingsalaries, depreciation on office facilities,advertising, insurance etc.. Fixed cost
can be further classified into threetypes: Committed cost Managed cost Discretionary
cost
 15. Variable cost:Variable costs are those costs that varydirectly and proportionately with
theoutput. There is a constant ratio betweenthe change in the cost and change in thelevel of
output. Direct materials cost anddirect labor cost are the costs which aregenerally variable
costs.

16. Mixed cost: Mixed costs are made up of fixed and variable elements. They are
combinationof semi-variable costs and fixed costs.

Accounting and Economic Costs

Money costs are the total money outlay sustained by a firm in producing an article. They comprise of wages
and salaries of labour, cost of raw materials, outlay on machines and equipments, depreciation and obsolescence charges
on machines, building and other capital goods, rent on buildings, interest on capital borrowed, expenses on power, light,
fuel, advertisement and transportation, insurance charges and all types of taxes. There are accounting costs which an
entrepreneur takes into account in making payments to the various factors of production.

“Explicit costs are the payments to outside suppliers of inputs.” There are other types of economic costs
called implicit costs. Implicit costs are the imputed value of the entrepreneur’s own resources and services. According to
Salvatore, “Implicit costs are the value of owned inputs used by the firm in its own production process.”

Production costs

In the production process many fixed and variable factors are used. They are employed at various prices. The expenditure
acquired on them is the total costs of production of a firm. Such costs are divided into total variable costs and total fixed
costs.

1. Total Variable Costs – Those expenses of production which change with the change in the firm’s output. Larger
outputs require larger inputs of labour, raw materials, power, fuel etc.

2. Total Fixed Costs – These are supplementary costs and are those costs of production which do not change with
the change in productivity. They are rent and interest payments, depreciation charges, wages and salaries of
permanent staffs etc.

Real Costs

Money costs are the outlay of production from the point of view of the producer. The efforts and sacrifices made by
capitalist to save and invest by the workers in foregoing leisure and by the landlords in the use of land, all constitute real
costs.

Opportunity costs

Benham defines Opportunity cost as “The opportunity cost of anything is the next best alternatives that could be produced
instead by the same factors or by an equivalent group of factors costing the same amount of money.”

Private and Social Costs

These include both explicit and implicit costs. Nevertheless, the production activities of a firm may lead to
economic benefit or harm for others. For instance, production of commodities like steel, rubber and chemicals, pollutes
the environment which leads to social costs.

The Cost function

The cost function expresses a functional relationship amidst total cost and factors that determine it. Usually the factors
that determine total cost of production (C) of a firm are the productivity (Q), the level of technology (T), the prices of
factors (Pt) and the fixed factors (F). It is expressed as follows.

C = f (Q, T, Pf, F)
Such a comprehensive cost function requires multi-dimensional diagrams which are hard to construct.

The Traditional Theory of Costs

The traditional theory of costs analyses the behaviour of cost curves in the short-run and long run and arrives at the
conclusion that both the short run and long run cost curves are U shaped but the long run cost curves are flatter than
the short run cost curves.

A. Firm’s Short Run Cost Curves

The short run is an epoch in which the firm cannot change its plant, equipment and the scale of organisation. To meet
the amplified demand, it can raise output by hiring more labour and raw materials or asking the existing labour force to
work overtime. The scale of organisation being fixed, the short run total costs TC are divided into total fixed costs (TFC)
and total variable costs (TVC), TC = TFC + TVC.

1. Total Costs – These are those expenses incurred by a firm in producing a given quantity or a commodity. They
include payments for rent, interest, wages, taxes and expenses on raw materials, electricity, water, advertising
etc.

2. Total Fixed Cost – These costs of production that do not change with output. They are independent of the level
of output.

3. Total Variable Costs – These costs of production that change directly with productivity. They rise when output
increases and fall when output declines.

4. Short-run average costs – In the short run analysis of the firm average costs are more important than total
costs. The units of productivity that a firm produces do not cost the same amount to the firm.

5. Short run average variable Costs – These are equal total variable costs at each level of output divided by the
number of units produced. SAVC = TVC / Q.

6. Short Run Average Total Costs – These are the average costs of producing any given output. They are arrived
at by dividing the total costs at each level of output by the number of units produced. The shape of these curves
is U shaped. SAC or SAVC = TC / Q = (TFC / Q) + TVC / Q = AFC + AVC

7. Short run Marginal Cost – A fundamental concept for the determination of the exact level of output of a firm is
the marginal cost. Marginal Cost is the addition to total cost by producing an additional unit of output.

The curve will look like this: Diagram 1

 B. Firms Long Run Cost Curves

In the long run, there are no fixed factors of production and hence no fixed costs. The firm can change its
size or scale of plant and employ more or less inputs. Thus in the long run all factors are variable and hence all costs are
variable.

The long run average total cost or LAC curve of the firm shows the minimum average cost of producing
various levels of output from all possible short run average cost curves SAC. Thus the LAC curves are derived from the
SAC curves. The LAC curve can be viewed as a series of alternative short run situations into any one of which the firm
can move.

Each SAC curve represents a plant of a particular size which is suitable for a particular range of output. The
firm will therefore make use of various plants up to that level where the short run average costs fall producing various
outputs from all the plants used together. Let these three plants represented by their short run average cost curves SAC1,
SAC2 and SAC3 which is represented in the diagram 2. Each curve represents the scale of the firm. SAC1 depicts a lower
scale while the movement from SAC2 to SAC3 shows the firm to be of a larger size.

Given this scale of firm it will produce up to the least cost per unit of output. For producing ON output, the
firm can use SAC1 or SAC2 plant. The firm will however use the scale of plant represented by SAC1, since the average
cost of production ON output is NB which is less than NA, the cost of producing this output on SAC2 plant. If the firm is
to produce OL output it can produce at either of the two plants.

But it would be advantageous for the firm to use the plant SAC2 for the OL level of output. But it would be
more possible for the firm to produce the larger output OM at the lowest average cost ME from this plant. However for
output OH, the firm would use the SAC3 plant where the average cost HG is lower than HF of the SAC2 plant. Thus in
the long run in order to produce any level of output the firm will use the plant which has the minimum unit cost.

If the firm expands its scale by the three stages represented by SAC1, SAC2, and SAC3 curves, the thick wav
like portions of these curves from the long run average cost curve. The dotted portions of these SAC curves are of no
consideration during the long run because the firm would change the scale of plant rather than operate on them.

Conclusion
 In either case, the LAC falls or rises more slowly than the SAC curve because in the long run all costs become
variable and few are fixed. The plant and equipment can be worked fully and more efficiently so that both the average
variable costs are lower in the long run than in the short run. That is why the LAC curve is flatter than the SAC curve.

Likewise, the LMC curve is flatter than SMC curve because all costs are variable and there are few fixed costs.
In the short run, the market cost is related to both the fixed and variable costs. As a result the SMC curve falls and rises
more swiftly than the LMC curve. It first calls and is below the LAC curve. Then it rises and cuts the LAC curve at its
lowest point E and is above the latter throughout its length as given in the diagram 3.