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INTRODUCTION OF FINANCE

Finance is the study of funds and management. Its general areas are

business finance, personal finance and public finance. It also deals with

the concepts of time, money, risk and the interrelation between the given

factors. It is basically focused on how the money is spent and budgeted.

Finance is a monetary resource allows businesses to purchase items that

will create goods for production and other services. The budget is the

documentation of the entire entrepreneurship.

A personal finance is related to how much money is needed by an

individual. It is concerned on financial resources and its usage. There are

various factors that affect decisions in handling personal finance which

are financing durable goods, paying for education, monthly bills, secured

loans, minimal debt obligations, health insurance and retirement plans.

Studying finance will lead you in wiser decisions making on your

financial funds. It can help you identify risks and benefits if you are

planning to put up your own business. Finance discipline requires you

certain abilities and trainings which can be developed over a period of

time. Finally, it will certainly help you in financially secured life.

CHAPTER-1 INTRODUCTION

MEANING OF FINANCE

The word ‘Finance’ is derived from an old French word ‘Finer’ , meaning

thereby to pay, settle or finish. It other words, the term ‘Finance’ means

‘money’ or ‘provision of funds’ as and when needed. According to

F.ZW.Paish, finance may be defined as, “the provision of money at the

time it is wanted.”

BUSINESS FINANCE

MEANING

Business finance means financing of business activities. A business needs

funds at every step to bring a business into existence and to operate a

business. In other words, all activities of business, be it plant and

machinery acquisition, production, marketing, human resource,

purchases, research and development, continuation to complete. Without

money, no business can be run efficiently, effectively and profitably.

APPROACHES OF BUSINESS FINANCE

The various authorities have viewed the term business finance differently.

For the purpose of exposition, the approach to the study of business

finance may be grouped into two categories:


1. Traditional Approach

The traditional approach of business finance is concerned with raising

of funds used in an organization. This category encompasses

instruments, institutions, practices through which funds are raised and

legal and accounting relationship between an enterprise and its

sources of funds. The authorities of this approach ignored the function

of efficient employment of finance. The utilization of administering

resources was considered outside the preview of the finance function.

As per this approach, the following aspects only were included in the

finance function.

a) Estimation of requirements of finance.

b) Arrangement of funds from financial institutions.

c) Arrangement of funds through financial instruments such as shares,

debentures, bonds and loans and

d) Looking after the accounting and legal work connected with the

raising of funds.

The traditional approach to business finance had a narrow view to the

extent of controlling the sources and application of funds. The subject

of business finance was treated from the investor’s viewpoint only,


placing emphasis on the long term financial problems and ignored the

important and typical problems of working capital management.

2. Modern Approach

The modern approach lays emphasis is not only on the raising of funds

but also on their effective utilization. This approach determines the

total amount of funds required for the firm, allocating these funds

efficiently to the various assets, obtaining the best mix of financing

and applying financial tools and techniques order to ensure a proper

use of the funds. Thus, the emphasis of modern approach of business

finance has been shifted from rising of funds to the effective and

judicious utilization of funds.

The modern approach of business finance is analytical way of looking

into the financial problems of the firm. An existing modern theory of

financial management is expressly concerned with the relationship

between profitability and the volume of capital used, depicting the

clear shift from controlling the sources and application of funds to the

function of efficient and effective use of funds. The modern approach

in business finance is of decision-making relating to various facts of

financial planning and control.


SIGNIFICANCE OF BUSINESS FINANCE

The significance/importance/need for business finance arises for the

following purposes:

1. Acquire fixed asset

Every business firm whether manufacturing or trading needs finance

to acquire fixed assets. Manufactures need finance to acquire land and

building, plant and machinery and vehicles for distribution goods.

2. Purchase raw-materials/goods

Manufactures require finance to acquire raw-materials, and

consumable stores for production. Traders need finance to acquire

goods for distribution.

3. Acquire services of human resource

Manufactures need finance to pay their workers, supervisor, manages

and other staff employed by them. Traders require finance to pay their

employed by them.

4. Meet other operating expenses

Every organization needs finance to meet day to day other operating

expenses like payment of electricity bills, water bills, telephone bills,

traveling and conveyance of staff, postage and telephone telegram

expenses and so on.


5. Adopt modern technology

With fast changing technology, business firms need finance to

modernize their plans and machineries, production methods and

distribution methods. An enterprise may decide to replace outdated

and obsolete assets with new assets to operate more economically.

FINANCE FUNCTION

MEANING

In the context, as a study of subject, the business finance and finance

function of business are inter changeably used. Business finance or

finance function embraces all theories, procedures, institution

instruments, problems and policies that are involved in the acquisition

and use of money by business enterprises.

DEFINITION

Business finance or finance function may be defined as “the process of

retaining, providing and managing of all the funds to be used in

connection with business activity. It is an activity concerned with

planning, raising, controlling and administrating of funds used in the

business.


FINANCIAL MANAGEMENT

MEANING

Financial management is that specialized functional area of general

management, is primarily concerned with the management of financial

aspects of an enterprise. The business finance or finance function centers

around the financial management of fund raising and using them

effectively. Thus, the financial management deals with procurement of

funds and their effective utilization with an intention to maximize wealth

of the owners of the business.

DEFINITIONS

Financial management can be defined as “Planning, Organising,

Directing and Controlling the financial activities to achieve the ultimate

goal of an organization, i.e., maximizing wealth of the firm for its

owners.”

NATURE AND CHARACTERISTICS OF FINANCIAL

MANAGEMENT

The following are main features of financial management:

1. Financial management is the management of finances of an

organization in order to achieve its objectives.


2. Financial management is that area of general management which is

concerned with the timely procurement of adequate finance from

various sources and its utmost effective utilization for the attainment

of organizational objectives.

3. Financial management is an area of finance which is concerned

primarily with financial decision making within an organistion.

4. Financial management involves planning, organizing, directing and

controlling of financial activities in an organization.

5. Financial management is concerned with optimal procurement and

effective utilization of funds in an manner that the risk, uncertainty,

cost and control considerations are properly balanced in given

situation.

6. Financial management is concerned with managerial decision making.

Decision making is futuristic and requires information and criterion.

Information is deduced from accounting. Criterion demands logic

which emanates from economics.

7. Financial management is continuous administrative function. In the

present day system of complex business environment it has become an

administrative function which is associated with acquiring of funds

and its judicious application.


8. Financial management is also deals with how much profit share

should be kept for expansion and how much be distributed as divided

among shareholders.

FUNCTIONS / DECISIONS OF FINANCIAL MANAGEMENT

Financial management as an integral part of the overall management is

primarily concerned with acquisition of funds and their effective

utilization with an intention to maximize the earnings and wealth of the

owners (shareholders) of the company. In this background, the following

major aspects/functions are taken up in detail under the study of financial

management:

A. Managerial Finance Functions/Decisions

Managerial finance function include all those financial decisions of

importance require specialized managerial skills. The important

managerial functions are given below:

1. Financing Decision

This decision/function related to the procurement of funds or

collection of capital for various investment proposals. In simple

words, it is related to the pattern of financing. Broadly, financing

decision/function is concerned with the determination of capital

needs and the sources of raising total funds required by the firm


through the issue of different types of securities, e.g., shares,

debentures, borrowing from banks and financial institutions etc

This decision/function involves the following issues:

a) Ascertainment of total funds requirement.

b) Categorization of fund requirement into long-term fund

requirement, medium and short-term fund requirement.

c) Determination of sources for fund raising, i.e., financial

instruments-equity shares, preference shares, debentures, bonds

etc

d) Analysis and examination of various sources of funds, and their

cost of capital, degree of risk and control.

2. Investment Decision

This decision/function related to selection of assets in which funds

are to be invested by the company. In other words, investment

decision relate to the total amount and assets to be held and their

composition in the form of fixed and current assets.

Investment alternatives are numerous. Resources are scarce and

limited. They have to be rationed and discretely used. Thus,

investment decision/function is concerned with the careful


evaluation of various alternative investment opportunities (project)

available to the company and selection of best opportunity.

The investment decision result in purchase of assets. Assets can be

classified into the following two broad categories:

Long-term investment decisions long- term assets.

Short-term investment decisions short-term assets.

Long-term Investment Decisions:

The long-term investment decisions relate to fixed assets, which

are generally referred to as Capital Budgeting Decisions. The

fixed assets are long term in nature. Basically, fixed assets

create earnings to the company. They give benefit in future.

Short-term Investment Decisions

The short-term investment decisions relate to current assets,

which are generally referred to as Working Capital

Management. The current assets are short-term in nature.

The financial management has to allocate the available scares

resources among cash and cash equivalents, receivables and

investors. Though these current assets do not directly contribute

to the earnings, their existence is necessary for proper, efficient

and optimum utilization of fixed assets.



a) Ascertainment of total volume of funds available with the

company.

b) Measurement of risk and uncertainty associated with the

investment proposals.

c) Selection of capital investment proposals.

d) Prioritizing of investment decisions.

e) Allocation of funds through ‘capital rationing’.

3. Dividend Decision

The term ‘dividend’ refers to the portion of profit, (after tax),

which is distributed to share holders of the company. It is a reward

or compensation to them for their investment made in the firm. The

dividend can be declared from the current profits or accumulated

profits.

The decision/function is concerned with decision regarding

distribution of earnings among share holders of the company. The

object of financial management is to increase the maximum wealth

of the company, and give maximum satisfaction to its owners. It is

a challenging job for a financial management to establish dividend

policy of the company i.e. to what extent the profits is to be


distributed and to be retained so as there is no adverse effect in the

current and future market price of shares of the company.


a) Ascertainment of divisible profits of the company.

b) Determination of dividend and retention policy of the firm.

c) Analysis and evaluation of impact of levels of dividend and

retention of earnings on the market value of the share, and

future earnings of the company.

d) Consideration of the liquidity of the company.

e) Reconsideration of distribution and retention policies in boom

and recession periods.

4. Liquidity Decision(Working Capital Management Decision)

Liquidity decision is concerned with the management of current

assets. Basically, this is called working capital management.

Working capital refers to funds to be invested in the business for a

short period usually up to one year. It is also known as short-term

capital or circulating capital. Working capital management

concerned with the management of all the items of working capital,

i.e., management of current assets and current liabilities. It deals

with examination, evaluation and decision regarding each and


every aspect/component of working capital. A proper balance must

be maintained between liquidity and profitability of the company.

This is the key area for financial management. The strategy is in

ensuring a continuous process as the conditions and requirements

of business change, time to time. In accordance with the

requirements of the firm, the liquidity has to vary and in

consequence, the profitability changes. This is the major dimension

of liquidity decision or working capital management.


a) Determination of requirement of total working capital.

b) Determination of optimum level of investment in each

components of working capital.

c) Determination of sources and mode of financing of working

capital.

d) How to gear working capital with the change its circumstances,

seasons and operating level.

B. Incidental Finance Functions

The incidental finance functions are those functions of clerical or

routine which are necessary for the execution of taken by the

management. Some of the important incidental finance functions are:


a) Supervision cash receipts and payments, and the safeguarding of

cash balance.

b) Proper custody and safeguarding of securities, insurance policies

and other valuable documents.

c) Record keeping of financial transactions and reporting.

d) Cash planning and credit management.

SIGNIFICANCE / IMPORTANCE OF FINANCIAL

MANAGEMENT

1. Implementation of business plans

In every business organization, where funds are involved, sound

financial management is necessary. It makes funds available at the

right time and uses them in an optimum way for implementation of

business plans.

2. Achieve objectives

The ultimate goal of every business organization is profit

maximization and wealth maximization. Financial management also

aims towards the same objective and hence it is important.


3. Business survival

Financial management gains prime importance, since finance is

critical for the survival of an organization. Finance is needed for the

working of all departments.

4. Financial decision making

The primary concern of financial management is considered to be

rational matching of funds of there uses in the light of appropriate

decision criteria.

5. Appraisal of business decisions

Almost all business decisions are appraised from the point of view of

financial management, making the financial management a key player

in the decision making process of an organization.

6. Helps co-ordination

All the functional areas of business organization have financial

implications. Financial management helps helps to co-ordinate them

and eliminate wastages.

7. Reduce risk and uncertainty

Financial management involves planning financial activities, and also

preparing for future financial uncertainties. Hence, it helps to face the

uncertain financial situations and there will be lesser risk.


8. Measurement of business performance

It is general belief that profitability of business is an index of sound

operation of all business activities. Financial management helps to

find out the performance of business activities in terms of profitability

of business.

9. Pervasiveness

Financial management is necessary for all the types of organizations,

whether profit or non-profit. It is required to all functions and

departments within the organization.

GOALS/OBJECTIVES OF FINANCIAL MANAGEMENT

Financial management is mainly concerned with the procurement of

funds and judicious use of these funds with an intention to protect and

safeguard the economic interest/welfare i.e., maximize the earnings

(profit) and wealth (value of equity shares) of the owners (share holders)

of the company. There are two conflicting goals/objectives are to be

achieved by financial management:

1. Profit maximization

2. Wealth maximization


1. Profit maximization

Profit earning is generally regarded as the main objective of business

firm. The term ‘profit’ refers to the amount of income earned by the

business firm, which is due to its owners (share holders). Profit

earning or profitability refers to a situation where output exceeds

inputs i.e., the value created by the use of input resources. Profitability

is an operational concept.

Each company collects its finances by way of issue of shares to the

public. Investors (shareholders) invest it shares with hope of getting

more dividends for their investment in the company.

It is possible only when the company’s earn maximum profits out of

its available resources.

If the company fails to distribute higher dividend, people will not be

keen to invest their money in such company, and persons who have

already invested, will like to sell their stocks. Therefore, it is the

objective of financial management is to safeguard the economic

interest/welfare of shareholders by deciding maximum profits or fair

profits in the form of dividend. Thus, profit maximization refers,

earning maximum profits out of its available organizational resources.


2. Wealth maximization

The primary objective of financial management is to maximize the

wealth to the owners (shareholders). Wealth of the owner is the

market value of equity shares.

Wealth maximization means maximization of the market price or

value of equity shares of the company. In other hoards, maximize the

value of the firm to its owners (equity share holder) i.e,. to maximize

the market price or value of equity shares. Share holders wealth will

be maximized if the market price/value of share is maximized, hence

wealth maximization is also termed as ‘value maximization’. Market

price or value of shares serves as a yard stick of the performance of a

company. Therefore, wealth maximization of the firm is the most

appropriate objective of the financial management. Thus, wealth

maximizations is to be more precise objective of financial

management.

The wealth maximization goal/objective considers:

a) Present and prospective earnings of the company.

b) Time pattern of return i.e., time value of money.

c) Intrinsic value of the assets of the company.

d) Risk associated with the operation of company.


e) Financial leverage adopted by the company.

f) Dividend policy of the company.

g) Long run and short run profits, both

h) Social objectives of business.

i) Political environment of the country.

j) Market rumors.

k) Masses psychology,etc.

COST

The ICMA, London has defined cost as “the amount of expenditure

(actual or notional) incurred on or attributable to a specified thing or

activity”.

COSTING

Wheldon has defined costing as, “the classifying, recording and

appropriate allocation of expenditure for the determination of costs, the

relation of these costs to sales value and the ascertainment of profitability.

COST ACCOUNTING

The CIMA of UK defined as “the process of accounting for costs from

the point at which expenditure is incurred or committed to the

establishment of its ultimate relationship with cost centres and cost units.


COST ACCOUNTANCY

According to the CIMA of UK “the application of costing and cost

accounting principles methods and techniques to the science, art and

practice of cost control and the ascertainment of profit ability.”

OBJECTIVES OF COST ACCOUNTING

1) Ascertainment of cost

This is the primary objective of cost accounting. For cost

ascertainment different techniques and systems of costing are used

under different circumstances.

2) Control of cost

Cost accounting aims at improving efficiency by controlling and

reducing cost. This objective is becoming increasing important

because of growing competition.

3) Guide to business policy

Cost accounting aims at serving the needs of management in

conducting the business with at most efficiency. Cost data provide

guidelines for various managerial decisions like make or buy, selling

below cost, utilization of idle plant capacity, introduction of a new

product etc.


4) Determination of selling price

Cost accounting provides cost information on the basis of which

selling prices of products or service may be fixed. In periods of

depreciation, cost accounting guides in deciding the extent to which

the selling prices may be reduced to meet the situation.

5) Measuring and improving performance

Cost accounting measures efficiency by classifying and analyzing cost

data and then suggests various steps in improving performance so that

profitability is increased.

ADVANTAGES OF COST ACCOUNTING

1) Reveals profitable and unprofitable activities

A system of cost accounting reveals profitable and unprofitable

activities. On this information, management may take steps to reduce

idle time, under-utilization of plant capacity, spoilage of materials etc.

2) Helps in cost control

Cost accounting helps in controlling costs with special techniques like

standard costing and budgeting control.

3) Helps in decision making


It supplies suitable cost data and other related information for

managerial decision-making, such as introduction of a new product

line, determining export price of products, make or buy etc.

4) Guides in fixing selling prices

Cost is one of the most important factors to be considered while fixing

prices. A system of cost accounting guides the management in the

fixation of selling prices, particularly during depression period when

prices may have to be fixed below cost.

5) Helps in inventory control

Perpetual inventory system which is an integral part of cost

accounting helps in the preparation of interim profit and loss account,

level setting etc are also used in cost accounting.

6) Aids in formulating policies

Costing provides such information as enables the management to

formulate production and pricing policies and preparing estimates of

contracts and tenders.

7) Helps in cost reduction

It helps in the introduction of a cost reduction programme and finding

out new and improved ways to reduce costs.


8) Reveals idle capacity

A concern may not be working to full capacity due to reasons such as

shortage of demand, machine breakdown or other bottlenecks in

production. A cost accounting system can easily work out the cost of

idle capacity so that management may take immediate steps to

improve the position.

9) Checks the accuracy of financial accounts

Cost accounting provides a reliable check on the accuracy of financial

accounts with the help of reconciliation between the two at the end of

the accounting period.

10) Presents frauds and manipulation

Cost audit system, which is a part of cost accountancy, helps in

preventing manipulation and frauds and thus reliable cost data can be

furnished to management and others.

DISADVANTAGES OF COST ACCOUNTING

1) It is unnecessary

It is argued that maintenance of cost records is not necessary and

involves duplication of work. It is based on the premise that a good

number of concerns are functioning prosperously without any system

of costing. This may be true, but in the present world of competition,


to conduct a business with utmost efficiency, the management needs

to know detailed cost information for its decision-making. Only a cost

accounting system can serve this need of the management and thus

help in the more efficient conduct of a business.

2) It is expensive

It is pointed out that installation of a costing system is quite expensive

which only large concerns can afford. It is also argued that installation

of the system will involve additional expenditure which will lead to a

diminution of profits. In this respect, it may be said that a costing

system should be treated as an investment and the benefits derived

from the system must exceed the amount spent on it. It should not

prove a burden on the finances of the company.

3) It is inapplicable

Another argument sometimes put forward is that modern methods of

costing are not applicable to many types of industry. This plea is not

very apt. the fault lies in an attempt to introduce a readymade costing

system in a firm. A costing system must be specially designed to meet

the needs of the business. Only then the system will work successfully

and achieve the objectives for which it is introduced. In fact,

applications of costing are very wide. All types of activities,


manufacturing and non-manufacturing, should consider the use of cost

accounting.

4) It is a failure

The failure of a costing system in some concerns is quoted as an

argument against its introduction in other undertakings. This is a very

fallacious argument. If a system does not produce the desired results,

it is wrong to jump to the conclusion that the system is at fault. The

reasons for the failure should be probed. In order to make the system a

success, the utility of the system should be explained and the

cooperation of the employees should be sought by convincing them

that the system is for the betterment.

METHODS OF COSTING

1) Job order costing

According to CIMA, UK “applies where work is undertaken to

customer special requirements”. Cost unit in job order costing is a job

or work order for which costs are separately collected and

accumulated. A job, big or small, comprises a specific quantity of a

product to be manufactured as per customer’s specifications. The

industries where this method is used include printing press, repair

shops, interior decorators, painters etc.


2) Contract costing or terminal costing

This is a variation of job costing and therefore, principles of job

costing apply to this method. The difference between job and contract

is that job is small and contract is big. It is well said that a contract is a

big job and a job is a small contract. The cost unit here is a ‘contract’

which is of a long duration and may continue over more than one

financial year. Contract costing is most suited to construction of

buildings, dams, bridges and roads, ship building etc.

3) Batch costing

Like contract costing, this is also a variation of job costing. In this

method, the cost of a batch or group of identical products is a cost unit

for which costs are ascertained. This method is used in companies

engaged in the production of readymade garments, toys, shoes and

tubes, component parts etc.

4) Process costing

As distinct from job costing, this method is used in mass production

industries manufacturing standardized products in continuous

processes of manufacturing. Costs are accumulated for each process or

department. Here raw material has to pass through a number of

processes in a particular sequence to completion stage. In order to


arrive at the unit cost, the total cost of a process is passed on to the

next process as raw material. Textile mills, chemical works, sugar

mills, refineries, soap manufacturing etc may be cited as examples of

industries which employ this method.

5) Operation costing

This is nothing but a refinement and a more detailed application of

process costing. A process may consist of a number of operations and

operation costing involves cost ascertainment for each operation

instead of a process.

6) Single, output or unit costing

This method of cost ascertainment is used when production is uniform

and consist of a single or two or three varieties of the same product.

Where the product is produced in different grades, costs are

ascertained grade-wise. As the units of output are identical, the cost

per unit is found by dividing the total cost by the number of units

produced. This method is applied in mines, quarries, brick-kilns, steel

production, flour mills etc

7) Operating or service costing

This method should not be confused with operation costing. Operating

costing is used in manufacturing products. For example, transport


understandings (road transport, railways, airways, shipping

companies) electricity companies, hotels, hospitals, cinema etc., use

this method. The cost units are passenger-kilometer or tone-kilometer,

kilowatts hour, a room per day in a hotel, a seat per show in cinema

etc. This method is a variation of process costing.

8) Multiple or complete costing

It is an application of more than one method of cost ascertainment in

respect of the same product. This method is used in industries where a

number of components are separately manufactured and then

assembled into final product. For example, in a television company,

manufacture of different component parts may require different

production methods and thus different methods of costing may have to

be used. Assembly of these components into final product still

requires another method of costing. Other examples of industries

which make use of this method are air-conditioners, refrigerators,

scooters, cars, locomotive works etc.

TECHNIQUES OF COSTING

1) Standard costing

This is a very technique to control the cost. In this technique, standard

cost is predetermined as a target of performance and actual


performance is measured against the standard. The difference between

standard and actual costs is analyzed to know the reasons for the

difference so that corrective actions may be taken.

2) Budgetary control

Closely allied to standard costing is the technique of budgetary

control. A budget is an expression of a firm’s plan in financial form

and budgetary control is a technique applied to the control of total

expenditure on materials, wages and overhead by comparing actual

performance with planned performance. Thus, in addition to its use in

planning, the budget is also used for control and co-ordination of

business operations.

3) Marginal costing

This is a technique of profit planning. In this technique, separation of

costs into fixed and variable (marginal) is of special interest and

importance. This is so because marginal costing regards only variable

costs as the products. Fixed cost is treated as period cost and no

attempt is made to allocate or apportion this cost to individual cost

centres or cost units. It is transferred to costing profit and loss account

of the period. This technique is used to study the effect on profit of

changes in volume or type of output.


4) Total absorption costing

It is a traditional method of costing whereby total costs (fixed and

variable) are charged to products. This is in complete contrast to

marginal costing where only variable costs are changed to products.

Although until recently this was the only technique employed by cost

application.

5) Uniform costing

This is not a separate technique or method of costing like standard costing

or process costing. Uniform costing simply denotes a situation in which a

number of firms adopt a uniform set of costing principles. It has been

defined by CIMA as “the use by several undertakings of the same costing

principles and/or practices”. This helps to compare the performance of

one firm with that of other firms and thus to derive of anyone’s better

experience and performance.

CLASSIFICATION OF COSTS

There are various ways of classifying costs as given below

1) Classification into Direct and Indirect Costs

Costs are classified into direct costs and indirect costs on the basis of

their identify ability with cost units or jobs or processes or cost centre.


Direct cost

These are those costs which are incurred for and conveniently

identified with a particular cost unit, process or department. Cost of

raw materials used and wages of machine operator are common

examples of direct costs. To be specific, cost of steel used in

manufacturing a machine can be conveniently ascertained. It is,

therefore, a direct cost. Similarly, wages paid to a tailor in a

readymade garments company for stitching a piece of trouser is a

direct cost because it can be easily identified in the cost of a

trouser.

Indirect cost

These are general costs and are incurred for the benefit of a number

of cost units, processes or departments. These costs cannot be

conveniently identified with a particular cost unit or cost centre.

Depreciation of machinery, insurance, lighting, power, rent,

managerial salaries, materials used in repairs etc are common

examples of indirect cost.

For example, depreciation of machine for stitching a piece of

trouser cannot be known and thus it is an indirect cost.


2) Classification into Fixed and Variable Costs

As on basis of behavior or variability, costs are classified into fixed,

variable and semi-variable.

Fixed cost

These cost remain constant in ‘total’ amount over a wide range of

activity for a specified period of time; i.e. these do not increase or

decrease when the volume of production changes.

For example, building rent, managerial salaries remain constant

and do not change with change in output level and thus are fixed

costs. But fixed cost ‘per unit’ decreases when volume of

production increases and vice versa, fixed cost per unit increases

when volume of production decreases.

Variable cost

These costs tend to vary in direct proportion to the volume of

output. In other words, when volume of output increases, total

variable cost also increases, and vice versa, when volume of output

decreases, total variable cost also decreases. But, the variable cost

per unit remains fixed.


Semi-variable or semi-fixed costs (mixed cost)

These costs include both a fixed and a variable component; i.e,

these are partly variable. A semi-variable cost has often a fixed

element below which it will not fall at any level of output. The

variable element in semi-variable costs changes either at a constant

rate or in lumps.

For example, introduction of an additional shift in the factory will

require additional supervisors and certain costs will increase by

jumps.

3) Classification into Controllable and Non-controllable costs

From the point of view of controllability, costs are classified into

controllable costs and non-controllable costs.

Controllable Costs

These are the costs which may be indirectly regulated at a given

level of management authority. Variable costs are generally

controllable by department heads. For example, cost of raw

material may be controlled by purchasing in larger quantities.

Non-controllable costs

These are those costs which cannot be influenced by the action of a

specified member of an enterprise. For example, it is very difficult

to control costs like factory rent, managerial salaries etc


4) Classification into historical costs and pre-determined costs

On the basis of time of computation, costs are classified into historical

costs and pre-determined costs

Historical costs

These are past costs which are ascertained after these have been

incurred. Historical costs are thus nothing but actual costs. These

costs are not available until after the completion of the

manufacturing operations.

Pre-determined costs

These are future costs which are ascertained in advance of

production on the basis of a specification of all the factors affecting

cost. These costs are extensively used for the purpose of planning

and control.

5) Classification into Normal and Abnormal costs

Normal cost

Normal cost may be defined as cost which is normally incurred on

a expected ones at a given level of output. This cost is a part of cost

of production.


Abnormal cost

Abnormal cost is that which is not normally incurred at a given

level of output. Such cost is over and above the normal cost and is

not treated as a part of the production. It is charged to costing profit

and loss account.

ELEMENTS OF COST

A cost is composed of three elements, it is material, labour and expenses.

Each of these elements may be direct or indirect.

1. Material cost

According to CIMA, UK, material cost is “the cost of commodities

supplied to an undertaking.” Materials may be direct or indirect.


Direct materials

Direct material cost is that which can be conveniently identified

with and allocated to cost units. Direct materials generally become

a part of finished products. For example cotton used in textile mill

is direct material.

Indirect material

These are those material which cannot be conveniently identified

with individual cost units. These are minor importance, such as

Small and relatively inexpensive item which may become a part

of the finished product, example: pins, screws, nuts and bolts,

thread etc

Those items which do not physically become a part of finished

products., example: coal, lubricating oil and grease, sand paper

used in polishing, soap etc

2. Labour cost

This is “the cost of remuneration (wages, salaries, commission, bonus,

etc) of the employees of an undertaking” (CIMA)

Direct labour

Direct labour cost consist of wages paid to workers directly

engaged in converting raw materials into finished products. These


wages can be conveniently identified with a particular product, job

or process. Wages paid to a machine operator is a case of direct

wages.

Indirect labour

It is of general character and cannot be conveniently identified with

a particular cost of units. In other words, indirect labour is not

directly engaged in production operation but only to assist or help

in production operation.

3. Expenses

All cost other than material and labour are termed as expenses. It is

defined as “the cost of service provided to an undertaking and the

national cost of the use of owned assets.” (CIMA)

Direct expenses

According to CIMA, UK, “direct expenses are those expenses

which can be identified with and allocated to cost centres or units.”

These are those expenses which are specifically incurred in

connection with a particular job or cost unit. Direct expenses are

known as chargeable expenses.


Indirect expenses

All direct cost, other than indirect materials and indirect labour

cost, are treated as indirect expenses. These cannot be conveniently

identified with a particular job, process or work order and are

common to cost units or cost centers.

Prime cost

This is the aggregate of direct material cost, direct labour cost

and direct expenses. Thus,

Prime cost = direct material +direct labour +direct expenses

Overhead

This is the aggregate of indirect material cost, indirect labour

cost and indirect expenses. Overhead is also known as on cost.

Thus

Overhead = indirect material + indirect labour + indirect

expenses

Overhead are divided into production overhead, office overhead

and selling overhead as follow:

Production overhead

Also known as factory overhead, works overhead or manufacturing

overhead, these are those overheads which are concerned with the


production function. It includes indirect materials, indirect wages

and indirect expenses in producing goods or services,

Indirect material

Example: coal, oil, grease etc, stationary in factory office,

cotton waste, brush, sweeping broom etc.

Indirect labour

Example: works managers salary, salary of factory, office staff,

salary of inspector and supervisor, wages of factory sweeper,

wages of factory watchman.

Indirect expenses

Example: factory rent, depreciation of plant, repair and

maintenance of plant, insurance of factory building, factory

lighting and power, internal transport expenses.

Office and administration overhead

This is the indirect expenditure incurred in general administrative

function, it is in formulating policies, planning and controlling

functions, directing and motivating the personnel of an

organization in the attainment of its objectives. These overheads

are of general character and have no direct connection with


production or sales activities. This category of overhead is also

classified into

Indirect material

Example: stationary used in general administrative office,

postage, sweeping broom and brush, etc

Indirect labour

Example: salary of office staff, salary of managing director,

remuneration of directors of the company.

Indirect expenses

Example: rent of office building, legal expenses, office lighting

and power, telephone expenses, depreciation of office furniture

and equipments, office air conditioning, sundry office expenses.

Selling and distribution overhead

Selling overhead is the cost of promoting sales and retaining

customers. It is defined as “the cost of seeking to create and

stimulate demand and of securing orders.” Examples are

advertisements, sample and free gifts, salaries and salesman, etc.

Distribution cost includes all expenditure incurred from the time

the product is completed until it reaches its destination. It is

defined as “the cost of sequence of operation which begins with


making the packed product available for dispatch and ends with

making the reconditioned returned empty packages, if any,

available for re-use”. Examples are carriage outwards, insurance of

goods in transit, upkeep of delivery vans, warehousing, etc.

Indirect material

Example: packing material, stationary used in sales office, cost

of samples, price list, catalogues, oil, grease, etc., for delivery

vans etc.

Indirect labour

Example: salary of sales manager, salary of sales office staff,

salary of warehouse staff, salary of drivers of delivery vans etc.

Indirect expenses

Example: advertising, travelling expenses, showroom expenses,

carriage outwards, rent of warehouse, bad debts, insurance of

goods in transit etc.


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term business finance

study of business finance

finance function

term finance

public finance

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