5.

1 DETERMINATION OF CAPITAL NEEDS

5.1.1 CAPITAL NEEDS
Finance is the life blood of business. No business can be successfully carried out without
adequate finance. Money is required to purchase land, to construct buildings, to purchase raw
materials and machines, to pay wages and salaries, to meet marketing expenses, to allow credit
facilities and so on. Therefore it is necessary to plan financial needs, the sources from which such
finance could be obtained and to ensure that the funds secured are effectively utilised in business.

5.1.2 CAPITAL
“Capital” in the business sense means the actual wealth or assets of a business in money. It
includes tangible property and Intangible property, that is used for production or more wealth
Tangible property includes (i) fixed assets such as land and building, plant and machinery,
furniture and fittings and other fixed assets and (ii) current assets such as cash balance, inventories,
book ‘debts and bills and other miscellaneous current assets.
Intangible property includes organisation expenses, operating losses, costs of financing and
other intangible assets such as goodwill, trade marks, patents and the like. In accounting sense,
capital represents the value of assets of a business less the liabilities.

5.1.3 FIXED CAPITAL (LONG TERM FINANCE)

Fixed capital is the capital which is invested n the fixed assets such as land and building,
plant arid machinery, office and factory equipments, furniture and fixtures etc., These assets are
retained permanently in the business to increase earning capacity. The business cannot be carried on
without them. The amount invested in them is recovered from the earnings alter a long period of time.
Thus the fixed capital fulfills the long term financial requirements of a concern for periods usually up to
ten years.
The amount of fixed capital needed differ from industry to industry. The fixed capital
requirements depends on (i) nature of industry (ii) size of industry (iii) quantity of production and (iv)
method of manufacture. For example, iron and steel industries require a heavy investment in fixed
capital. But the fixed capital needed is lower for industries such as cotton, textiles, soap, sugar, etc.,

5.1.4 WORKING CAPITAL (SHORT TERM FINANCE)

Every industry needs some funds to meet day-today financial requirements. Such capital is
known as working capital.

Working capital is required for the following:

a. Purchase of raw materials.
b. Payment of salary and wages.
C. Cost of maintenance.
d. Advertisement and selling expenses.
e. Postage and telephone expenses.
 f. Transportation expenses.
g. Medical expenses etc.

5.1.5 IMPORTANCE (ADVANTAGES) OF WORKING CAPITAL

Industries with insufficient working capital may collapse within a short period. The following
are the advantages of having sufficient working capital.
1. Feeling of security and confidence.
2. Maintenance of solvency of the company.
3. Creation of sound goodwill
4. Easy availability of cash discounts and bank loans.
5. Steady work for off-season purchasing.
6. Facility for off-season purchasing.
7. Quick and steady return to investors.
8. Rise in management morale.

5.1.6 SOUCES OF FINANCE (RESOURCES OF CAPITAL)

The various sources of finances are as follows

1. Issue of shares.
2. Issue of debentures.
3. Public deposits.
4. Commercial banks.
5. Ploughing back of earnings or sell financing.
6. Various special financial institutions.

Issue of shares:
The company invites members of the public through the prospectus to buy shares. Those who
purchase shares of the company, become a part owner of the company.

Issue of shares is the most important method of raising long term finance or fixed capital. The
money raised from shareholders is not returned to them until the company is liquidated. Legal
formalities are required for issue of shares.

Issue of debentures :
The finance required by the company is obtained as loan. The total loan to be raised is
divided into many equal portions. Each portion is known as debenture. Like shares, the debentures
are offered to the public by means of a prospectus. The terms and conditions on which they are
issued are given on the back of the debenture certificate. Legal formalities are required for issue of
debentures.
Public Deposits :
It consists of acceptance of deposits by a company directly from the members of public for
periods varying from six months to several years. In the case of public deposits no legal formalities
are required. Collection of deposits may be done in consultation with the Reserve Bank of India. It has
laid down rule that a company shall invite a deposit only through an advertisement, including a
statement of financial position of the company.

These deposits are unsecured. If the company has the confidence of the public, this method
of financing is very simple and easy to get. A non banking company cannot accept more than 25
percent of its paid up capital reserves by way of public deposits.

Commercial Banks
These banks meet only short term requirements of the business concerns, (i) by granting
advances, loans, overdraft and cash credit and (ii) by discounting bills, hundies and other commercial
papers.

The usual method of lending by bank is granting cash credit. A cash credit permits the
borrower to withdraw from the bank up to a stipulated amount. The banks grant cash credit on the
execution of promissory notes with two ‘signatures or the pledge of stock of raw materials or
hypothecation. The bank usually does not grant cash credit or other types of loans unless the
borrower is able to furnish full security. The bank charges interest on the amount actually withdrawn.

Ploughing back of earnings:

This is also known as "internal financing" or “self financing’ Under this system, the entire
profits are not distributed as dividends but a part of earned profits is retained. These retained profits
are used to finance the long term as well as short term needs. Ploughing back a part of the profits is a
good method of financing for expansion and improvements of company.

Special financial institutions

The Government has set up special financial Institutions at the state and national level with
the object of stimulating industrial development in the country. Some of the institutions are (i) The
Industrial Finance Corporation of India (ii) State Finance Corporations (iii) The Industrial Credit and
Investment Corporation (iv) Unit Trust of India (v) Industrial Development Bank of India. There are
financial institutions at the international level also.

To obtain assistance from the above financial institutions, an application together with a
project report requesting loan is to be sent. The financial institution will examine the project report with
the help of experts regarding the feasibility of the project Based on the merits of the project, the
institution will finance the industry
5.1. 7 SHARES
The owned capital of a company is divided into equal units known as shares. The company
invites members of the public through its prospectus to buy shares. Those who purchase shares are
known as shareholders and they become a part owner of the company A shareholder will get a
portion of company profit corresponding to the number of shares held by him For example the capital
of a company may be Rs. 5,00,000 which may be divided into 50,000 shares of Rs. 10 each. If Mr. X
purchases 1000 shares amounting Rs. 10,000 and the company declares dividend of 10% then Mr. X
will get Rs. 1000 ( 10,000 x 10%) by way of profit from the company.

5.1.8. TYPES O1 SHARES

Under companies Act, a company can issue only ‘two kinds of shares

1. Preference shares 2. Equity shares

1. Preference Shares
Preference shares are those, which have preference in respect of (i) payment of dividend and
(u) return of capital in the event of winding up of the company. Out of the profits of the company, the
preference shareholders are paid dividends first at a fixed rate.

Preference shares may be ‘cumulative’ or 'non - cumulative’ In case of cumulative preference

shares, if no dividend is paid in a certain year due to inadequate profit, they can claim the same in the
subsequent years Thus arrears of dividends go on accumulating. In case of non cumulative
preference shares, of dividends do not accumulate. If due to inadequacy of profits, no dividend is paid
in a particular year, dividends for such year will not be paid in future at all.

Preference shares may be convertible or non- convertible. If the preference shareholders are
given a right to convert their shares into equity shares within certain fixed period, those shares are
known as convertible preference shares. If such a right of conversion is not given, they will be known
as non-convertible preference shares.

A company may issue another kind of preference shares known as redeemable preference
shares. If a company issues such shares, it undertakes to return the amount paid on such shares after
sometime. Those which are not redeemed are known as irredeemable preference shares.

2. Equity shares
Shares which are not preference shares are called equity shares. They are also called as
ordinary shares. The equity shareholders get dividend after the payment of dividend to the preference
shareholders. The rate of dividend payable on equity shares is not fixed. It may vary from year to year
depending upon the amount of profits and the intention of the board of directors. In the event of the
winding up of the company, capital is returned to them only after return of capital to the preference
shareholders and after payment of all other claims such as debentures etc.,

Equity shareholders occupy primary position in the company posses voting right and hold
control over the affairs of the company. They are responsible for formulating policies of the company.
These share holders will earn good dividends when the company is prospering. But at same time they
run the risk of getting nothing when the company is facing depression. Thus they undertake risk.

5.1.9 DEBENTURES
A debenture is an acknowledgement of a debt by a company. The debentures are uniform
parts of a loan raised by the company. Like shares, they are offered to the public by means of
prospectus.

The debenture holders are simply the creditors of the company and not its owners as the
shareholders are. They simply get interest and are not entitled to share profits or losses of the
company. They do not hold any voting rights in any meetings of the company. In the event of winding
up of the company, the debenture holders receive the payment due to them before any shareholders
can claim their capital.

5.1.10 KINDS OF DEBENTURES

The following are the various types of debentures.

1. Registered Debentures are those which are made out in the name of a particular person who
is registered by the company. Interest is payable t the registered holders only.
2. Bearer Debentures are made out of the bearer. They can be transferred by mere delivery.
Coupons are annexed to the debenture certificate. Interest is paid to the debenture bolder on
surrendering the coupon.
3. Secured Debentures are those which are secured by mortgage on some of the assets of the
company.
4. Unsecured debentures are those which are not secured by any mortgage on the assets of the
company. This is also called as ‘simple or naked debentures.
5. Convertible debentures are those which can be exchanged for shares in the company under
certain conditions.
6. Redeemable debentures are those for which the company is bound to repay the amount of
debenture after the expiry of certain specified period.
7. Irredeemable debentures are those which are repayable at the option of the company. No
time is fixed to pay the amount of debentures.
5.1.12 FINANCIAL INSTITUTIONS
The following are the financial institutions that give loan to the industries. Short term loans are
easily available from banks and financial institutions.

At International level:
1. International Banks
2. Investment Companies

At National level:
1. The industrial Finance Corporation of India (ICF)
2. The industrial Credit and Investment Corporation of India (ICIC) .
3. The Industrial Development Bank of India (1DB)
4. The National Industrial Development Corporation(NIDC)
5. The Unit Trust of India (UTI)
 6. The Life Insurance Corporation of India (LIC)
7. Nationalised Banks

At state level
1. State Finance Corporation (SFC)
2. State Industrial Development Corporations (SIDC)
3. Small Industrial Development Corporations (SIDCO)
4. Nationalised Banks

In Tamil Nadu
1. Small Industries Promotion Council of Tamilnadu (SIPCOT)
2. Tamilnadu Industrial Investment Corporation (TIIC)
3. Tamilnadu Industrial Development Corporation (TIDCO)
4. Small industries Development Corporation, Tamilnadu (SIDCO)

REVIEW QUESTIONS
1. What is ‘capital’ and what is its importance. Explain Long Term anal Short Term Finance.
2. What are the resources of capital? Explain briefly each of them.
3. What are the factors that affect working capital
4. State and explain the various types of shares for meeting capital needs.
5. State and explain the various types of debentures for meeting the capital needs.
6. What are the differences between a share holder and debentures holder.
7. What are the differences between preference share holder and equity share holder.
8. Make a comparative study of equity share, preference share and debenture.
9. What are the various financial institutions that advance loans to the industries.

FACTORY COSTING
5.2.1 MEANING OF COSTING

Costing or cost accounting may be defined as a the art of keeping the accounts regarding the
various elements of cost. It includes classifying and recording all kinds of expenditure and
presentation of suitable data for the control of cost. The technique and process of finding cost is
known as costing.

5.2.2 ADVANTAGES (OBJECTIVES) OF COSTING

The following are the objectives of a good costing system.
1. To account promptly and accurately all kinds of expenses.
2. To prepare estimates and quote rates to the customer.
3. To decide “make or buy” decisions.
4. To analyse the various items of expenditure for proper con
 5. To waste and improve economy.
6. To compare actuals with estimated cost.

5.2.3 ELEMENTS OF COST

The following are the elements of cost
1. Direct material cost
2. Direct labour cost
3. Direct expenses
4. Overheads (other expenses)

Overhead expenses consists of

• Indirect material
• Indirect labour
• Indirect expenses

5.2.4 DIRECT MATERIAL COST

All materials from which the product is manufactured is known as direct material. In other
words, all materials that become part of the finished product is known as direct materials. The cost of
direct materials is known as direct material cost.

Examples:
1. Leather for making shoes.
2. Sugar for making candles.
3. Wax for making candles.
4. Wood and nails for making chairs.
5. Cast iron, Copper wire etc., for making electric motor

5.2.5 DIRECT LABOUR COST

The labour actually spent by workers to manufacture product is known as direct labour. This
is also called as productive labour. The wages paid to productive labour is known as direct labour
cost.

Examples:
The wages for -
1. 1. A turner of lathe operation. -
2. A fitter for fitting operation.
3. A mechanic for an engine repair work.
4. A painter for painting works.
5. A welder for welding works.
5.2.6 DIRECT EXPENSES
These are expenses (other than direct labour and direct material) incurred specifically to a
particular job such as -
• Cost of pattern, drawings, designs etc, specially prepared for a particular job.
• Cost of special tools, jigs and fixtures.
• Cost of experimental work carried out.

5.2.7 OVERHEADS (or) ON COSTS

All indirect expenses of a factory are known as overheads or on costs. Overheads are
classified into the following three categories.
• Factory overheads
• Administrative overheads
• Sales overheads

5.2.8 FACTORY OVERHEADS

Indirect expenses incurred by the factory on production floor is called factory overheads. The
items are general in nature and cannot be directly charged to any product. They consist of the cost of
the following

a. Indirect material
b. Indirect labour
c. Miscellaneous expenditure

a. Indirect Materials
These are materials used in the factory that do not become a part of finished product but
necessary for production process.

Examples
Coal, Coke, Lubricants, Coolants, Tools, Cotton Waste, Stationery, Materials for Repair etc.,

b. Indirect Labour
All labour which helps the productive labour is known as indirect labour.

Examples:
Foremen, Works engineer, Inspectors, Material movement, Maintenance men, Watch and
Ward etc.,

c. Miscellaneous Expenditure
This expenditure is of general nature and is spent for keeping up production.
Examples
Depreciation, Repairs to buildings, Repairs to equipments, Insurance, Rent, Taxes, Freight
charges, Power, Light, Welfare expenses etc.,

5.2.9 ADMINISTRATIVE OVERHEADS

All expenses incurred in the administration of an undertaking is called administrative
overheads. This consists of cost of indirect materials, indirect labour and miscellaneous expenses.

Examples:
a. Indirect Materials
Stationery, Furniture, Type writer, Fans etc.,
b. Indirect Labour
Salaries for office manager, accountants, clerks, attenders etc.
c. Miscellaneous Expenses
Depreciation of office equipment rent, maintenance of office equipments, insurance, postage,
telephone and telegrams, legal expenses, audit charges etc.

5.2.10 SALES OVERHEADS

All expenses incurred sales overhead it consist in marketing a p is called of the cost of
indirect materials, indirect labour and miscellaneous expenses

Examples:
a. Indirect Materials:
Catalogues, leaflets, price list, packing materials, Stationery etc,
b. Indirect labour:
Salaries to sals manager and other sales office personnel, travelling, allowances etc
c. Miscellaneous Expenses:
Advertising postage, telephone and telegram, sales office and godown rent, insurance
depreciation of sales office equipment entertainment charges, cost of quotations and tenders,
commission and discounts etc.,

5.2.11 GENERAL, FIXED AND VARIABLE OVERHEADS

General Overheads
Some times the administrative and selling overheads are grouped together under the name
General Overheads.

Fixed Overheads
These are the indirect expenses which remain constant whatever may be the volume of
production. This mean that these indirect expenses do not vary -with the production.
 Examples of such overheads are salaries of high officials, building rent, insurance charges,
etc.,

Variable Overheads
These are the indirect expenses which vary with the volume of production.
Examples of such expense are power, fuel oil, materials, unskilled labour etc.,

5.2.12 SELLING PRICE OF A PRODUCT

The selling price of product is the sum of direct material cost, direct labour cost, overheads
and profit.
The selling price of product has the following components.
1 Prime cost
2. Factory Cost
3. Production cost
4. Total cost or sales cost

1. Prime Cost
= Direct Material Cost + Direct our Cost + Direct Expenses (if Any)
2. Factory Cost
= Prime Cost + Factory Overheads

2. Factory Cost
= Prime Cost + Factory Overheads
3. Production Cost
= Factory Cost + Administrative Overheads
4. Total Cost or Sales Cost.
= Production Cost + Sales Overheads

General overheads
Sometimes administrative and sales overheads are put together and given as general
overheads. In such cases
Total Cost = Factory Cost + General Overheads
Sales Price :
If profit is added to the total cost of product, sales price is arrived. The customers get the
article by paying the price named as selling price.
Sales Price Total Cost + Profit
The above procedure to arrive at sales price of product is illustrated by a block diagram shown in fig
5.2.1.

5.2.13 PROBLEMS ON SALES PRICE OF A PRODUCT

Example I :
Calculate the selling price of one gear from the data given below
No.of gears produced=500
Material Cost=Rs.5000
Manufacturing Wages=Rs3000
Factory Overheads=100% of DLC
General Overheads=12.5% of Factory Cost
Profit=10% of total cost

Solution
Prime Cost:
=Direct material cost + Direct labour cost
=Rs.5000.00 + Rs.3000.OO
= Rs.8000.00
Factory Cost
= Prime cost + Factory overheads
= Rs.8000.OO + Rs. 100% of labour cost
= RS.8000.00+RS.300000
= Rs.11000.00
Total cost
= Factory cost+ Administrative overheads +Sales overheads
= Factory cost + General overheads
= Factory cost + 12.5% of Factory cost
= Rs.11000.00+ l 11000
= Rs.11000.00+ 1375.00
= Rs.12375.00
Sales price of 500 gears
= Total cost + profit
= Total cost + 10% of total cost
= Rs.12375.OO +10% x 12375
= Rs.13612.50
Selling price of one gear43612.5O/ = Rs. 27.23 = Rs 27.25 Ans
Example2:
A Factory producing 300 door handles incise direct material cost of Rs. 500. 00, direct labour
cost of Rs. 400.00 and Factory overheads of Rs. 450. 00. Calculate selling price of one door harule
assuming selling on cost as 30% off actory cost and profit as 10% of selling price.

Solution
Prime cost
= Material cost + labour cost
= Rs.500.OO ÷ Rs.400.OO 4 Rs.900.QO
Factory Cost
= Prime cost + Factory overheads = Rs.900.OO+Rs.450.OO
= Rs.1350.OO
Total cost
= Factory cost + selling on cost S =Factory cost -i of factory cost
= Rs. 1350.00 + 30% x 1350 5 S =Rs. 1350.00 + Rs. 405.00
= Rs. 1755.00.
let X be the Selling price of 300 door h Then of it 10% se11i p 10% of ‘ 0.1 X
Selling price Total Cost + Profit
i.e X Rs.175 + 0.1
I.e. O.9X RS.175 S
Therefore X 1755/0.9 =195000
Hence Selling price of One door h 1950.00/300 = Rs.6.SO

Example 3
Three labourers Q employed to ca 35 cast iron flanges in a day. Each flange weights 3 Kg.
and the flange Costs Rs. 2. 50. per Kg. The labors are paid 80. 00 per day. jf the Over heads
expenses are 150% of direct labour cost, calculate cost of producing One flange

solution
Material Cost :
No. of flange produced per day : 35
Weight of each flange : 3Kg
Mate cost S Rs.2.5 per Kg
Therefore tot materal cost = 35 x 3 • 50 Rs. 262.50

Labour Cost :
No. of labours employed : 3 5
Wages Paid Rs.80 per day
Therefore total labour cost 3 x 80 Rs. 240.00
Overheads:
This is given as 150% of labour cost
= 150% x 240 = Rs. 360.00
Total cost = Material cost ÷ Labour cost + Overheads
= Rs.262 + Rs. 240 + Rs. 360.00
= Rs.862.50. for producing 35 flanges.

Production Cost per Flange

Example.4 :
The direct material cost per unit of a product is Rs. 5.20. The direct man hours for 50 units of
the product = 225 hrs. The factory 0 U axe calculated on the basis of 1 00 percent of direct labour
cost. The mean labour wages is estimated as Rs. 9 per hour. The and selling expenses are taken as
1 50 percent off actuary expenses. A Discount of2O percent is given for the distributors on the list
price. The price of the product is fixed on the basis o at on the total cost as profit. Fix the price per unit
of the product.

Solution
Let us calculate cost particulars per unit of the product
i. Direct material cost per unit = Rs.5.20
ii. Direct labour cost per unit
Labour hrs for 50 units : 225
Labour’ s hrs per unit : 225/50
: 4.5 hrs
Labour wages per hour : Rs.9.00
Labour cost per unit Rs.9 x 4.5 : Rs. 40.50

iii. Factory overheads 100% of direct labour cost

= 100% of Rs.40.50 = Rs.40.50
iv. Administrative and selling expenses (overheads)
. = 150% of factory expenses (Overheads)
= 150%x Rs.40.50 = Rs.60.75
v. Total cost
= (i) + (ii) + (iii) + (iv)
= 5.20 + 40.50 + 40.50 + 60.75
= Rs. 146.95
vi. Sales Price Total Cost + Profit
= Rs. 146.95 + 20% of total cost
 = Rs.146.95 + 20% x 146.95
= Rs.146.95 + 29.39 — Rs. 176.34
vii. List Price
Let X be the list price
Sales Price = List price - Discount
= List price - 20% list price
=X – 0.2X = 0.8X
Therefore list price X = Sales Price/0.8 176.34/0.8.
= Rs.220.50 Ans

Example 5 :
A factory is producing 1 000 taper pins per hour on an automat machine. Its material cost is
Rs. 375, Labour cost is Rs.245 and the direct expenses is Rs.80. The factory on cost is Rs. 1 50% of
the total labour cost and the office on cost ‘is 50% of the total factory cost. If the selling price of each
taper pin is Rs. I . 50, find out whether the company is in loss or gain and by what amount?

Solution
Material Cost = Rs.375.OO
Labour cost = Rs.245.OO
Direct Expenses = Rs. 80.00
Prime cost = Rs. 700. 00

Overhead Charges
Factory on cost = 1 5 0% of labour cost
= 1.5 x 245 = Rs. 367.50
Factory cost = Prime cost + Factory on cost
= Rs.700 + Rs.367.50
= Rs. 1067.50
Now, office on cost = 50% of the factory cost
= 0.5 x 1067.50
= Rs. 533.75
Hence total cost of production of 1000 taper pins
= Factory cost + Office on cost
= Rs.1067.50 + 533•75
= Rs.1601.25
Production cost per piece
= Rs. 1601.25/1000
= Rs.1.60 per piece
Bus selling of each taper pin Rs. 1.50
Hence the company is in a loss of ( Ra. 1.60 - 1.50)
 = 10 paise per taper pin

Example 6 :
A factory employed 50 workers during a month off3O days. The details of expenditure in that
month is given below:
Materials cost =Rs.30,000
Wages for each worker =Rs. 7. 50 per hour
Duration of work = 8 Hours Per day
Number of holiday’s in the month = 5 days
Total overhead expenses =Rs.15,000
Calculate total cost of production.

Solution
i Material cost = Rs.30,000.OO
Calculation of labour cost:
Number of workers = 50
Number of working days = (Days in the month — Holidays)
= (30 - 5) = 25 days
Duration of work/day = 8 hours
Therefore number of man hours for the month
= 50 x 25 x 8
= 10,000 hours
Labour wages = Rs.7.50 per hour
ii. Labour cost for the month = 7.50 x 10,000 = 75,000
iii. Overhead expenses =Rs. 15,000
Therefore total cost of production
= Material cost + Labour cost + overheads
= 30,000 + 75,000 + 15,000
= Rs.1,20,000.OO Ans.

5.2.14 BREAK - EVEN ANALYSIS

Break even point is that point at which a neither makes a profit nor incurs a loss.
As explained already there are two types of costs, fl1 cost and variable cost
Fixed costs do not increase or decrease with the volume of production Example rent,
insurance, salaries to top officials etc.
Variable costs increase or decrease with the production volume, such as raw material, direct
labour, power indirect material etc.,
If production is zero, fixed costs will nor change but variable costs will be reduced zero.

Break -even chart

A break even chart is very useful device to show the relationship between costs, volume of
output and profit. Refer fig.5.2.2
Costs (Fixed and variable) and sales revenue are shown on vertical axis. On the horizontal
axis, sales volume in units and production volume in units are marked.

Three lines are drawn in the graph.

1. Fixed cost line. Fixed costs do not change with the volume of production.
2. Total cost line. Since the total cost is the sum of fixed cost and variable cost, the total cost
increase with increase in production volume.
3. Sales revenue line. This line starts from zero sales.
The point of intersection of sales line and total cost line is the break even point (BEP). Below
this point losses occur. Above it, profits are earned.
Let F = Fixed c S = Sales price per unit
V = Variable cost per unit
Q = Quantity at break even point
At break even point,
Sales revenue = ‘Total cost
That is, Q x S = F + QV
Therefore Q = F/ (S-V) units.
When quantity of sales is less than Q 1051 will occur, If more than Q profits axe made and If
equal to Q the will be no loss no gain.
Sales value at BEP
= Sales price per unit x Q at BEP
=SxQ
= S x F/(S—V)

Advantages or objectives of break even analysis

1. To determine volume of sales to attain desired profit
2. To find price of an article to give desired profit
3. To improve performance of factory by cost control
4. To select economical production process
5. To compute costs and revenues for all possible volumes of output
 6. To find whether to make or buy

5.2.15 PROBLEMS ON BREAK - EVEN ANALYSIS

Example 1
The fixed costs to manufacture certain products during a year is Rs. 8, 00, 000. Variable
cost per unit is Rs. 40. The estimated sales for the period are valued at Rs. 20, 00,000. Sales p rice
per unit is Rs.200. Calculate the break even point and profit.

Solution :
F= Fixed cost
V = variable cost per unit S = Sales price per unit
I = Quantity at break even point .= Q = F/(S-V) = 8,00,000/(200 - 40) =

To calculate profit
Qty sold = Sales revenue/ Sales price per unit
i.e = 20,00, 000/200=10,000 units
Total cost of production = F + QV
= 8,00,000 + 10,000 x 40
= Rs.12,00,000
profit = Sales Revenue — Total production cost
= 2O,00,000 12,00,000
= Rs.8,00, 000Ans.

Example 2
Fixed cost in a factory is Rs. 1 5,000per year. The variable costs are Rs.2 per unit and the
selling price is Rs.4 per unit calculate break even point.

Solution
F = Rs. 15,000
V = Rs.2 / -
S = Rs.4 / -
Q =?
Break even Point Q F/(S-V)
= Fixed cost
= Variable cost per unit
= Sale s price per unit
= Break even point
= 1 5 , 000 / (4-2) = 7500 Units Ans.

5.2.16 DEPRECIATION
Depreciation can be defined as the reduction in value of an asset due to passage of time, use
or abuse, wear and tear or lack of demand for use.

Causes of Depreciation
The following are the causes due to which assets depreciate.
1. Wear and Tear
2. Physical Decay
3. Inadequacy
4. Deferred maintenance or Neglect
5. Obsolescence

1. Wear and tear of machines

When a machine is put into service, deterioration because of the chemical and mechanical
actions of machine.

For example, the bearings of all machine wear, the on the machine begins to wear off, a new
tyre on car wears, etc., Deterioration of this kind which can be rectified by proper repairs and renewals
is known as wear and tear.

2. Physical decay
Even when a machine is kept under good maintenai4, there is general deterioration Buildings,
Boilers, insulated wire etc, will become useless due to passage of tune The decay may be so great
that repairs are uneconomical The’ need replacement Such deterioration is called physical decay

3. Deferred maintenance or Neglect

Even though repairs and maintenance are properly done, all physical assets m course of time
will depreciate below the original value. If proper repairs and maintenance are I carried out, the value
of asset will fall below the value of ‘properly maintained assets. This fall in amount is known deferred
maintenance or neglect.

4. Inadequacy
The assets may become useless because of increase demand of service. It may still be in
good condition and adequate to do the work for which it was installed.

For example, a 5 ton crane may be in good condition and of modern type, but it becomes
useless if it has to handle 10 tons. This kind of decreased value is called "inadequacy". It has no
connection with age of service or the physical condition of the assets.

5. Obsolescence
Assets may lose its value because of the introduction of more efficient and productive new
inventions. Such deprecation is called obsolescence.

It is very similar to inadequacy but to different causes. Machinery thrown out of use to
inadequacy may still have a high market value. But machinery not used due to obsolescence has only
scrap value.
5.2.17 METHODS OF DEPRECIATION

The following are the important methods of depreciation.

1. Straight line method.
2. Percentage on diminishing cost method.
3. Sinking fund method.

5.2.18 STRAIGHT LINE METHOD

This is also known as the fixed installment method. In this method depreciation amount is
calculated by dividing the difference between the original cost of the assets and its scrod value by the
estimated life of assets in years.

This amount is recovered every year form the business and Set aside.

Example:
Let original cost of machine = V = Rs.15, 000
Salvage (scrap) value = S = Rs.3,000
Estimated years of service =N= 1.0
Annual depreciation charges =P

Then P = (V—S)/N = (15000 - 3000)/ 10 = Rs.1200/year

This method is simple and hence widely used. The amount of depreciation is same every
year.

5.2.19 PERCENTAGE ON DIMNISHING COST

METHOD (REDUCING BALANCE METHOD)
This method is also known as fixed percentage method. A fixed percentage of the book value
of an asset in a year is taken as the depreciation amount for that year. The book value of an assets in
the beginning of a year is equal to the difference between the book value of the previous year and the
amount of depreciation in the previous year.
As the book value of an asset decreases every year, the amount of depreciation in each year
decreases though the percentage of depreciation is kept constant.
The fixed percentage of depreciation is calculated from the following formula
P=1 - (S/V)1/N
Where P = Fixed percentage of depreciation
= Original value of an asset
S = Salvage or scrap value of an asset
N = Estimated life of asset in years
 If the scrap value is zero or negative, the value of ‘I” can not be determined and hence this
method can not be used.

Example
Estimated life of asset = N = 10 years
Original value of asset = V = Rs.3000
Scrap value of asset = S = Rs.600
Then, percentage of depreciation P
= 1 — (S/V)h/N
= 1 — (600/3000)1/10
= 0.15 = 15%

Value of asset at the beginning of 1st year = Rs.3000 Depreciation for the 1st year = 3000 x 15/100
Rs.450

5.2.20 SINKING FUND METHOD

In this method a sum of money is set aside annually in a bank. The amount will accumulate
with compound interest. By the end of the life of an asset, an amount equal to the original cost of the
asset less its scrap value will be available in the bank.
 The amount of depreciation by this method is calculated from the formula

Where,
Estimated years of life = N
Rate of interest =r
Original value of asset = S
Amount of depreciation = D
Let us assume N = 10; r = 8%, V = Rs. 15,000; S = Rs.3,000
Then the depreciation amount

5.2.21 PROBLEMS ON DEPERCIATION

Example 1
A lathe was purchased for Rs. 85,000/- on 1st Jan 1978 The erection and installation charges
were Rs. 5, 000/-. The lathe was replaced by a new one on 31st Dec. 1 997. Ifthe scrap value was
estimated as Rs. 15,000/- what should be the rate of depreciation fund on 1 5th June 1 98 7. : Use
straight line method of depreciation.

Solution
Total cost = Lathe cost + cost of erection
= 85000+5000
= Rs.90,000
Scrap value S = Rs. 15,000
Life of lathe N = from lstJan. 1978 to 31st Dec. 1997
= 20years
Rate of depreciation = (V - S) /N
= (90000 - 15000)/20
= Rs.3750/per annum Ans

To fund the depreciation fund on 15th) June 1987

Number of installments of depreciation fund accumulated from 1st Jan. 1978 to 15th Juiie
1987 is 9 (nine)
Therefore depreciation fund collected up to 15th’ June 4987.
 = Rs.3750x9 = Rs.33750/-Ans
Example 2 :
A car was purchased for Rs.2,88,000. Its life was estimate as 15 years and the scrap value
Rs.42,000. Using diminishing, balance method calculate the percentage of depreciation fund a the
end of three years.

Solution :
Let P = Percentage rate of depreciation = ?
V = Original value of the car = Rs.2,88OO 0
S = Scrap value of. the car = Rs 42 000
N = Life time of the car = l5years
Then P = 1 - (S / V) I/N

= 1 — (42000/288000)1/15
= 1 — (0.146)0.067
= 1 — 0.88 = 0. 12 = 12% Ans
Depreciation fund for first year
d1 = V x P = 2,88000 x 0. 12 = 34560.00
The value of the car at the end of first year
V1 = (V-d1) = (288000—34560) = Rs.253440.00
Depreciation fund for the second year
d2 = V1 X p = 253440x0.12 =Rs.304128030413
The value of the car at the end of the second year
V2 = (V1 – d2) = (253440 — 30412 = 223O27.20
Depreciation fund for the third year .
d2 = V2 x p = 223027.20 x 0.12 = Rs.26763
Value of the car at the end of the third year
V3 = (V2-d3) (223027.20 - 26763.30) = 196263.90
Depreciation fund at the end of the third year
= (d1 + d2 + d3) OR (V- V3)
= (34560 304 13 26763) OR (288000 - 196264)
= Rs. 91736 Ans.
Note This problem easily be solved by using tabular column as shown under article 5.2.19.

Example 3
A machine was purchased for Rs. 50, 000. The estimated life ofthe machine is 1 5 years and
the scrap value is Rs. 15,000. If the rateof interest on depreciation funds is charged at 8%, calculate
the rate of depreciation by sinking fund method.

Solution :
Let r = Rate of Interest = 8% 0.08
 N = Life of asset in years = 15 years
V = Original value of the asset = Rs. 50,000
S = Scrap value of the asset = Rs.15,000
D = Rate of depreciation ?

Ans : Rate of depredation Rs. 1289. 15 per year

REVIEW QUESTIONS
1. Explain the following elements of cost
a. Direct material
b. Direct labour. Give example
2. Give a list of items which comprises the elements known as factory overheads and explain.
3. What do you mean by term ‘costing’. What are the objectives of good costing system.
4. 4. What are the elements of cost. Explain each element with examples.
5. What do you mean by ‘on costs’. What are various classification of overhead expenses.
Explain each one of them with examples.
6. What are (i) Administrative over heads (ii) Sales overheads (iii) Factory overheads. Give a list
of items coming under the above overheads.
7. Using block diagram, explain how the selling price of an article is arrived at. Illustrate your
answer with an example.
8. What is depreciation, Explain the causes of depreciation.
9. What are different methods of depreciation of assets. Explain the following methods.
a. Straight line method
b. Percentage on diminishing cost method
c. Sinking fund method
10. What is break - even point. Explain with a diagram
11. A cupola was purchased for Rs.30,000. Rs.5000 more was spent on its erection and
commissioning. The estimated residual value on the cupola after 10 years is Rs. 7000.
Calculate the annual rate of depreciation by straight line method. Also determine the
depreciation fund collected at the end of seven years from the date of the purchase of cupola.
(Ans Rs.2800, Rs. 19,600)
 12. A machine was purchased for Rs. 12,000. The estimated useful life of the machine is 5 years.
The estimated scrap value is Rs. 2000. Compare the depreciation rates determined from the
following methods.
i. Straight line method
ii. Sinking fund method with an interest at the rate of 5% on depreciation fund.
(Axis: Rs.2000, Rs. 1809.75)
13. The cost of an asset is Rs. 6000. Its estimated scrap value at the end of 3 years is Rs.3000.
Using reducing balance method calculate depreciation rate. Also estimate the depreciation
fund at the end of two years. (Ans: 20.6%, Rs. 2217.40)
14. An industrial plant has an initial value of Rs. 2,20,000. It salvage value at the end of 20 years
is Rs. 40,000. What is the rate of depreciation if sinking fund method at 8% interest
compounded annually is adopted. (Ans : Rs. 3034.43)
15. Estimate the sales price to be quoted for a product from ‘/ then data: Direct material cost per
piece : Rs. 14 Direct labour cost per piece : Rs. 8 Factory overheads 100% of prime costs
16. General overheads 25% of factory cost. Profit 10% of total cost
17. The following costs are booked against a work order. Direct materials = Rs. 7000. Direct
labour = Rs.3500 Factory overheads is 60% based on direct material. The administrative and
selling overheads 100%. Determine the cost per unit if the batch size as per work order is 350
units.
18. A factory producing 150 electrical bulbs a day involves ‘7 direct material cost of Rs. 250,
direct labour cost of Rs.200 and factory overheads of Rs.225. Assuming a profit of 10% of
selling price and selling on cost of 30% of factory cost, calculate selling price of one electric
bulb (Ans: Rs.6.50) 18. What is meant by break even analysis. Find out the break even
quantity for the following data. Fixed cost Rs. 500; variable cost Rs. 2 per unit. Sales price
Rs.3 per unit.
19. At a sales volume of Rs. 2,10,000 the variable cost is Rs.70,000. Fixed costs are Rs.
1,00,000 and the profit is Rs. 40,000. What is break even point.
(Hint: At break even, profit is zero. Hence at break even point, variable cost is (70,000 -
40,000) = 30,000 Break even point = fixed cost + Variable cost at B.E.P) H .3

MATERIAL MANAGEMENT
5.3.1 INTRODUCTION
Material means raw materials, components, sub- assemblies, finished products and all other
indirect materials.
Materials occupy 30% to 40% of total cost of production. In certain cases, 60% to 70% of cost
of production is spent on materials. Hence great and careful attention shall be made on the usage of
material. Even a small saving in the cost of material can reduce production cost to a considerable
extent. Material management and control is very essential to increase profit.
 Material management is a function which involves number of functions like determination of
quality, quantity, purchasing, storing, issuing and dispatching. It is a systematic and scientific function
of a group of people for better procurement, storage and distribution of materials.

5.3.2 INVENTORY (STOCK) CONTROL

Inventory means materials held In stock for later USC. inventories include raw .materials,
bought out components, general stores, spare parts, manufactured parts, semifinished parts, tools
and gauges, work in process etc.,

The above items are stocked in order to meet expected demands in future. It is necessary to
ma inventories for the smooth functioning of an organisation. In the absence of a proper stock control
system, overstock understocking may occur.
Inventory control is the scientific method of finding (a) how much stock to be maintained in
order to meet the production demands and (b) to provide right type of material at right time’ in the right
quantities and at competitive price.

5.3.3 OBJECTIVES OF GOOD STOCK CONTROL SYSTEM

A good stock control system has the following advantage (objectives)
1. Materials are neither overstocked nor understocked,
2. Materials are made available as and when required
3 Production delays due to materials shortage are avoided
4. Price discounts can be obtained by bulk purchase of materials at proper time.
5. Bulk purchase reduces tranportation costs.
6. Money invested in inventory (stock) is kept minimum.
7. Material cost is reduced and hence production cost reduces.

5.3.4 DISADVANTAGES OF OVERSTOCKING

1. Capital lock up and unnecessary loss of interest.
2. Fall of prices will result in heavy losses.
3. Material obsolescence happens when cheaper and better quality substitutes are developed.
4. Losses due to pilferages and damages.
5. Necessity for large storage space.
6. Increased material handling.
7. Increased storage costs.

5.3.5 GROUPING OF MATERIALS

For achieving the objectives of inventory control, it is essential to make a systematic analysis
of all items in the stores. Industry consumes thousands of items of stores. It is difficult and costly to
give high degree of control to each and every item. Therefore selective control is applied to
inventories.
 For selective control, it is necessary to group the items depending upon their importance.
High degree of control is given to the group of important items and less attention is given, to the group
of less important items. The items can be grouped according to their use, consumption, lead time,
money value etc., There are various types of analysis to group items. The most important analysis in
ABC analysis.

5.3.6 ABC ANALYSIS

ABC analysis Is used to have higher degree of control on vital items for “Always Better
Control”.
The principles of selective control applied to inventories and the techniques of grouping the
Items in stores is known as ABC analysis.
The criterion used for the ABC analysis is the money value of the items consumed and not
the quantity consumed. Maximum attention is given to items which consume more money and less
attention is given to items which consume less money.
If annual consumption of various items in an organisation is worked out in terms of rupees
value, it will be found that
i. Nearly 10% of items consume 70% of total annual consumption cost in rupees. These
items require higher degree of control. These items are classified as A - items.
ii. Nearly 20% of items consume 20% of annual consumption cost. These items are of
medium importance and classified as B - items.
iii. Nearly 70% of items consume 10% of annual consumption cost. These items are called C
– items and they do not require strict control.

The above is only guide lines and individual organisation have to arrive at correct figures.
 The fig 5.3.1 shows a graph between the percentage of total item a in each category and
percentage of total annual consumption cost.

5.3.7 ADVANTAGES OF ABC ANALYSIS

i. Capital lock up inventories can be reduced.
ii. The time and energy be reduced.
iii. Better Storing, handling and delivery of materials can be planned
iv. Suitable Purchasing methods can be decided for A, B and C items
v. 'C' items are more in number and less in Value R proper review 5 can be decided

CONTROL FOR A, B AND C ITEMS

Policies for A’ 1 (less than 10% items more than 70% value)
1. To reduce the capital locked up in inventories. ‘A’ shall be order frequently
2. Annual or half Yearly Purchase contract with scheduled deliveries is economical
3. Ordering qua re-order points and safety stock shall be revised more often
4. As far as Possible o or more suppliers shall be f for each item. If one supplier fail to Supply,
other supplier can be approached.
5. ‘A’ items shall be controlled and purchased directly by the Purchasing manager him
6. The purchase department should pay a attention to expedite the delivery of item since these
items are Stocked to a minimum level.

Policies for B’ items less than 20% items less than 20% value)
1. They do not require close control as ‘A’ items, but they need more attention arid control than
‘C’ items
1. 2 Order quantities, re-order point and safety stock shall be fixed for ‘B’ items Revision once in
a year is sufficient
2. 3 Items shall be ordered less frequently than ‘A’ items, 3 to 6 orders per year is recommended

Policies of C Items (more than 70% items less than 10% value
1. Large quantities can be kept in stock (6 months to o year stock)
2. Annual or half yearly orders should be placed to reduce paper work The discounts for bulk
purchase can utilised.
3. Items should be grouped as Electrical, hardware, paints etc and one group of item should be
ordered at one time.
4. For each group of item, a review period should be

5.3.9 QUANTITY STANDARDS IN INVENTORY CONTROL

There are five important quantity standards used to control inventory
1. Maximum stock
2. Minimum stock
3. The standard order
4. Ordering point or re-order level (ROL)
5. Lead time or procurement time.
The above are explained below with the aid of fig 5.3.2

1. Maximum Stock:
This is the upper limit of inventory and largest quantity which should be kept in stores. The
stock shall never be allowed to go beyond this limit.
Maximum Stock = Safety Stock + Standard Order

2. Standard Order
This is the quantity to be purchased at any time Repeat order for a given product are always
for this quantity.

3. Minimum stock o -safety stock or buffer stock

This is the predetermined level of stock which should be maintained always. Stocks should
not be allowed to go below this limit except in emergency. The minimum stock is stored to guard
against delays in supplies and other bottle necks in transport.
Safety Stock = (Maximum lead time - Normal lead time) x Consumption rate

4. Re-order level (ROL)

This is the level of stock at which a fresh order must be placed to procure materials. This is
usually the minimum stock plus procurement period requirement. When this level is reached, the
process of purchasing is started.
ROL = Safety Stock + Procurement period requirement

5. Procurement Period (or) Ordering period (or) lead time

Lead time is the total time from the time of preparation of purchase requisition to the time of
receipt of materials into stock.
Lead time involves the time for completion of the following activities.
1. Raising a purchase requisition.
2. Inquiries, quotations, scrutiny and approval
3. Placement of an order.
4. Supplier’s time to make the goods ready.
5. Transportation and clearing.
6. Receipts of goods at the Company.
7. Receiving and inspections.
8. Taking into stock.

5.3.10 PROCUREMENT AND CONSUMPTION CYCLE

i. Consider an item having steady consumption all through the year and the item is
available immediately on placing an order without fail.
In such a case the item would have the procurement and consumption cycle shown in Fig
5.3.3 (a)
 At A the stock is zero and hence an order is placed. The stock will be brought up to a level Q
as the delivery is immediate. The stock is now steadily issued out up to B’ and another order would be
placed at B’ to bring the stock to level Q and so on.
ii. But in practice, the supply of materials will not be immediate. It may take several weeks or
months before the supplies are received, inspected and taken in stock. This tithe is called as “Lead
Time”,
Therefore in order to receive supplies before the stock reaches a zero level, it is necessary to
order the materials much in advance, that is, when the stock available is efficient for the lead time.
This is known as re-order level and is shown graphically in figure 5.3.3 (b).
ROL (Reorder Level) = Lead Time consumption
iii. We have assumed in the previous case that the consumption rate and lead time are
constant throughout the year. But in actual case, the consumption rate of material and lead time are
not constant throughout the year. If consumption rate rises or the supplier fails to supply material
within the expected lead time, a stock out will occur. To guard against this, an extra stock is
maintained and this extra stock is called as Buffer stock or Safety stock or Reserve.
The safety stock should be sufficient for the period of difference between maximum lead time
and normal lead time.
i.e., Safety stock = (Maximum lead time - Normal lead time) x Consumption rate

For example, let us assume the daily consumptions is 100 units, normal lead time 15th and maximum
lead time is 30 days.
Therefore Safety stock = (30 - 15) X 100 = 1500 units
Therefore,
ROL = Safety Stock + Normal lead time consumption.
Referring to Fig 5.3.3 (c), the ordered materials are not received at B and hence materials are
issued from safety stock.

5.3.11 INVENTORY CARRIES COST

This is the money spent in keeping the material in stock. This includes the following items of
expenditure.
1. The loss of interest on the money invested in the stock.
2. The salaries and wages of the stores personnel.
3. The rent for the stores and insurance charges.
4. The depreciation and repair costs for the equipments.
5. Any loss of material through pilferage and damages.
6. Stationery and other consumables used by the stores.
Inventory carry charges increase as the value of materials stored increases. In other words
inventory carrying charges are proportional to the value of inventory.
5.3.12 ORDERING COSTS (OR) SET UP COST (OR) PROCUREMENT COST
This is the money spent in the process of placing purchase order. It includes the following
items of expenditure.
1. Salaries and Wages for the staff of the purchase department.
2. The depreciation of equipments and furniture.
3. Postage, Telephone and Telegram bills.
4. Stationery and other consumables required.
5. The entertainment charges for vendors.
6. Travelling expenses.
7. Lawyers and court fees due to any legal matters.
If number of orders are more, ordering costs will be more. In other words, expenditure on
ordering of material is directly proportional to the number of orders placed. Ordering cost is expressed
as cost per order.

5.3.13 ECONOMIC ORDER QUANTITY (EOQ)

Consider the procurement of the entire quantity of an item required in a year. In this case,
inventory carry cost will be high. Hence for keeping inventory carry cost low, it is better to procure
them in small quantities. But this will increase the number of orders and hence ordering costs. This is
shown graphically in Fig. 5.3.4.
At a particular quantity, the sum of ordering cost and inventory carry costs is least. This
quantity is called Economic order Quantity (EOQ). At EOQ, inventory carry cost is equal to ordering
cost.
Economical Order Quantity (EOQ) is the quantity at which sum of ordering cost and inventory
carry cost is least.

Let
A = Annual requirement Quantity per order Cost per unit in rupees
Q = Ordering cost or procurement cost per order in rupees
C = Inventory carry charges per rupee expressed as decimal.
I = Inventory carry charges per rupee expressed as decimal
Ordering Cost = Cost per order x No.of orders
= S x A/Q =AS/Q
Carry cost = (Average inventory) x (Cost per unit) x (inventory carry cost
per unit)
= Q/2 x C x I = QCI/2
At EOQ; ordering cost = Carry cost
i.e., AS/Q = QC

Therefore Q2 =

That is, EOQ = Q =

other Formula for EOQ

It can be seen that –
IC = Carry cost per unit per annum
Let R = IC = Carry cost per unit per annum

Then EOQ =

5.3.14 NUMERICAL EXAMPLES ON EOQ

Example 1
If the demand for an item is 3600 units per annum, pro- curement cost is Rs. I 00/- and carry
cost is Rs.2/- per unit per annum, calculate EOQ.

Solution

EOQ = or

Given A = 3600 units per annum

S = Rs.100/- per order
R = Rs.2/- per unit per annum

Example 2
The annual demand for an item is 4000 units. The inventory carry cost is 1 0% of the stock
cost is 10% of the stock cost. Cost per units is Rs.30/- The ordering cost is Rs. 60/- per order. order
quantity.

Solution
 EOQ = or

Given A = Annual demand = 4000 units

= Inventory carry cost = 10% = 0.1
C = Cost per unit
S = Ordering cost per order = Rs.60/-

EOQ = or

Example 3
The annual requirement of an item for a firm is 10, 000 units. Ordering cost is Rs. 9.25. Carry
cost per unit per year is Rs. 5. What is EQQ ? If the lead time is 3 days and the firm works 300 days
in a year what is re-order level

Solution
Let A = Annual consumption = 10,000 units
S = Ordering cost per order = Rs. 9.25
R = Carry cost per unit per year = Rs.5/-
Re-order level = ROL
= Safety stock + Lead time consumption
Safety stock = 0(given)
Lead time consumption
= Daily consumption x lead time in days
= (10000/300) x 3 = 100 units
Hence ROL = 0 + 100 = 100 units Ans

Example 4
The rate of use of particular raw material from stores is 20 units per year. The cost of placing
and receiving an order is Rs.40.OO. The cost of each unit is Rs.l00. The cost of thrrying ini;entory in
percent year is 0. 16. Determine EOQ. If maximum lead time is 5 months and normal lead time is 3
months, safety stock and order point.

Solution
Let A = Annual requirement = 20 units
S = Ordering cost per order = Rs.40
c = Cost per unit Rs. 1 00 .
I = Inventory carry charges = 0.16

Order point
= ROL = Safety stock + Nornial lead time Consumption
Safety stock
= (Maximum lead time — Normal lead time) x consumption rate
Maximum lead time = 5 months
Normal lead time = 2 months
Rate of consumption = 20/12 unit per month
Hence, Safety stock = (5 - 2) x 2G/12 = 5 units Ans
ROL=5+ 2 x (20/12) = 8 units Ans

Example 5
The annual demand for an item is 4000 units. The inventory carry costs is 10%. Cost per unit
is Rs.30. The ordering cost

Solution
Let A = 1000 units
S = Rs.60.
I = 10%=0.1
C = Rs.30

Re- order point = ROL = Safety Stock + Lead time consumption

Safety Stock = 0 (given)
Lead time consumption = Daily consumption X Lead time in days
= (4000/300) X 9 = 120 units
Therefore ROL = 0 + 120 = 120 units Ans

Example 6
The daily requirement of lubricant in an industry is 6 tins and the company works 300 days in
a year. Cost of lub is Rs. 42 per tin. The procurement cost per order is Rs.16. Inventory carry cost is
20%. Calculate EOQ. If maximum lead time is 10 days and normal lead time is 5 days, what is safety
stock and re-order level?

Solution
Let A = Annual demand = 6 X 300 = 1800 tins
S = Ordering cost per order = Rs. 16
I = Inventory cost per annum = 20% = 0.2
C = Cost per unit = Rs.42
Safety Stock
= (Maximum lead time- Normal lead time)X Consumption rate
= (10—5)x 6 = 3Otins. Ans
ROL = Safety stock + Normal lead time consumption
= 30 + (5x6) =ô0 tins. Ans

5.3.15 RECORDS IN INVENTORY CONTROL

Maintaining of records up to date is the basic requirement for good inventory control system.
The various cards records) used in the inventory are
• Stock Measurement card
• Stock History card
• Stock Position advice note

5.3.16 STOCK MEASUREMENT CARI (SMC)

This is used to know at a glance the stock position, balance on order, balance on individual
order and number of orders not yet matured. A specimen stock measurement card is shown in Fig.
5.3.5

While maintaining the card, the following points are to be observed.

1. Issues must be posted every day.
2. When re-order level is reached, orders must be placed immediately.
Any system of stock control must provide up-to-date and accurate information on the stock
position at all times. S.IC is the main source of information on the stock position, inventory value and
the necessity for ordering.

The following particulars regarding the stock are noted in the stock measurement card.
• Material specifications
• Re-order
 • Minimum stock
• Stock position as on date with details of material received, issued and balance
• Particulars of material on order

5.3.17 STOCK HISTORY CARD (SHC)

Materials ordered for one component is sometimes used for the other component. To avoid
this, “Stock History Card” is maintained.
In the front page of stock history card, the following particulars are recorded.
• Material specification
• Annual consumption of material
• Ordering history
• Delivery schedule
• Details of authorised substitute material
• Minimum stock
The back page of stock history card shows the list of items using the particular material. No
material shall be issued by the stores for items not mentioned on the back of SHC. This prevents
misuse of material.

5.3.18 STOCK POSITION ADVICE NOTE (SPA NOTE)

When materials are received and issued in large quantities, there is possibility that the actual
balance may be less or more than the balance shown in stock measurement card. To inform the stock
controller about this difference, a stock advice note is prepared. Periodical checking of actual stock is
taken and entries are made in the stock position advice note. A specimen form is given in Fig. 5.3.6.
A clerk attached to the stock control will check the stock measurement cards and verify
whether calculations are all correct. He enters this under ‘recorded’ column in the stock position
advice note. The note is sent to stores where the physical stock is counted and entered in “actual”
column. The controller will be informed of the loss or credit. If the loss is beyond the normal limit, the
stock control must look into the stores situation.

REVIEW QUESTIONS
1. Define inventory
2. What is stock control and what are its objectives
3. What are the benefits of having good stock control system
4. What are the disadvantages of having excess inventories
5. Discuss briefly “ABC Analysis” with graph. What are it a advantages.
6. Discuss inventory policies for A, B and C items.
7. With the help of a diagram, explain
i. Maximum Stock ii. Safety Stock
iii. Re-order Point iv. Procurement Period
8. 1hat is lead time and what are the various activities that occur during lead time.
9. What is safety stock and why it is necessary.
10. With the help of diagrams, explain procurement and consumption cycle.
11. What are inventory carrying charges. How they are calculated.
12. What are ordering costs. How they are calculated.
13. What is economic order quantity. Explain with a diagram. Derive a formula for
EOQ.
14. The annual requirement for an item in an industry is 120 units. The cost per unit is
Rs.60/-. The procurement cost is Rs.20/- per order and inventory carrying cost is
10%. Find out the EOQ (Ans: 29 units)
15. The rate of use of a particular raw material by a firm from stores is 20 units per day.
The cost of placing an order is Rs.40/-. The cost of each unit is Rs.l00/- The cost of
carrying inventory per year is 0.16. Determine the economic order quantity if the
firm works 300 days a year. If lead time is 10 days and 5 days requirement is kept
as a safery stock, find safety stock and ROL. (Ans.174., 100, 300)
16. Determine the Economic Order Quantity from the following data:
1. Average annual demand = 10,000 units
2. Inventory carry cost = 20% per rupee value per year
3. Cost of placing an order = Rs. 100/-
4. Cost per unit = Rs.5/-(Ans: 1414 units)
17. Find the EOQ from the following data.
i. Average annual demand = 30,000 units
ii. Carry cost per annum = Rs.2.50 per unit
iii. Cost of placing an order = Rs.70/- (Ans: 1296 units)
18. A plant producing hydraulic valves can supply the factory ware house at the rate of
750 per month. The ware house ships 3000 valves per year at a unit selling price of
Rs.250. Considering the plant’s ordering and set up cost of Rs.300 and the
inventory carry cost rate of 20% per annum, what quantity the ware house should
order from the plant. (Ans: 1.90 Units)
19. The rate of use of particular raw material from stores is 200 units per day. The
company works for 290 days in a year. The cost of placing an order is Rs.50. The
cost of each unit is Rs.90. The cost of carrying inventory in percent per year is 0.8.
 What is economic order quantity If lead time is 10 days and 5 days requirement is
kept as safety stock, calculate re-order point. (Ans. 598, 1000, 3000)
20. Find the economic order quantity from the following data
1. Average annual demand = 30,000 units
2. Carry cost of inventory per annum = Rs.2.50 per unit
3. Cost of placing an order = Rs.70/-
4. Number of working days in a year = 300
5. If the maximum lead time is 20 days and the normal lead time is 10 days, calculate
safety stock and re-order level.
21. Write short notes on the following
i. Stock measurement card
ii. Stock history card
iii. Stock Position Advice Note

5.4 PURCHASING AND STORE KEEPING

5.4.1 PURCHASING OR PROCUREMENT

Purchasing means buying of equipments materials, tools, components etc., required for an
industry. Purchasing is a primary function. The success of an industry depends on the efficiency of
purchasing department. Careful buying reduces the cost of materials and increases profits. The
persons employed for that job should be sincere, honest and intelligent. Materials shall be purchased
in right quality, in right quantity from right source, at right time and at righ price.

Objectives of Purchasing Department:

1. To purchase at right time (When to purchase?)
2. To purchase from reliable supplier (Where to purchase?)
3. To purchase in right quantity (How much to purchase?)
4. To purchase in right quality (What to purchase?)
5. To purchase economically (At what rate to purchase?)

5.4.2 PURCHASING PROCEDURE

The purchasing procedure involves the following steps

1. Analysing the purchase requisition and bill of materials received from
stores and deciding the quantity to be purchased with specifications.
2. Preparing list of suppliers.
3. Inviting quotations/tenders from suppliers with terms and conditions.
4. Preparing comparative statements of rates, terms and conditions.
 5. Selecting the right supplier based on quality, rate, terms and
conditions.
6. Placing the purchase order with the selected supplier.
7. Taking follow up action to get materials in time.
8. Inspecting the materials received. If discrepancies are found corrective
action shall be taken.
9. Verifying the supplier’s bill for payments.
10. Closing the order and maintenance of records and files.

1. Purchase requisition
In an industry, whenever a department needs materials, ii is officially brought to the notice of
the purchasing department, through a document known as purchase requisition. The purchase
department-takes action to purchase materials on the basis of purchase requisition. A purchase
requisition contains the following information.

a. Specifications of materials
b. Quantity and quality of materials
c. Date by which material is required.
d. Place at which the materials should be delivered.

A purchase requisition is prepared in duplicate and is signed by authorised persons only.

2. Bill of Materials:
A bill of materials is a list of all standard items required for a job. It is generally prepared by
the production planning department and send to stores. It is an advance intimation to the store keeper
about the requirement of materials. The store keeper works out the total material requirement from bill
of materials, find out the existing stock and decides the actual materials to be purchased. Then a
purchase requisitions is prepared and sent to purchase department.

3. List of Suppliers:
Reliable suppliers shall be selected. For items which are purchased frequently, the regular
and reliable suppliers of materials are preferred.

For purchasing new items, suppliers list may be prepared -from catalogues, Journals,
Advertisements, Trade Exhibitions, Trade directories, etc. It is always better to maintain a record of
classified list of suppliers dealing with various items. This record shall be kept updated.

4. Inviting tender/Quotations:
 The tender/quotations are invited from the firms dealing with the supply of required items. It is
an enquiry to know whether the vendor (seller) can supply the desired items within the specified
period and if so, at what rate and terms and conditions.

There are three types of tenders.

(i) Single tender
(ii) Closed tender and
(iii) Open tender.

In single tender, only a single reliable firm will be asked to supply materials. The rates are
fixed by mutual acceptance. This method is used when quality of materials is of great importance.

In closed tender, tenders are invited only from some limited firms. These firms are generally
registered firms with the buyer. This system is also called “Limited Tender system”.

In open tender, tenders are invited from all interested suppliers. The tender notice is issued in
news papers and trade journals. This system is also known as unlimited tender system.

A tender notice shall contain the following particulars

a. Name of material with detailed specifications.
b. Quantity to be purchased.
c. The make of the material, if necessary.
d. Whether sample is required.
e. Period of delivery.
f. Earnest money to be deposited.
g. Terms and conditions ‘of purchase such as payment, place of delivery, validity of tender,
guarantee period etc.
h. Date, time and place of receiving and opening tenders

5. Comparative Statement:
After receiving the quotations from different suppliers, they are studied and a comparative
statement of rates and other terms and conditions is prepared. This helps-to study the various offers
easily in one glance. After studying the comparative statement thoroughly, the supplier is selected.

It is not always necessary to purchase the items only from the firms quoting lowest rates. The
following factors shall also be considered in selecting the supplier.

i. Quality of the materials and make.

ii. Period of supply and guarantee period.
iii. Other expenses like freight, tax, packing and forwarding charges etc.
 iv. Reliability of the supplier.
v. Terms of payment etc.

6. Purchase order:
After selecting the supplier, a purchase order is sent to him. It is a letter sent to the supplier,
asking to supply material. It is a legal document and authorises the vendor to supply materials and
bill.
Six copies of purchase order are prepared and signed by the purchase officer. Out of these
copies, one copy each is sent to (i) supplier (ii) Store keeper (iii) Accounts Section (iv) Inspection
department and (v) the department placing purchase requisition. The sixth copy -is retained by the
purchase department for record.

7. Follow up of Purchase Order:

Merely placing the purchase order will not guarantee the supply. The purchase department
shall maintain contact with the supplier. The supplier shall be reminded of delivery period. It must be
ensured that materials will be supplied in time. In case, materials are not received in time, corrective
actions shall be taken, such as transferring order to other vendors, change of transport etc.

8. Inspection of Materials Received:

After the receipt of materials, the same is inspected and compared with the purchase order.
The discrepancies found are promptly informed to the supplier. The rejected materials are returned to
the supplier for replacement.

9. Verifying Supplier’s Bill or Invoice

The bills are verified for the correctness of the materials (quantity and quality) received and
the prices. It must be ensured that the discount if any has been allowed in the bill. The bill must also
be verified for taxes and other terms and conditions.
Alter confirming the above, the bill is passed for payment.

10. Closing the Completed Order

The file copy of purchase order is removed and entries such as “materials received in good
condition”, “bill passed for payment” etc are made. Then it is stored in the file of closed orders.

5.4.5 STORE KEEPING

Stores is a place where goods are kept. Stores is the heart of any industry. Store keeping
refers to the sale custody of all materials stocked in stores. Store keeper is responsible for this.
Materials are to be stored in stores in such a manner that there is no possibility of theft, fire, damage
and pilferage. The materials shall be easily located and issued easily.

5.4.6 ADVANTAGES (OBJECTIVES) OF STRE KEEPING

 1. To ensure that their is no over stocking of materials.
2. To avoid stock out position and maintain safety stock.
3. To examine carefully all materials received.
4. To arrange for systematic and efficient storing of materials.
5. To maintain accurate records of materials received and issued.
6. To prevent theft, wastage, damage etc.

5.4.7 DUTIES OF STORE - KEEPER/FUNCTIONS OF STORES DEPARTMENT

1. To receive raw materials, equipments, spare parts, finished goods etc and check them.
2. To keep record of materials and their cost.
3. To plan layout of stores and store the materials systematically so that materials can be
located easily.
4. To inform the purchasing department to arrange fox purchase of materials when stock
position comes to Re-order level.
5. To make entries of receipts and issues of materials and keep the records up to date.
6. To issue materials promptly, only on receipt of authorised requisition.
7. To prevent unauthorised persons entering the stores.
8. To make periodical physical stock verification.
9. To maintain stocks safely and prevent theft, damage, pilferage etc.,

5.4.8 STORES LOCATION

In general, stores shall be located close to the point of use. But this is always not possible.
Stores location depends upon the nature and value of items to be stored. The following points shall be
kept in mind while locating stores.
1. The location shall minimise the total handling costs and other costs involved in stores operation. -
2. It shall provide protection from theft, damage etc.,
3. All departments shall have easy access to stores.

Centralised Store
In this system there will be only one stores under the control of one supervisor. The
storeroom should be as far as possible close to the point of use. This will reduce handling cost and
eliminate lot of manual work. This system is suitable only for small factories.

Advantages and Disadvantages of Centralised Store

1. Better control and supervision.
2. Less manpower requirement and hence reduced costs.
3. Better layout can be planned.
4. More material handling and hence increase in costs.
5. Access to stores by each department is not easy.
Descentralised Stores:
In big industries having many departments, stores cannot be located where it convenient to all
departments. It is found beneficial to have separate stores.
For example, the materials required for machine shop are stored near machine shop. The
materials required for foundry department are stored near foundry. This system is known as
decentralised stores.
Sometimes such as stationary, cotton waste, soap etc., are common to all departments.
These shall be kept at centralised place.

Advantages and Disadvantages of Decentralised Stores:

1. Reduced material handling and related costs.
2. Easy access to every department.
3. More man power requirement and hence increase in - over head cost.
4. Control and supervision is difficult.
5. Efficient security arrangements are required

5.4.11 ARRANGEMENT OF STORES MATERIALS

lf the stores is small, it is not difficult for the storekeeper to remember the location of item. He
can easily pick up materials during the issues. But if the store is very large with thousands of items, it
will be very difficult to remember the location of every item. Hence to locate the items easily, the items
are given code numbers. For example, if a particular item is given a code number in the records as
22- 15 C - 10, it means the item is in room or area number 22 and kept in ‘C’ shelf of rake number 15
and its bin card number is 10.
Therefore any stores personnel on duty can easily locate the position of the item.

5.4.12 BIN CARD

This is a card which is attached to each bin, rack etc., in the stores. The following details are
shown in bin card.
1. Details of materials received.
2. Details of material issued.
3. Balance of material on hand.
4. Material code number.
5. Ledger folio (page) number.
6. Maximum and minimum stock.
7. Re order level.

A specimen bin card is shown in fig 5.4.1

 Stock position is entered in bin card at every transaction. Bin card is very handy and useful to
the storekeeper for ready reference of stock position.
Bin cards are prepared in duplicate. One card is attached to the bin and other with the store
keeper for ready reference. The stock position in the bin cards should agree with the stock ledger
accounts. Bin cards are checked periodically by inspectors to see that they are accurately maintained.

5.4.13 STOCKTAKING (OR) PHYSICAL VEBJFICATION OF STORES

To detect arithmetical errors or loss due to fraud etc., actual stock of materials on hand is
counted and compared with ledger balance. The causes for differences (excess or shortage) are
investigated. This process is known as physical verification of stores.

Methods of Stocktaking
The following are the two methods of stock taking.
a. Annual Physical Verification.
b. Perpetual inventory or continuous stock taking system.

a. Annual Physical Verification

Near the end of accounting year, usually in March - April, stores are closed for few days. No
material is issued to anybody.
A team of stock verifying officers physically check and count each and every item in stores.
The same is compared - with ledger balance. A list of differences is prepared. Dam aged and obsolete
items are also detected and recorded. Those due to arithmetical error are rectified. Those due to
actual loss are classified into
i. Routine loss due to shortage etc.
ii. Loss due to negligence or fraud.
 Routine losses are written off. Losses due to negligence are recovered from persons
responsible or written off. Losses due to fraud should be seriously dealt with. If necessary criminal
proceedings shall be taken.
In this method, all the items can be checked at one time and there is no possibility of leaving
any item unchecked. This method is generally used is small industries dealing with a limited number
of items.

b. Perpetual Inventory:
In big industries, dealing with large number of stores items, it is not economical to close down
stores for few days for annual stock verification. In this case, perpetual inventory or continuous stock
taking system is used.
In this method, items are checked continuously throughout the year. Only few items are
checked everyday or at frequent intervals. It is not necessary to close the stores.
An item is generally checked when it reaches its minimum level. Every item of store is
checked at least once or twice a year.
The causes for differences found if any are investigated and corrected.
The shortages are written off if they are due to routine losses such as breakage, pilferage etc.
The shortage are corrected if they are due to arithmetical error and wrong entries. If shortages are
due to negligence and fraud, it should be seriously dealt with.

Advantages of perpetual inventory:

i. Stores are not closed and hence production is not stopped
ii. Since only few items are checked everyday, this system is less costly and less tiring as compared
to annual stock verification.
iii. The causes for shortages can be detected then and there and rectified immediately.

Necessity (Advantages) of stocktaking

l. To ensure correctness of actual stock with ledger balance.
2. To find causes for excess or shortage in stock
3. To correct and update the stores record
4. To detect and prevent losses due to fraud.
5. To calculate the value of stock

REVIEW QUESTIONS
1. What are the objectives of purchasing department?
2. Describe the purchasing procedure to be adopted for a medium size industry? medium size
industry?
3. Write short notes on -
i. Purchase requisition
ii. Tenders/Quotation
iii. Bill of materials
iv. Purchase order
4. What is a comparative statement and what is its use?
5. Distinguish between purchase requisition and purchase order.
6. Differentiate between signal tender, closed tender and open tender.
7. What are the functions of material receiving department of a company?
8. Distinguish between purchase requisition and stores requisition.
9. Briefly explain different methods of is’ of materials.
10. What do you mean by store keeping and what are its objectives?
11. What are the main functions of stores organisation and what are the advantages of good store
keeping?
12. Write duties of storekeeper in medium size general-purpose workshop?
13. What are the different types of stores and where they are to be located? Explain with merits and
demerits of each type.
14. Distinguish between centralised stores and decentralised stores?
15. Write short notes on -
i. Bin card ii. Stocktaking
iii. Perpetual inventory
iv. Annual stock verification