School of Business Management

SCHOOL OF BUSINESS MANAGEMENT

DEPARTMENT OF MANAGEMENT

MBA FM 01

International Financial Management

Unit I

International Finance is an important part of financial economics. It mainly discusses the issues related with monetary interactions of at least two or more countries. International finance is concerned with subjects such as exchange rates of currencies, monetary systems of the world, foreign direct investment (FDI), and other important issues associated with international financial management.

Like international trade and business, international finance exists due to the fact that economic activities of businesses, governments, and organizations get affected by the existence of nations. It is a known fact that countries often borrow and lend from each other. In such trades, many countries use their own currencies. Therefore, we must understand how the currencies compare with each other. Moreover, we should also have a good understanding of how these goods are paid for and what is the determining factor of the prices that the currencies trade at.

Note − The World Bank, the International Finance Corporation (IFC), the International Monetary Fund (IMF), and the National Bureau of Economic Research (NBER) are some of the notable international finance organizations.

International trade is one of the most important factors of growth and prosperity of participating economies. Its importance has got magnified many times due to globalization. Moreover, the resurgence of the US from being the biggest international creditor to become the largest international debtor is an important issue. These issues are a part of international macroeconomics, which is popularly known as international finance.

Importance of International Finance

International finance plays a critical role in international trade and inter-economy exchange of goods and services. It is important for a number of reasons, the most notable ones are listed here:

International finance is an important tool to find the exchange rates, compare inflation rates, get an idea about investing in international debt securities, ascertain the economic status of other countries and judge the foreign markets.
Exchange rates are very important in international finance, as they let us determine the relative values of currencies. International finance helps in calculating these rates.
Various economic factors help in making international investment decisions. Economic factors of economies help in determining whether or not investors’ money is safe with foreign debt securities.
Utilizing IFRS (International Finance Reporting Standards) is an important factor for many stages of international finance. Financial statements made by the countries that have adopted IFRS are similar. It helps many countries to follow similar reporting systems.
IFRS system, which is a part of international finance, also helps in saving money by following the rules of reporting on a single accounting standard.
International finance has grown in stature due to globalization. It helps understand the basics of all international organizations and keeps the balance intact among them.
An international finance system maintains peace among the nations. Without a solid finance measure, all nations would work for their self-interest. International finance helps in keeping that issue at bay.
International finance organizations, such as IMF, the World Bank, etc., provide a mediators’ role in managing international finance disputes.

The very existence of an international financial system means that there are possibilities of international financial crises. This is where the study of international finance becomes very important. To know about the international financial crises, we have to understand the nature of the international financial system.

Without international finance, chances of conflicts and thereby, a resultant mess, is apparent. International finance helps keep international issues in a disciplined state.

Evolution of the International Monetary System can be analyzed in four stages as follows:-

1) Gold Standard, 1876-1913

2) Inter-war Years, 1914-1944

3) Bretton Woods Systems, 1945-1973

4) Flammable exchange Rate Regime since 1973

1) The Gold Standard 1876-1913:- The fundamental principle of the classical gold standard was that each country should set a par value its currency in terms of gold and they try to maintain this value. Thus, each country had to establish the rate at which its currency could be converted to the weight of gold. Also, under the gold standard, the exchange rate between any two currencies was determined by their gold content. Thus, the three important features of the gold standard were, First, the government of each country defines its national monetary unit in terms of gold. Second, free import or export of gold and third two way convertibility between gold and national currencies at a stable rates. These conditions were met during the period 1875-1914.

Each country’s government then agreed to buy or sell gold at its own fixed parity rate on demand. Thus helped to preserve the value of each industrial currency in terms of gold and hence, the fixed partner between currencies. Under this system, it was extremely important for a country to back its currency value by maintaining adequate resources of gold. Because of the rigidity of the system, it was a matter of time before major countries decided to abandon the gold standard, starting with the United Kingdom in 1931 in the midst of a worldwide recession. With a 12% unemployment problem.

2) Inter war years, 1914-1944 The gold standard as an International Monetary System worked well until World War I interrupted trade flows and distorted the stability of exchange rates for currencies of major countries. There was widespread fluctuation in currencies in terms of gold during Word War I and in the early 1920s. As countries began to recover from the war and stabiles their economies, they made several attempts to return to the standard. The United States returned to gold in 1919 and the United Kingdom in 1925. The key currency involved in the attempt to restore the international gold standard was the pound sterling which returned to gold in 1925 at the old mint parity exchange rate of $4.87/ £. From 1934 till the end of World War II, exchange rates were theoretically determined by each currency’s value in terms of gold. World War II also resulted in many of the World’s major currencies closing their convertibility. The only major currency that continued to remain convertible was the dollar.

3) The Bretton Woods System, 1945-1972: The negotiations at Bretton Wood made recommendations in 1944:

- Each nation should be at liberty to use macro-economic policies for full employment.

- A monetary system was needed that would recognize that exchange rates were both a national and an international concern.

The establishment of International Monetary System created two new institutions:- IMF and World Bank. The basic purpose of this new monetary system was to facilitate the expansion of world trade and to use the US dollar as a standard of value. Thus the main points of the post war system evolving from the Bretton Woods conference were:-

- A new institution, IMF would be established in Washington DC.

- The US Dollar would be designated as reserve currencies, and other nations would maintain their foreign exchange reserves principally in the form of dollars or pounds.

- Each fund member would establish a par value for its currency and maintain the exchange rates for its currency within one percent of par value.

- A fund member could change its par value only with fund approval and only if the country’s balance of payments was in fundamental disequilibirium”

This system worked without major changes from 1947 till 1971. the system however suffered from a member of inherent structural problems. There was imbalance in the roles and responsibilities of the surplus and deficits nations.

4) The Flambé exchange Rate Regime, 1973- Present Since 1973, most industrial concerns & many other developing countries allowed their currencies to float with government intervention, whenever necessary, in the foreign exchange market. The alternative exchange rate system which followed are as follows:

- Crawling peg:- A cross between a fixed rate system and a fully flexible system are the semi-fixed systems such as the crawling peg. This differ from fixed rates because of their greater flexibility in terms of the exchange rate movements.

- Flexible (Floating) system:- Under a flexible or floating system, the market force, based on demand and supply determines a currency’s value. A surplus in a country immediate higher prices, mass reserve, and opportunities costs. In addition, too much money on reserve leads to a loss of investment opportunities. On the other hand, a countries deficit will lower its currency value.

In the absence of government intervention, the float is said to be ‘clean’. It becomes ‘dirty’ when there is a control bank intervention to influence exchange rates, which is a common action, especially by those with inflation and trade problems. Critics of floating exchange rates contend that the system causes uncertainty which discourages trade while promoting speculation.

Bretton Woods Conference

The Bretton Woods Conference, formally known as the United Nations Monetary and Financial Conference, was the gathering of 730 delegates from all 44 Allied nations at the Mount Washington Hotel, situated in Bretton Woods, New Hampshire, United States, to regulate the international monetary and financial order after the conclusion of World War II.

The conference was held from July 1–22, 1944. Agreements were signed that, after legislative ratification by member governments, established the International Bank for Reconstruction and Development (IBRD) and the International Monetary Fund (IMF).

Objectives Of The Bretton Woods System

Since the beginning of the 19th century, globalization, international trade and free trade between countries became the new economic order and several attempts have been made since then to develop policies and schemes to ensure the stability of the international monetary system. It is safe to say that in truth, the world economy has never been in a state of utopia, but nevertheless, we have never stopped trying to attain such.

The Bretton Woods era of 1944 to 1977, one of the few fairly successful schemes the world powers created in trying to achieve economic utopia, though existed for a short period, has been accredited as being one of the most successful international monetary systems, so impressive was the economic stability and growth of the era that there have been ongoing talks for a comeback of the system.

In this paper we attempt to shed some light on the defunct Bretton Woods system and the possibility of its comeback. In the first section, we discuss its history, design and objectives. Second section, we discuss the reasons for its demise. Third section, we discuss the reasoning behind the calls for a new Bretton Woods. Fourth section, we discuss the obstacles that could prevent the establishment of a new Bretton Woods and lessons from its past experience. Section five will contain the conclusion and some recommendations.

Bretton Woods system

The Bretton Woods system of monetary management established the rules for commercial and financial relations among the United States, Canada, Western Europe, Australia and Japan in the mid-20th century. The Bretton Woods system was the first example of a fully negotiated monetary order intended to govern monetary relations among independent nation-states. The chief features of the Bretton Woods system were an obligation for each country to adopt a monetary policy that maintained the exchange rate (± 1 percent) by tying its currency to gold and the ability of the IMF to bridge temporary imbalances of payments. Also, there was a need to address the lack of cooperation among other countries and to prevent competitive devaluation of the currencies as well.

Preparing to rebuild the international economic system while World War II was still raging, 730 delegates from all 44 Allied nations gathered at the Mount Washington Hotel in Bretton Woods, New Hampshire, United States, for the United Nations Monetary and Financial Conference, also known as the Bretton Woods Conference. The delegates deliberated during 1–22 July 1944, and signed the Bretton Woods agreement on its final day. Setting up a system of rules, institutions, and procedures to regulate the international monetary system, these accords established the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD), which today is part of the World Bank Group. The United States, which controlled two thirds of the world's gold, insisted that the Bretton Woods system rest on both gold and the US dollar. Soviet representatives attended the conference but later declined to ratify the final agreements, charging that the institutions they had created were "branches of Wall Street."^[1] These organizations became operational in 1945 after a sufficient number of countries had ratified the agreement.

On 15 August 1971, the United States unilaterally terminated convertibility of the US dollar to gold, effectively bringing the Bretton Woods system to an end and rendering the dollar a fiat currency.^[2] This action, referred to as the Nixon shock, created the situation in which the US dollar became a reserve currency used by many states. At the same time, many fixed currencies (such as the pound sterling, for example) also became free-floating.

Why did the Bretton Woods system fail?

Because Bretton Woods put an effective limit on how much money you could borrow, and the United States wanted to spend more money than they could spend under those constraints.

Bretton Woods was, more or less, a modified gold standard. It tied all major currencies to the U.S. dollar, which was effectively tied to the gold reserves in Fort Knox. Although you couldn't buy gold in the United States, other governments were entitled to take U.S. dollars and insist on delivery of gold.

By 1973, the U.S. was hit with a tripple whammy of new social programs (developed by L.B. Johnson) the Vietnam War (which continued to be escalated by Nixon) and rising oil prices. The U.S. was effectively putting more currency in circulation by selling T-Bills and printing cash.

France became worried about their U.S. $ currency reserves, feeling that the U.S. couldn't continue to spend and borrow at their current rate and guarantee delivery of gold. As such, they started to make noises that they were going to insist on gold delivery. This posed a big problem - there was a little more U.S. currency in circulation than their was gold to back it up.

Had the French not continued to insist that the Americans back up all of their currency (a "loose money" model) then Bretton Woods could have continued? However, had the French made good on their threat, it could have caused a run on the gold reserves, eventually leading to a reduction of currency in circulation when the U.S. needed more of it.

So the Americans simply announced that their currency would float against other currencies instead of being fixed. They then announced that gold could be traded freely again. That allowed the Americans to borrow as much money as they wanted without constraint.

The current Euro crisis is similar - being on the Euro restricts how much money you can borrow. Being on the Drachma doesn't. However, in the Euro's case, the Eurozone decided not to confront Greece over their spending and allowed them to re-finance their debt.

What Is the Role of the IMF and the World Bank?

The fall of the gold standard led countries to raise trade barriers, devalue their currencies to compete against one another for export markets and curtail usage of foreign exchange by their citizens. All these factors led to declining world trade, high unemployment, and plummeting living standards in many countries. In 1944, the Bretton Woods Agreement established a new international monetary system. The creation of the International Monetary Fund (IMF) and the World Bank were two of its most enduring legacies.

The World Bank and the IMF, often called the Bretton Woods Institutions, are twin intergovernmental pillars supporting the structure of the world’s economic and financial order. Both have taken on expanding roles, and there have been renewed calls for additional expansion of their responsibilities, particularly in the continuing absence of a single global monetary agreement. The two institutions may seem to have confusing or overlapping functions. However, while some similarities exist (see the following figure), they are two distinct organizations with different roles.

“Despite these and other similarities, however, the Bank and the IMF remain distinct. The fundamental difference is this: the Bank is primarily a development institution; the IMF is a cooperative institution that seeks to maintain an orderly system of payments and receipts between nations. Each has a different purpose, a distinct structure, receives its funding from different sources, assists different categories of members, and strives to achieve distinct goals through methods peculiar to itself.”

International Monetary Fund

History and Purpose

The architects of the Bretton Woods Agreement, John Maynard Keynes and Harry Dexter White, envisioned an institution that would oversee the international monetary system, exchange rates, and international payments to enable countries and their citizens to buy goods and services from each other. They expected that this new global entity would ensure exchange rate stability and encourage its member countries to eliminate the exchange restrictions that hindered trade. Officially, the IMF came into existence in December 1945 with twenty-nine member countries. (The Soviets, who were at Bretton Woods, refused to join the IMF.)

In 1947, the institution’s first formal year of operations, the French became the first nation to borrow from the IMF. Over the next thirty years, more countries joined the IMF, including some African countries in the 1960s. The Soviet bloc nations remained the exception and were not part of the IMF until the fall of the Berlin Wall in 1989. The IMF experienced another large increase in members in the 1990s with the addition of Russia; Russia was also placed on the IMF’s executive committee. Today, 187 countries are members of the IMF; twenty-four of those countries or groups of countries are represented on the executive board.

The purposes of the International Monetary Fund are as follows:

To promote international monetary cooperation through a permanent institution which provides the machinery for consultation and collaboration on international monetary problems.
To facilitate the expansion and balanced growth of international trade, and to contribute thereby to the promotion and maintenance of high levels of employment and real income and to the development of the productive resources of all members as primary objectives of economic policy.
To promote exchange stability, to maintain orderly exchange arrangements among members, and to avoid competitive exchange depreciation.
To assist in the establishment of a multilateral system of payments in respect of current transactions between members and in the elimination of foreign exchange restrictions which hamper the growth of world trade.
To give confidence to members by making the general resources of the Fund temporarily available to them under adequate safeguards, thus providing them with opportunity to correct maladjustments in their balance of payments without resorting to measures destructive of national or international prosperity.
In accordance with the above, to shorten the duration and lessen the degree of disequilibrium in the international balances of payments of members.

In addition to financial assistance, the IMF also provides member countries with technical assistance to create and implement effective policies, particularly economic, monetary, and banking policy and regulations.

The IMF’s Current Role and Major Challenges and Opportunities

Criticism and Challenging Areas for the IMF

The IMF supports many developing nations by helping them overcome monetary challenges and to maintain a stable international financial system. Despite this clearly defined purpose, the execution of its work can be very complicated and can have wide repercussions for the recipient nations. As a result, the IMF has both its critics and its supporters. The challenges for organizations like the the IMF and the World Bank center not only on some of their operating deficiencies but also on the global political environment in which they operate. The IMF has been subject to a range of criticisms that are generally focused on the conditions of its loans, its lack of accountability, and its willingness to lend to countries with bad human rights records.David N. Balaam and Michael Veseth, Introduction to International Political Economy, 4th ed. (Upper Saddle River, NJ: Pearson Education International/Prentice Hall), 2005.

These criticisms include the following:

Conditions for loans. The IMF makes the loan given to countries conditional on the implementation of certain economic policies, which typically include the following:

Reducing government borrowing (higher taxes and lower spending)
Higher interest rates to stabilize the currency
Allowing failing firms to go bankrupt
Structural adjustment (privatization, deregulation, reducing corruption and bureaucracy)

2. Exchange rate reforms. “When the IMF intervened in Kenya in the 1990s, they made the Central bank remove controls over flows of capital. The consensus was that this decision made it easier for corrupt politicians to transfer money out of the economy (known as the Goldman scandal). Critics argue this is another example of how the IMF failed to understand the dynamics of the country that they were dealing with—insisting on blanket reforms.

3. Devaluations. In the initial stages, the IMF has been criticized for allowing inflationary devaluations.

4. Free-market criticisms of the IMF. “Believers in free markets argue that it is better to let capital markets operate without attempts at intervention. They argue attempts to influence exchange rates only make things worse—it is better to allow currencies to reach their market level. They also assert that bailing out countries with large debts is morally hazardous; countries that know that there is always a bailout provision will borrow and spend more recklessly.

5. Lack of transparency and involvement. The IMF has been criticized for “imposing policy with little or no consultation with affected countries.

6. Supporting military dictatorships. The IMF has been criticized over the decades for supporting military dictatorships.

Opportunities and Future Outlook for the IMF

The 2008 global economic crisis is one of the toughest situations that the IMF has had to contend with since the Great Depression.

For most of the first decade of the twenty-first century, global trade and finance fueled a global expansion that enabled many countries to repay any money they had borrowed from the IMF and other official creditors. These countries also used surpluses in trade to accumulate foreign exchange reserves. The global economic crisis that began with the 2007 collapse of mortgage lending in the United States and spread around the world in 2008 was preceded by large imbalances in global capital flows. Global capital flows fluctuated between 2 and 6 percent of world GDP between 1980 and 1995, but since then they have risen to 15 percent of GDP. The most rapid increase has been experienced by advanced economies, but emerging markets and developing countries have also become more financially integrated.

The founders of the Bretton Woods system had taken for granted that private capital flows would never again resume the prominent role they had in the nineteenth and early twentieth centuries, and the IMF had traditionally lent to members facing current account difficulties. The 2008 global crisis uncovered fragility in the advanced financial markets that soon led to the worst global downturn since the Great Depression. Suddenly, the IMF was inundated with requests for standby arrangements and other forms of financial and policy support.

The international community recognized that the IMF’s financial resources were as important as ever and were likely to be stretched thin before the crisis was over. With broad support from creditor countries, the IMF’s lending capacity tripled to around $750 billion. To use those funds effectively, the IMF overhauled its lending policies. It created a flexible credit line for countries with strong economic fundamentals and a track record of successful policy implementation. Other reforms targeted low-income countries. These factors enabled the IMF to disburse very large sums quickly; the disbursements were based on the needs of borrowing countries and were not as tightly constrained by quotas as in the past.

The IMF has sought to correct some of the criticisms; according to a Foreign Policy in Focus essay designed to stimulate dialogue on the IMF, the fund’s strengths and opportunities include the following:

1. Flexibility and speed. “In March 2009, the IMF created the Flexible Credit Line (FCL), which is a fast-disbursing loan facility with low conditionality aimed at reassuring investors by injecting liquidity…Traditionally, IMF loan programs require the imposition of austerity measures such as raising interest rates that can reduce foreign investment…In the case of the FCL, countries qualify for it not on the basis of their promises, but on the basis of their history. Just as individual borrowers with good credit histories are eligible for loans at lower interest rates than their risky counterparts, similarly, countries with sound macroeconomic fundamentals are eligible for drawings under the FCL. A similar program has been proposed for low-income countries. Known as the Rapid Credit Facility, it is front-loaded (allowing for a single, up-front payout as with the FCL) and is also intended to have low conditionality.

2. Cheerleading. “The Fund is positioning itself to be less of an adversary and more of a cheerleader to member countries. For some countries that need loans more for reassurance than reform, these changes to the Fund toolkit are welcome.

3. Adaptability. “Instead of providing the same medicine to all countries regardless of their particular problems, the new loan facilities are intended to aid reform-minded governments by providing short-term resources to reassure investors. In this manner, they help politicians in developing countries manage the downside costs of integration.”

4. Transparency. The IMF has made efforts to improve its own transparency and continues to encourage its member countries to do so. Supporters note that this creates a barrier to any one or more countries that have more geopolitical influence in the organization. In reality, the major economies continue to exert influence on policy and implementation.

To underscore the global expectations for the IMF’s role, China, Russia, and other global economies have renewed calls for the G20 to replace the US dollar as the international reserve currency with a new global system controlled by the IMF.

The World Bank and the World Bank Group

History and Purpose

The World Bank came into existence in 1944 at the Bretton Woods conference. Its formal name is the International Bank for Reconstruction and Development (IBRD), which clearly states its primary purpose of financing economic development. The World Bank’s first loans were extended during the late 1940s to finance the reconstruction of the war-ravaged economies of Western Europe. When these nations recovered some measure of economic self-sufficiency, the World Bank turned its attention to assisting the world’s poorer nations. The World Bank has one central purpose: to promote economic and social progress in developing countries by helping raise productivity so that their people may live a better and fuller life.

The Bank is currently involved in more than 1,800 projects in virtually every sector and developing country. The projects are as diverse as providing microcredit in Bosnia and Herzegovina, raising AIDS-prevention awareness in Guinea, supporting education of girls in Bangladesh, improving health care delivery in Mexico, and helping East Timor rebuild upon independence and India rebuild Gujarat after a devastating earthquake.

Today, The World Bank consists of two main bodies, the International Bank for Reconstruction and Development (IBRD) and the International Development Association (IDA), established in 1960. The World Bank is part of the broader World Bank Group, which consists of five interrelated institutions: the IBRD; the IDA; the International Finance Corporation (IFC), which was established in 1956; the Multilateral Investment Guarantee Agency (MIGA), which was established in 1988; and the International Centre for Settlement of Investment Disputes (ICSID), which was established in 1966. These additional members of the World Bank Group have specific purposes as well. The IDA typically provides interest-free loans to countries with sovereign guarantees. The IFC provides loans, equity, risk-management tools, and structured finance. Its goal is to facilitate sustainable development by improving investments in the private sector. The MIGA focuses on improving the foreign direct investment of developing countries. The ICSID provides a means for dispute resolution between governments and private investors with the end goal of enhancing the flow of capital.

The current primary focus of the World Bank centers on six strategic themes:

The poorest countries. Poverty reduction and sustainable growth in the poorest countries, especially in Africa.
Postconflict and fragile states. Solutions to the special challenges of postconflict countries and fragile states.
Middle-income countries. Development solutions with customized services as well as financing for middle-income countries.
Global public goods. Addressing regional and global issues that cross national borders, such as climate change, infectious diseases, and trade.
The Arab world. Greater development and opportunity in the Arab world.
Knowledge and learning. Leveraging the best global knowledge to support development.

The World Bank provides low-interest loans, interest-free credits, and grants to developing countries. There’s always a government (or “sovereign”) guarantee of repayment subject to general conditions. The World Bank is directed to make loans for projects but never to fund a trade deficit. These loans must have a reasonable likelihood of being repaid. The IDA was created to offer an alternative loan option. IDA loans are free of interest and offered for several decades, with a ten-year grace period before the country receiving the loan needs to begin repayment. These loans are often called soft loans.

Key Differences Between IMF and World Bank

The following are the major differences between IMF and World Bank:

The International Monetary Fund is a controller of the world’s monetary system. World Bank is a global financial institution.
The IMF focuses on bringing economic stability, whereas the World Bank laid emphasis on economic growth of the developing nations.
The size of the World Bank is more than three times larger than the size of the International Monetary Fund.
The International Monetary Organization is a unitary organization while the World Bank is bilateral organization.
At present, there are 188 member countries of the IMF, but if we talk about world bank, it has 188 member countries of IBRD and 172 member countries of IDA.
International Monetary Fund came into existence to provide advice and assistance. Conversely, the World Bank is created to facilitate lending.
The major objective of the IMF is to deal with matters related to the financial sector and macroeconomics. On the other hand, the purpose of the World Bank is to reduce poverty and to promote economic development.

European Monetary System

European Monetary System (EMS) was an arrangement established in 1979 under the Jenkins European Commission where most nations of the European Economic Community (EEC) linked their currencies to prevent large fluctuations relative to one another.

After the demise of the Bretton Woods system in 1971, most of the EEC countries agreed in 1972 to maintain stable exchange rates by preventing exchange rate fluctuations of more than 2.25% (the European "currency snake"). In March 1979, this system was replaced by the European Monetary System, and the European Currency Unit (ECU) was defined.

The basic elements of the arrangement were:

The ECU: With this arrangement, member currencies agreed to keep their foreign exchange rates within agreed bands with a narrow band of +/− 2.25% and a wide band of +/− 6%.
An Exchange Rate Mechanism (ERM)
An extension of European credit facilities.
The European Monetary Cooperation Fund: created in October 1972 and allocates ECUs to members' central banks in exchange for gold and US dollar deposits.

Although no currency was designated as an anchor, the Deutsche Mark and German Bundesbank soon emerged as the centre of the EMS. Because of its relative strength, and the low-inflation policies of the bank, all other currencies were forced to follow its lead if they wanted to stay inside the system. Eventually, this situation led to dissatisfaction in most countries, and was one of the primary forces behind the drive to a monetary union (ultimately the euro).

Periodic adjustments raised the values of strong currencies and lowered those of weaker ones, but after 1986 changes in national interest rates were used to keep the currencies within a narrow range. In the early 1990s the European Monetary System was strained by the differing economic policies and conditions of its members, especially the newly reunified Germany, and Britain (which had initially declined to join and only did so in 1990) permanently withdrew from the system in September 1992. Speculative attacks on the French Franc during the following year led to the so-called Brussels Compromise in August 1993 which established a new fluctuation band of +15%.

The European Monetary System was no longer a functional arrangement in May 1998 as the member countries fixed their mutual exchange rates when participating in the euro. Its successor however, the ERM-II, was launched on 1 January 1999. In ERM-II the ECU basket was discarded and the new single currency euro has become an anchor for the other currencies participating in the ERM-II. Participation in the ERM-II is voluntary and the fluctuation bands remain the same as in the original ERM, i.e. +15 percent, once again with the possibility of individually setting a narrower band with respect to the euro. Denmark andGreece became new members.

Arbitrage” in Foreign Exchange Market

Arbitrage is the process of a simultaneous sale and purchase of currencies in two or more foreign exchange markets with an objective to make profits by capitalizing on the exchange-rate differentials in various markets.

The arbitrage opportunities exist due to the inefficiencies of the market. While dealing in the arbitrage trade, an individual can make profits only out of price differences of similar or identical financial instruments traded on different exchange markets. Thus, the price differential is captured as a trade’s net payoff. This payoff should be large enough to cover the expenses incurred in executing the trade.

For example: Suppose the stock of company A is trading at Rs 2000 on BSE while the same stock is trading on NSE at Rs 2500. A trader can earn a profit of Rs 500 by buying the stock on BSE and immediately selling the same shares on NSE. This arbitrage opportunity can be availed until BSE runs out of shares of company A or until BSE and NSE adjusts the price differences so as to wipe out the arbitraging opportunity.

The importance of arbitrage lies in its ability to correspond foreign exchange rates in all the major foreign exchange markets. The arbitraging involves the transfer of foreign exchange from the market with a lower exchange rate to the market with a higher exchange rate. Hence, arbitraging equates the demand for foreign exchange with its supply, thereby acting as a stabilizing factor in the exchange markets.

The arbitrage opportunity can be availed only where the foreign exchange is free from controls, and if any, controls should be of limited significance. If the sale and purchase of foreign exchange are under severe control and regulation, then the arbitrage is not possible. Practically, the arbitrage opportunity exists for a very brief period since in the mature markets the most of the trading has been taken by the algorithm-based trading (a trading system that relies heavily on mathematical formulas and computer programs to determine the trading strategies). These algorithm-based trading are quick to spot and is quite easy for a trader to keep track.

MARKET VOLATILITY OFFERS OPPORTUNITIES FOR ARBITRAGE HUNTERS

Increased volatility in global markets, triggered by lack of consensus on stock valuations, has led to big arbitrage opportunities between the depository receipts of Indian companies listed in foreign markets and their stocks traded on domestic bourses.

A study by Instanex Capital Consultants Ltd, a Mumbai-based specialist on research and trade in depository receipts of Indian companies, indicates that 41 of the 162 dual-listed stocks tracked by the firm offer an average arbitrage—the difference between the prices of the same stock on different exchanges—profit of up to 6%.

“In any volatile market, where trading decisions are faster, speculation is greater, and investors lack rationality, arbitrage opportunities witness a natural rise,” said Gautam Chand, chief executive officer of Instanex.

Depository receipts of many large Indian companies are listed in the US and Europe. Based on where they are listed, the receipts are known as ADRs (American depository receipts) or GDRs (global depository receipts).

According to the report, investors in 29 firms whose depository receipts are cheaper than local shares can have an average return of 1.9% if they buy the depository receipts and sell the shares in India.

Bajaj Hindustan Ltd offers the highest advantage. Buying its GDRs on the Luxembourg Stock Exchange and selling on the Bombay Stock Exchange would fetch returns of 5.43%.

In the reverse case, when the local share is trading lower than its depositary receipt, 12 stocks offer an average return of 1.73% after transaction charges. Tata Motors Ltd’s New York Stock Exchange-listed depository receipts offer the biggest advantage, providing a 4.6% profit opportunity after expenses.

Contrary to recent perception, it is not true that arbitrage opportunities in depository receipts are dropping, insists Shweta Rai, an analyst at Instanex who prepared the report on increased arbitrage opportunities.

Instanex Capital, established in 1993, operates from Mumbai and New York. It is a special situations investment sub-manager to many international funds. The company also runs the Instanex Skindia DR Index, which tracks GDR, ADR prices.

Among liquid GDRs and ADRs in the Skindia DR Index, the highest premium is on Satyam Computer Services Ltd, which offers 18% over the local share prices.

However, the quantum of shares listed by Satyam in foreign markets is relatively low. Therefore, Satyam ADRs always enjoyed a demand-driven premium, said a portfolio fund manager, who did not want to be named.

Tata Communications Ltd’s ADRs, trading at a 4.9% discount to the company’s local share price, as well as Infosys Technologies Ltd’s ADRs at a 5.8% premium and Mahindra and Mahindra Ltd’s GDRs at a 3.75% premium offer attractive arbitrage opportunities for investors with access to depository receipts.

Market Integration

Market integration is a term that is used to identify a phenomenon in which markets of goods and services that are somehow related to one another being to experience similar patterns of increase or decrease in terms of the prices of those products. The term can also refer to a situation in which the prices of related goods and services sold in a defined geographical location also begin to move in some sort of similar pattern to one another. At times, the integration may be intentional, with a government implementing certain strategies as a way to control the direction of the economy. At other times, the integrating of the markets may be due to factor such as shifts in supply and demand that have a spillover effect on several markets.

When market integration exists, the events occurring within two or more markets are exerting effects that also prompt similar changes or shifts in other markets that focus on related goods. For example, if the demand for baby dolls within a given geographical market were to suddenly be reduced by 50%, there is a good chance that the demand for baby doll clothing would also decrease in proportion within that same geographical market. Should the baby market increase, this would usually mean that the market for doll clothing would also increase. Both markets would have the chance to adjust pricing in order to deal with the new circumstances surrounding the demand, as well as adjust other factors, such as production.

Market integration may occur with just about any type of related markets. With a stock market integration, similar trends in trading prices for assets related to a given industry may be found in two or more markets around the world. In like manner, financial market integration may occur when lending rates in several different markets begin to move in tandem with one another. In some cases, the integration within a nation may involve the emergence of similar patterns within the capital, stock, and financial markets, with those trends coming together to exert a profound influence on the economy of that nation.

Market integration can often be a very positive situation, especially if the emerging pattern regarding pricing is indicative of an increasingly prosperous economy. At the same time, assessing integration between markets can also be a useful tool in identifying trends that are less than desirable, and having the chance to begin reversing those trends while there is still time. For this reason, financial analysts as well as economists will often monitor activity in related markets, identify any signs of integration and make recommendations on what strategies could be used to make the most of the emerging situation.

Financial Intermediaries - Meaning, Role and Its Importance

A financial intermediary is a firm or an institution that acts an intermediary between a provider of service and the consumer. It is the institution or individual that is in between two or more parties in a financial context. In theoretical terms, a financial intermediary channels savings into investments. Financial intermediaries exist for profit in the financial system and sometimes there is a need to regulate the activities of the same. Also, recent trends suggest that financial intermediaries role in savings and investment functions can be used for an efficient market system or like the sub-prime crisis shows, they can be a cause for concern as well.

Financial Intermediation

Financial intermediaries work in the savings/investment cycle of an economy by serving as conduits to finance between the borrowers and the lenders. In the financial system, intermediaries like banks and insurance companies have a huge role to play given that it has been estimated that a major proportion of every dollar financed externally has been done by the banks. Financial intermediaries are an important source of external funding for corporates. Unlike the capital markets where investors contract directly with the corporates creating marketable securities, financial intermediaries borrow from lenders or consumers and lend to the companies that need investment.

Role of the Financial Intermediaries

1. Self-employment programme: Employment growth is a sign of economic development. Financial Intermediaries, by providing finance for starting self-employment programmes are generating more production and income in the country. In India, after the nationalization of commercial banks, a number of programmes have been initiated by banks for self-employment schemes.

2. Entrepreneurial Development Programmes (EDPs): have been successfully launched by various banks. Initially through Lead Bank Scheme, banks were developing employment opportunities at the district level. Later on, Service Area Approach was adopted in 1978 by which certain specific areas were allotted to the banks for launching different economic programmes for the development of such areas.

3. Integrated Rural development scheme: Under this scheme, financial intermediaries were financing socially and economically depressed people by providing loans to them for various economic activities. One third of the loan will be a subsidy and the remaining two-thirds of the loan will carry a lower rate of interest under the interest subsidy scheme of RBI. In this way, various economic programmes aimed at improving rural economic conditions were undertaken.

4. Housing Finance: As a part of improving dwelling houses, financial intermediaries are providing housing loans. They are also providing refinancing facility to agencies such as HUDCO (Housing and Urban Development Corporation). This has enabled many fixed income group people to avail the housing loan. Normally, to a borrower under this facility, a bank provides 3-year aggregate net income as a maximum amount or the cost of the house, whichever is less.

5. Priority Sector: As per RBI guidelines, commercial banks have to provide certain percentage of their lending to priority sector which consists of agriculture and its allied activities, such as poultry, dairy, etc, cottage industries, small scale industries, small industry and business.

6. Backward area Development: In order to prevent regional disparities, financial intermediaries have been advancing loans to industries which are started in backward areas. Government has given certain concessions in the form of tax benefits to such industries and banks provide cheap loans so that the backward areas could attract more industries.

7. Introduction of Electronic system: Computer is being used by financial intermediaries for most of their activities now and they are able to link their branches through a network. This has resulted in quicker transfer of funds between centres and this has helped customers in realizing their cheques in a speedy manner. It is for this purpose, that Magnetic Ink Character Recognition (MICR) cheques have been introduced. The customer can also make use of Home banking facility by linking their computer system with the bank and instructions can be provided for transfer of funds. This facility, if developed throughout the country, will not only help in the movement of funds but also reduce the disparity in the interest rate.

Unit II

Materials Management: Objectives, Scope and Functions

Materials management is concerned with management functions supporting the complete cycle of material flow, from the purchase and internal control of production materials to planning and control of work in process, to warehousing, shipping and distribution of the finished product. An effective materials management process ensures that the right kinds of materials are at the right place whenever needed.

Materials management is concerned with planning, directing and controlling the kind, amount, location, movement and timing of various flows of materials used in and produced by the process.

Objectives of Materials Management:

Materials management objectives are categorized into:

1. Primary objective

2. Secondary objectives

1. Primary Objectives:

“Making available (supply) of materials in specified quantity and quality at economic cost and maintaining the continuity of supply. Minimization of investments in materials and inventory costs, and assuring high inventory turnover.”

2. Secondary Objectives:

Secondary objectives help to achieve the primary objectives.

The secondary objectives can be stated as:

1. Purchasing the items from a reliable source at economic price.

2. Reduction of costs by using various cost reduction techniques such as variety reduction, standardization and simplification, value analysis, inventory control, purchase research etc.

3. Co-ordination of the functions such as planning, scheduling, storage and maintenance of materials.

Scope of Materials Management:

Materials management encompasses all the aspects of the materials i.e. material costs, material supply and material utilization. Materials management is concerned with material planning and materials control activities.

Integrated Materials Management:

Materials required for production purpose are normally procured and stored in the plant and issued to manufacturing when there is a requisition. Materials are to be purchased in advance and stored to ensure uninterrupted supply.

There should be a proper co-ordination and co-operation among different functional heads of materials department to optimise the operations of materials management. The materials function to be effective, the objective must be to maximise materials productivity. An integrated approach to materials management i.e. materials planning and control must look in to the problem areas in a co- coordinated manner in order to maximise the effectiveness of materials management.

An integrated materials management will result in the following advantages:

a. Better accountability for materials and material concerned costs.

b. Better co-ordination within the materials functions and also other functional areas of business.

c. Better performance and effectiveness.

d. Adaptability to automated and computerised systems.

The important areas to improve materials planning and control are:

1. Value analysis and purchase price analysis.

2. Materials planning and control (Inventory Control).

3. Stores control.

4. Waste management.

5. Materials handling.

Irrespective of the type of the organisation, the basic material related functions performed at the organisation are:

1. Purchasing

2. Inbound traffic from suppliers to company

3. Receiving

4. Inventory Control

5. Production control

6. In plant storage

7. Material handling

8. Packaging and shipping

9. Outbound traffic

10. Warehousing and distribution.

Purchasing:

Purchasing plays a crucial role in the materials management because it is concerned from input stage up to the consumption in manufacturing. Purchasing functions as a monitor, clearing house and a pipeline to supply materials needed for production.

Dr. Walters defines scientific purchasing as:

“Procurement by purchase of the proper materials, machinery and equipment and supplies of stores used in manufacturing of the product, adopted to marketing in the proper quantity and quality at the proper time and at the lowest price consistent with quality desired.”

The basic elements in purchasing are:

1. The origin of demand for materials and components based upon the requisitions made to purchase department by user departments with all the details like descriptions, quantity and quality specifications.

2. Specifications are checked and verified and purchase plan is made for items demanded

3. Selection of source of supply.

4. Preparation of purchase order by supplier (order acceptance) and acceptance of terms and conditions.

5. Follow up to ensure prompt delivery of right quality and quantity of materials.

6. Incoming inspection of materials (both to check quality and quantity) to ensure correct material as per specification.

7. Checking supply invoice against purchase order and goods received and payments are made.

Methods of Buying:

Methods of purchasing will vary according to the nature of demand and the market conditions.

The principle methods of buying are:

1. Purchasing by requirement (Hand to mouth buying).

2. Purchasing for a specified future period.

3. Market purchasing.

4. Speculative buying.

5. Contract buying.

6. Group purchasing of small items.

7. Forward buying.

8. Hedging.

Source Selection (Vendor Selection):

The selection of right source of supply is an important aspect in materials management. The vendor is to be examined with respect to his capability and competency to supply right quality of material at right time and at a competitive price.

The buyer looks for the following details before a decision regarding vendor selection is made:

1. Production Capabilities:

(a) Capacity to manufacture the products as per the specifications and required quantities.

(b) Availability of spare capacity.

2. Financial Position of the Vendor:

(d) The type of the company – Private limited, Partnership or Sole proprietorship.

(e) Company’s capital structure.

(f) Financial position and profitability of the company since last 3-4 years.

3. Technical Capabilities:

(g) Whether the available plant and equipment’s ere in a position to meet the quality and quantity specifications of the customer.

(h) Whether there are enough technically skilled and trained people.

(i) Whether R&D facilities are available.

(j) What is the market standing of the vendor with respect to quality and delivery commitments (Reliability of supply).

(k) Whether he has enough storing and warehousing facilities.

(l) Quality control procedures – whether an ISO-9000 certified supplier.

4. Other Conditions:

(m) Working conditions in the vendor company.

(n) Industrial relations and bargaining power of unions.

(o) Possible reasons for interruptions in supply.

Vendor Relations:

Purchase department should establish a sound relationship with vendors based on mutual trust and benefit to ensure smooth supply of materials/parts as per the quality and quantity required. So, apart from a formal commercial relationship as a customer, a long lasting and mutually rewarding relationship is to be established.

A strategic partnership between the buyer and supplier is defined as a continuing relationship involving a commitment over an extended time period, an exchange of information and acknowledgment of risks and rewards of the partnership. A sound relationship emerges from the proper help and co-ordination on the part of both buyer and supplier.

The expectations from buyers include:

a. Promptness in delivery.

b. Meets the quality and quantity requirements.

c. Entertains occasional rush orders.

d. Flexibility in quantity to be supplied.

e. Can wait for the bills.

f. Competitive pricing.

The expectations from the vendors:

a. Consistent orders

b. Prompt payment of the bills.

c. Extend help during difficulty both financial and technical.

d. Continuity of orders.

Vendor Rating (Evaluation of Suppliers):

The appraisal of the vendor performance is a continues process.

The vendor can be rated on various characteristics such as:

1. Delivery (To deliver as on time as per the order).

2. Quality (To delivery as per specifications).

3. Price.

4. Other factors such as capability to meet urgent/rush orders readiness to try out new designs or new methods etc.

In vendor rating, one usually gives weightage to these various characteristics and measures the performance of the vendors periodically on the basis of certain norms and procedures. Every company should have a formal vendor rating system. It is not only beneficial to the buyer company but also for the supplier company. Vendors will get the feed-back based on objective evaluation and can compare its own performance with that of competitors. It is a fair evaluation since the rating is based on facts and not on opinions or prejudices. Vendor Company’s can know their shortcomings and improve upon them.

Generally, there are three methods of vendor rating:

1. Categorical plan

2 Weighted point method

3. Cost ratio method.

Just In Time (JIT) Purchasing:

Just in time purchasing is a major component of JIT manufacturing system. The basic concept of JIT purchasing is to establish agreement with vendors to deliver small quantities of materials/parts just in time for production. This approach is quite contrast to traditional approach of bulk buying.

The features of JIT purchasing are:

a. Reduced lot sizes

b. Frequent and. reliable delivery schedules.

c. Reduced and highly reliable lead times.

d. High quality level of purchased parts.

The JIT purchasing aims at a single reliable source for each item and consolidation of several items from each supplier.

The reduction of number of suppliers in JIT purchasing has the following advantages:

1. Consistent quality

2. Minimum investment and resources such as buyer’s time, travel and engineering

3. Focused attention on vendors

4. Savings on tooling

5. Establishment of long-term relationship.

For making JIT work, the following conditions are put on purchasing department:

1. Reduction in number of suppliers.

2. Locating the suppliers who are nearby.

The success of JIT purchasing depends on how well the firm establishes the strategy of single sourcing. The suppliers should be seen as “Outside” partners who can contribute to the long run well fare buying firm.

Pricing of Issues of Materials

1. First in First out (Commonly Called FIFO):

Under this method material is first issued from the earliest consignment on hand and priced at the cost at which that consignment was placed in the stores. In other words, materials received first are issued first.

The units in the open ling stock of materials are treated as if they are issued first, the units from the first purchase issued next, and so on until the units left in the closing stock of materials are valued at the latest cost of purchases. It follows that unit costs are apportioned to cost of production according to their chronological order of receipts in the store.

This method is most suitable in times of falling prices because the issue price of materials to jobs or works orders will be high (materials issued from the earliest consignments which were purchased at a higher rate) while the cost of replacement of materials will be low.

But in case of rising prices this method is not suitable because the issue price of materials to production will be low while the cost of replacement of materials will be high.

Advantages of FIFO Method:

1. The main advantage of FIFO method is that it is simple to understand and easy to operate.

2. It is a logical method because it takes into consideration the normal procedure of utilising first those materials which are received first. Materials are issued in order of purchases, so materials received first are utilised first.

3. Under this method, materials are issued at the purchase price; so the cost of jobs or work orders is correctly ascertained so far as cost of materials is concerned. Thus, the method recovers the cost price of the materials.

4. This method is useful when prices are falling.

5. Closing stock of materials will be valued at the market price as the closing stock under this method would consist of recent purchase of materials.

6. This method is also useful when transactions are not too many and prices of materials are fairly steady.

Disadvantages of FIFO Method:

1. This method increases the possibility of clerical errors, if consignments are received frequently at fluctuating prices as every time an issue of materials is made, the store ledger clerk will have to go through his record to ascertain the price to be charged.

2. In case of fluctuations in prices of materials, comparison between one job and the other job becomes difficult because one job started a few minutes later than another of the same nature may be issued materials at different prices, merely because the earlier job exhausted the supply of the lower priced materials in stock.

3. For pricing one requisition more than one price has often to be taken.

4. When prices rise, the issue price does not reflect the market price as materials are issued from the earliest consignments. Therefore, the charge to production is low because the cost of replacing the material consumed will be higher than the price of issue.

2. Last In First Out (Commonly Called LIFO) Method:

As against the First in First Out method the issues under this method are priced in the reverse order of purchase i.e., the price of the latest available consignment is taken. This method is sometimes known as the replacement cost method because materials are issued at the current cost to jobs or work orders except when purchases were made long ago.

This method is suitable in times of rising prices because material will be issued from the latest consignment at a price which is closely related to the current price levels. Valuing material issues at the price of the latest available consignment will help the management in fixing the competitive selling prices of the products. This method was first introduced in the U.S.A. during the Second World War to get the advantages of rising prices.

Advantages of LIFO Method:

1. Like FIFO method, this is simple to operate and is useful when transactions are not too many and the prices are fairly steady.

2. Like FIFO, this method recovers cost from production because actual cost of material is charged to production.

3. Production is charged at the recent prices because materials are issued from the latest consignment. Thus, effect of current market prices of materials is reflected in the cost of sales provided the materials are recently purchased.

4. In times of rising prices, LIFO method of pricing issues is suitable because materials are issued at the current market prices which are high. This method thus helps in showing a lower profit because of increased charge to production during periods of rising prices and lower profit reduces burden of income-tax.

Disadvantages of LIFO Method:

1. Like FIFO, this method may lead to clerical errors as every time an issue is made, the store ledger clerk will have to go through the record to ascertain the price to be charged.

2. Like FIFO, comparison between one job and the other job will become difficult because one job started a few minutes after another of the same type many bear a different charge for materials consumed, merely because the earlier job exhausted the supply of the lower priced or higher priced materials in stock.

3. For pricing a single requisition, more than one price has often to be adopted.

4. The stock in hand is valued at price which does not reflect current market price. Consequently, closing stock will be understated or overstated in the Balance Sheet.

3. Average Cost Method:

The principle on which the average cost method is based is that all of the materials in store are so mixed up that an issue cannot be made from any particular lot of purchases and, therefore, it is roper if the materials are issued at the average cost of materials in store.

Average may be of two types:

(i) Simple Arithmetic Average and

(ii) Weighted Arithmetic Average.

(i) Simple Average Price:

“A price which is calculated by dividing the total of the prices of the materials in the stock from which the material to be priced could be drawn by the number of the prices used in that total”. (C.I.M.A.)

Simple average price is calculated by dividing the total of unit purchase prices of different lots in stock on the date of issue by the number of prices used in the calculation and quantity of different lots is ignored.

This method may lead to over-recovery or under-recovery of cost of materials from production because quantity purchased in each lot is ignored.

(ii) Weighted Average Price:

“A price which is calculated by dividing the total cost of materials in the stock from which the materials to be priced could be drawn by the total quantity of materials in that stock.” (C.I.M.A.)

The weighted average price takes into account the price and quantity of the materials in store.

Advantages of Average Cost Method:

1. This method is rational, systematic and not subject to manipulation. It is representative of the prices that prevailed during the entire period rather than of the price at the beginning, end, or at one point of issue during the period because it is based on the average of the material costs of the various lots available in the store.

2. Average price method is considered to be the best method when prices fluctuate considerably because this method tends to smooth out fluctuations in prices.

3. Issue prices are not to be calculated each time issues are made. Issue prices are changed only when new lot of materials is received.

4. This method recovers the cost of materials from production.

5. This method maintains the issue prices as near to the market prices as possible.

6. This method eliminates the necessity for adjustments in stock valuation.

Disadvantages of Average Cost Method:

1. The greatest disadvantage of this method is that a fresh rate calculation will have to be made as soon as a new lot of materials are purchased which may involve tedious calculations. Thus, there are chances of clerical errors.

2. Issue price of materials does not represent actual cost price of materials issued but it represents average cost of materials in stores.

3. At the time of rising prices, it over-states profit but not as much as FIFO because average price is lower than the most recent price.

(4) Closing stock is not valued at current cost.

It is the average cost method which is mostly used by different organisations because it satisfies most of the conditions of a good method of valuing material issues.

4. Highest In First Out (HIFO) Method:

This method is based on the assumption that the closing stock of materials should always remain at the minimum value; so the issues are priced at the highest value of the available consignments in the store. The method is not popular as it always undervalues the stock which amounts to creating a secret reserve. The method is mainly used in case of cost plus contracts or monopoly products as it is helpful in increasing the price of the contract or products.

Material Losses in Cost Accounting

Losses of material during handling, storage or manufacturing are called as material losses in cost accounting. We could classified material losses into two parts i.e. normal losses and abnormal losses.

Normal Losses: Losses which are unavoidable are called Normal losses. Normal losses of material can not be completely avoided but may be controlled to a limited extent .These losses are transferred to factory overheads .Examples of material losses are as follows:

Losses by evaporation
Loss due to loading and unloading
Losses due to breaking the bulk etc.

Abnormal Losses: Losses that arises due to inefficiency in operations, carelessness etc. is called as abnormal losses. These losses are charged to coasting profit and loss account. Examples of abnormal losses are as follows:

Breakage
Fire, accident, flood etc.
Improper storage
Theft

Forms of Material Losses:

Material losses could arise in the form of waste, scrape, spoilage and defectives.

Waste: It comprise of all visible, invisible losses that can not be collected and also unsalable portion of the collected loss. Examples of waste are dust, smoke, gases etc.

Scrap: It represents the unusable loss which can be sold. It is measurable and has a minor value .Scrap may arise in the form of turning’s, filing etc. from metal; off-cuts and cut pieces in leather & cloth industry .

Spoilage: Spoilage is those materials or components which are so damaged in the manufacturing and operation process that they can not be repaired or reconditioned. Spoiled units do not attain the quality required and it is not economic to correct them.

Defectives: A good in which there is a manufacturing fault or defect is called Defective goods, this fault could be removed by applying additional cost called rectification cost.

Material Losses:

Material losses may take the form of waste, scrap, defectives and spoilage. Problems of spoilage, waste, defective units and scrap are bound to arise in almost all manufacturing concerns, so there is usually a difference between the quantity of the output and the input.

Usually the quantity of the output is less than that of the input because of waste, scrap or spoilage. Efforts should be made to reduce the difference between the quantities of the output and the input so that cost of production may be reduced.

Methods of treatment of spoilage, waste etc. and the interpretations given to these terms vary considerably from one industrial concern to another because of different situations arising in different concerns. The terms are also loosely used; for example, waste and scrap may be taken to have the same meaning.

1. Waste:

Waste is defined as discarded substances having no values. In many industries, some waste is inevitable. Such waste may arise due to the inherent nature of materials, chemical reaction, evaporation, drying, sublimation of goods etc. Waste can also be in the form of smoke, gas, slag or dust which arises in the course of a manufacturing process.

Waste may be invisible or visible. The former type of waste (i.e., waste due to drying, evaporation etc.) is invisible whereas the latter type of waste (i.e., gas, smoke, slag etc.) is visible. Waste has practically no measureable value. Rather in some industries, the waste instead of realising any value creates a problem for its disposal incurring further costs. The waste may be normal and abnormal from the point of view of treatment in costing.

Normal Waste:

It is the loss which is unavoidable on account of inherent nature of material. Some materials such as liquid materials lose their weight due to evaporation. Similarly, there are some materials (i.e. coal) which are wasted due to loading and unloading. Materials may be wasted due to breaking the bulk into smaller parts.

Normal waste is unavoidable and as such may be reduced to some extent if there is strict control but cannot be totally eliminated. Such loss can be estimated in advance on the basis of past experience or chemical data. As waste has practically no value, its treatment in costing is relatively simple. The normal process loss is recorded only in terms of quantity.

Abnormal Waste:

Any loss caused by unexpected or abnormal conditions such as sub-standard materials, carelessness, accident etc. or loss in excess of the margin anticipated for normal process loss should be regarded as abnormal waste.

All cases of abnormal waste should be thoroughly investigated and steps taken to prevent their recurrence in future. Responsibility for abnormal wastage should be fixed on purchasing, storage, production and inspection staff to maintain standards. Abnormal waste should not be allowed to affect the cost of production as it is caused by abnormal or unexpected conditions.

Such loss representing the cost of materials, labour and overhead incurred on the wastage should he transferred to Profit and Loss Account (Costing Profit and Loss Account where no integral system of accounting is maintained) and not added to the cost of production so as to make meaningful comparison of costs of production of different periods.

2. Scrap:

Scrap is discarded material having some values. It represents fragments or remnants of material that are left from certain type of manufacture. It is a material loss but has small value without further processing. Examples of scrap are available in operations like turning, boring, punching, sawing, shavings, moulding, etc. from metals on which machine operations are carried out; saw dust and trimmings in the timber industry; dead heads and bottom ends in foundries; and cuttings, pieces and splits in leather industry.

Such scrap can be solid because it can be used by other industries by melting in furnaces. Scrap is always physically available unlike waste which may or may not be physically present in the form of a residue. Thus scrap is always visible whereas waste may or may not be visible. Further, waste may not have any value whereas scrap must necessarily have a value.

There are three types of scrap, namely:

(a) Legitimate scrap,

(b) Administrative scrap,

Legitimate scrap arises due to the nature of operation like turning, boring, punching etc. as discussed above. This type of scrap can be pre-determined and efforts should be made that it should not be more than the pre-determined quantity. Administrative scrap arises due to administrative action, such as, a change in the method of production.

Defective scrap arises because of use of inferior quality of material or bad workmanship or defective machines. Such type of scrap is abnormal because it arises due to abnormal reasons.

Treatment of Scrap:

The useful methods for the treatment of scrap are as follows:

1. If realisable value of normal scrap is insignificant (i.e., legitimate scrap and administrative scrap) it may be credited to Profit and Loss Account like other income. This method of treatment of scrap is suitable when the scrap is of very little value and when the market for it is uncertain. This method is known as treatment by neglect.

This method is not suitable for effective control over scrap because detailed records of scrap are not kept and scrap cost is not shown as an element of cost in the cost sheet. Scrap which is not sold and is in stock is valued at nil for balance sheet purposes and thus vitiates the valuation of closing stock.

Accounting of scrap by this method is also inaccurate as there is a time lag between the sales and the production. There is also a possibility that scrap may arise in one period but may be accounted (i.e., sold) in another period and thus distorts the profits of two periods.

2. The sale value of scrap may be deducted from the cost of materials consumed or factory overhead. This method is suitable when several production orders are commenced at a time and it is not possible to find scrap for each other. This method is, however, not effective in controlling scrap arising in different processes, jobs or orders.

When overheads are absorbed on the basis of pre-determined rates, it is more appropriate to credit an estimated allowance for the scrap instead of the amount of actual scrap.

The journal entries for recording the scrap are:

(i) Dr. Scrap Account (with an estimated allowance) Cr. Factory Overhead Control Account

(ii) Dr. Cash/Debtors (Amount realised on sale) Cr. Scrap Account.

Profit or loss on sale of scrap may be transferred to the Profit and Loss Account at the end of the year. When scrap is sold on a day-to-day basis and no stock is maintained, the journal entry is: Dr. Cash/Debtors Account (with realisable value) Cr. Factory Overhead Control Account

3. The scrap may be assigned a cost if it can be related to the job which yielded the scrap. It will help in giving reasonable credit to the jobs which yielded scraps. This method of treatment is suitable when scraps from the various jobs widely differ in nature.

4. It is possible that scrap arising in one job may be used in another job. In such a case material transfer note for transfer of scrap from one job to another job should be prepared and credit should be given to the job where scrap arises and debit should be given to the job for the amount of scrap transferred to it.

Sometimes, scrap may be returned to stores when some further processing has to be done before that can be utilised for other jobs. Job returning the scrap is credited with the value of the scrap returned to stores.

5. When the actual scrap is in excess of the pre-determined quantity (i.e., normal quantity), the cost of the excess scrap is transferred to Costing Profit and Loss Account after deducting there-from the sale proceeds of such excess scrap. The valuation of excess scrap is done in the same way as the valuation of abnormal waste is done.

6. The cost of defective scraps after deduction there-from the sale a proceeds of such scrap is transferred to Costing Profit and Loss Account because it is an abnormal loss.

3. Defectives:

Defective products or units are those which do not meet with dimensional or quality standards and are reworked for rectification of defects by application of material, labour and/or processing and salvaged to the point of either standard product or substandard product to be sold as seconds. Therefore, defectives are that portion which can be rectified at some extra cost of re-operation.

Defectives may arise due to the following reasons:

1. Sub-standard materials.

2. Poor workmanship.

3. Poor maintenance of machines.

4. Wrong tool setting.

5. Faulty design of products.

6. Bad supervision.

7. Careless inspection.

8. Poor working conditions.

9. Lack of control, such as humidity, furnace temperature etc.

10. Excessive short runs.

Defectives are bad products which are not totally spoiled and can be rectified or restored to original or near-original condition at some extra cost of re-operation. The additional cost of rectifying the defectives is added to the total cost and the quantity of defectives rectified is added to the quantity of good output because defective units rectified can be sold as “seconds”. Rectification of defective units is advisable only when the cost of rectification is low and more profitable than to sell as spoil 3d units.

Treatment of Cost of Rectification of Defectives:

Following methods may be adopted for the treatment of this cost:

1. If the defective production is identified with a specific job or department, the cost of rectification is charged to that specific job or department.

2. If the defective production is not identified with a particular job or department, the cost of rectification is added to general factory overhead.

3. If the defective production is due to abnormal reasons, the rectification cost is transferred to Costing Profit and Loss Account.

Every possible effort should be made to reduce the number of defectives because they increase the cost of production. Control of defectives is an operational correction, so steps should be taken to eliminate the reasons responsible for defectives. Right from the design stage to the output of the final product stage, each one should be looked into carefully for avoiding defectives.

Standardisation of products and operations, comparison of actual performance with standards laid down in regard to defectives, feedback and reporting and incentive scheme for minimising defectives will go a long way in reducing the quantity of defectives.

4. Spoilage:

Spoilage refers to production that does not meet with dimensional or quality standards in such a way that it cannot be rectified economically and is junked and sold for a disposal value. So it occurs when goods are so damaged in course of manufacturing process as to become not rectifiable with some additional cost.

Material used in spoiled units can be used again as material by the same or another process or product. Spoilage cost is the difference between the cost incurred upto the point of rejection less salvage value or cost of material used.

Spoilage arises due to sub-standard materials, poor workmanship, faulty tool setting, poor maintenance of machines, bad supervision and careless inspection.

Spoilage should not be confused with scrap. Scrap arises at the initial stages of production operations whereas spoilage takes place more towards the finishing production stages with larger loss of added value to the cost of material used.

Spoilage can be of two types:

(1) Normal spoilage and

(2) Abnormal spoilage.

According to Charles T. Horngren, “Normal spoilage is what arises under efficient operating conditions; it is an inherent result of the particular process and is thus uncontrollable in the short run.

Abnormal spoilage is spoilage that is not expected to arise under efficient operating conditions; it is not an inherent part of the selected production process”. Abnormal spoilage can be controlled because it arises as a result of inefficient operating conditions.

Normal spoilage is planned spoilage that management is willing to accept and is controllable by higher level of management which determines the nature of products and processes. On the other hand, abnormal spoilage can be controlled by first-line supervision which can exert influence over inefficiency.

Treatment of Cost of Spoilage:

The treatment of cost of spoilage depends upon the nature of spoilage. If the spoilage is normal, the cost is borne by good units of output. In case of abnormal spoilage, cost of spoilage is transferred to Costing Profit and Loss Account. When, however, the normal spoiled units are used again as raw material in the same manufacturing process, no separate treatment becomes necessary.

If they are used for another process, job or order, a proper credit should be given to the process job or order giving rise to the spoilage keeping in view the utility value of the spoilage to the process, job or order for which the same is used.

Control of Wastage, Scrap, Defectives and Spoilage:

Every effort should be made to reduce the cost of production by exercising control on wastage, scrap, defectives and spoilage.

Following steps may be taken in this direction:

1. Reports relating to the wastage, scrap, defectives and spoilage should be prepared in time to locate the reason responsible for the wastage etc. An immediate corrective action should be taken on the basis of the reasons responsible for the loss.

2. Wastage, scrap, defectives and spoilage should be standardised by following standard costing system. It should be seen that actual wastage, scrap, etc. should be within normal limits allowed.

3. Good quality of materials should be used. Better the quality of materials less is the wastage, scrap and spoilage.

4. Control of wastage, scrap, defectives and spoilage should start with the designing of the products. The type of materials that will result in the minimum wastage, scrap, defectives and spoilage are decided at the designing stage. Better quality of equipment should be used to get better return, so type and shape of equipments to be used for manufacturing process should be decided at the designing stage.

5. Properly trained personnel should be employed to reduce the quantum of wastage, scrap, defectives and spoilage.

Unit III

Labor cost

Labor cost represents human contribution. Labor cost is sensitive in nature. The reason is that the labor cost is fully based on the human behavior i.e. labor behavior.

The control of labor costs requires the control of the labor behavior. Therefore, the management should study human behavior, performance of labor, time and motion study, labor turnover, labor approach in order to control the labor cost.

Labor cannot be stored for future reference. It is very much similar to the perishable nature of materials. Some materials may lose its quality and not used for the purpose of production. Such materials will be waste one. Likewise, once labor is lost, the same cannot be recovered and not effectively used in the days to come.

If labor is kept idle, the management should pay remuneration or wages for such idle time. Hence, the management incurred two losses. They are loss of labor working hours and monetary loss. Hence, the management is very keen in the control of labor cost.

Classification of Labor Cost

The labor cost may be classified in the following ways.

1. Direct Labor Cost

Direct Labor cost is that portion of salary or wage, which can be identified with and charged to a single unit cost of production.

Characteristics of Direct Labor Cost:

The direct labor cost has the following characteristics.

It has direct relationship with the product or process or cost unit.
It can be measured quantitatively.
It is sufficiently material in amount.

2. Indirect Labor Cost

It is not identifiable within the production of goods and services even though directly incurred. These costs are incurred in the production place. Sometimes, some cost center may render service to the production departments or production activities. Such cost centers purchase, engineering and time keeping.

3. Controllable Labor Cost

A labor cost can be controlled by the management during production period and even during absence of production. A standard time and time rate may be fixed and request the labor to complete the job or order within such time. If so, the labor cost can be controlled to some extent.

4. Non-Controllable Labor Cost

A labor cost, which cannot be easily controlled by the management. A job or order can be completed by a group of labors. The efficiency of such group of labors differ in nature. A labor can use his/her efficiency in full as per the prevailing environment in the product place. If so, the cost cannot be controlled by the management.

Information required for Labor cost control

The following information is required for labor cost control effectively

1. Cost of recruitment of labor.

2. Training cost of workers.

3. Labor Turnover.

4. Idle Time.

5. Over Time.

6. Shift Work.

7. Labor Efficiency.

8. Number of workers.

9. Wastage.

10. Spoilage.

11. Wages Paid.

Methods or ways of Labor cost control

The management to control the labor cost effectively may exercise the following ways.

1. Proper production planning.

2. Fixing of standard time.

3. Fixing of clear-cut wage structure.

4. An agreement with workers.

5. Preparation of labor budgets i.e. Labor Cost Budget and Labor Hours Budget.

6. Performance reports of labor.

7. Fixing of specific incentive payment.

Control over Labor Costs

Labor costs constitute a significant portion of the total cost of a product. Labor cost may be excessive due to inefficiency of labor, high labor turnover, idle time and unusual overtime work, inclusion of bogus workers in the wages sheet and many other related factors.

Inefficiency of labor is also a cause of excessive material and overhead costs. Therefore, economic utilization of labor is a need of the present day industry to reduce the cost of production of the products manufactured or services rendered.

Management is interested in labor costs on account of the following:

1. To use direct labor cost as a basis for increasing the efficiency of workers ;

2. To identify direct labor cost with products, orders, jobs or processes for ascertaining the cost of every product, order, job or process ;

3. To use direct labor cost as a basis for absorption of overhead, if percentage of direct labor cost to overhead is to be used as a method of absorption of overhead ;

4. To determine indirect labor cost to be treated as overhead; and

5. To reduce the labor turnover.

Hence, control of labor costs is an important objective of management and the realisation of this objective depends upon the cooperation of every member of the supervisory force from the top executive to the foreman.

From functional point of view, control of labor costs is affected in a large industrial concern by the co-ordinated efforts of the following six departments:

1. Personnel Department,

2. Engineering Department,

3. Rate or Time and Motion Study Department,

4. Time-keeping Department,

5. Pay-roll Department, and

6. Cost Accounting Department.

Meaning of systems of wages payment

The success of a concern largely depends upon the efficiency of labor and the efficiency of labor is considerably affected by the amount of wages paid to them. Some personal are of the view that the profit of a concern can be maximized only by reducing the wages rates payable to be workers. But this view is not correct. It should be remembered that low-paid workers' are usually inefficient that leads to wastage of materials, less economic use of tools, frequency breakdown of machinery and loss of time as a result of which the cost of production goes up, reasonable and fair wage rates allowed ultimately lead to more economic use of machines, tools, materials and time. Therefore, the importance of the method of wages of wages payment should never be under-estimated.

Method or system of wages payment must possess the following characteristics:

• Should be simple to operate and easy to understand.

• Should guarantee a minimum wage to every worker.

• Should be acceptable to the employer and the employee.

• Should be flexible enough so the changes may be made according to the requirements.

• Should ensure the establishment of industrial peace.

The principle methods of wages payment are as follow:

1. Time rate system

2. Piece rate system

3. Incentive wage system (payout plan)

Piece rate system

In this method, wages are paid to the employees after completion of work. Under it, a worker is paid on the basis of output. Not the time by him to perform the work. This is one of the simplest and most commonly used systems of wages payment. In this system, the wage rate is expressed in terms of per unit of output, per job or per work-order. This amount of wages payable to a workman under this method is to be calculated as follows:

Total wages = total output x wages rate per unit of output

=output units x unit rate

=actual yield x unit or piece rate

This system is suitable in the following cases:

• Where a work is of a repetitive natures.

• Where the measurement of work is simple.

• Where the quality and accuracy of output is not very important.

• Where strict supervision is not possible.

Advantages of piece rate system

The main advantages of piece rate systems are as follows:

a. Simplicity: just like time rate system, the piece rate system is also simple to operate and easy to understand. It does not involve tedious calculations.

b. Incentive to workers: This system provides an increase to the workers to work hard as the wages are paid on the basis of quantity of output not on the basis of time. So efforts and rewards are correlated.

c. Ascertainment of accurate labor cost: since the wages are paid on the basis of output, the exact cost of labor per unit of output or job can be considerable.

d. No payment for idle time: under piece rate system, any payment is made to the workers for the idle time as a result of which the cost of supervision is not considerable.

e. Proper care and use of machine and tools: the workers rake proper care of their machine and tools since breakdown of machine and tools means decrease in output resulting in less remuneration to them.

Disadvantages of piece rate system

This system has the following disadvantages:

a. Less attention to quality: as the payment of wages is made on the basis of output, the workers, in order to maximize their output, work with sense of hurry, which may affect the quality of the output adversely.

b. Inefficient use of machine and materials: since the wages are paid on the basis of quantity of output, an excursive wastage of materials and frequent breakdown of machinery may be caused by the workers due to their efforts to obtain maximum output.

c. No guarantee of minimum wages: since there is direct relationship between quality of output and wages, the workers suffer if they fail to work efficiently. There is no guarantee of minimum daily wages o workers.

d. Dissatisfaction among inefficient workers: the inefficient workers, who work slowly, become dissatisfied by reason of lower wages as compared to the wages paid to their efficient counterparts.

e. Adverse effect on worker's health: the worker may try to abnormally to earn more which has an adverse effect on their health and efficiency. So, this method is not accepted by trade union.

Time rate system

Under this system, the amount of remuneration or the total wages payable to the workers depends on the time for which he is employed. This is simple and common method of wages payment. In this method, the workman is paid an hourly, daily, monthly or yearly rate rat of wages.

Thus the worker is paid on the basis of time and not on his performance or unit of output. The amount of wages payable to a workman under this method is to be calculated as follows:

Total wages = actual time take x time rate

Or, total wages = total hours worked x wages rate per hour.

This method is suitable to be applied in the following circumstances:

• Where the quality of work is more important than production.

• Where the volume of production is not within the control of labor.

• Where it is difficult to fix the unit of output.

• When it is volume of production is not within the control of labor.

• The nature of work is such that there is no basis for incentive plan.

• Where the amount of output cannot be accurately measured, counted and standardized.

Advantages of time rate system
This method is widely used even at the present time on account of the following advantages:
a. Simplicity: it is very easy to understand and simple to calculate the earnings of worker under this method.
b. Guarantee of minimum wages: it guarantees a minimum wages to the workers.
c. Quality production: since this amount of wages is not linked with the quantity of output, this method ensures production of better quality due to the careful attention of the workers.
d. Unity among workers: under this method, all workers falling under a particular category are paid at equal rate without any consideration of their quantity of output. It encourages a feeling of equality among workers on account of which this method is also favored by trade unions.
e. Economical: it involves less clerical work and detailed records are not necessary. Since the output is not the criteria for determination of wages, tool and materials are handled carefully. Wastage are also minimized.

Disadvantages of time rate system
This method has the following disadvantages:
a. No incentive to the efficient workers: This system lacks incentive to efficient workers since all works are paid equally and no distinction is made between efficient and inefficient workers. So efforts and rewards are not correlated.
b. Go-slow policy: the workers, in order to earn higher wages for overtime work, may try to perform the worker slowly which leads to increase in labor cost per unit.
c. Dissatisfaction among the efficient workers: the efficient workers are paid wages at the rate equal to these payable ton inefficient workers, which creates dissatisfaction among the efficient workers.
d. Payment for idle time: under this method, idle time of the workers is also paid that increase the cost of production.
e. High cost of supervision: since there is no direct link between quantity of output and wages, wastage of time on the part of the workers is common, the avoidance of which requires considerable supervision leading to increase costs.

Incentive wages payment plan

To remove the defects of both time rate and piece rate systems of wages payment, incentive plans have been developed. Under these plans, the advantages of time and piece-wages system are combined, and incentives are provides to workers to work hard. The characteristics of these plans are as follows:
i. Incentives by way of bonus and other are given to efficient works for time saved.
ii. A standard time is fixed and the worker is to perform the given work within the standard time. The standard time is set after making time studies for the performance of specific job.

The incentive is compromise between the two extremities, on the one, if the workers are paid according to time, hey a nothing if time is saved and on the other hand, if they are paid on the basis of piece rate, employers get nothing, if time is saved. Under incentive plans, the employer as well as the workers shares the benefit of time saved, and both labor and overtime costs are reduced.

The incentive plans should be selected according to the nature of work and other circumstances. It should be accepted by the management as well as labor otherwise it does not function successfully. The payment of wages may be made according to any of the following plans:

Individual bonus plan

According to individual bonus plan, the bonus of each worker is calculated separately. Some methods of calculating wages under individual bonus plan are discussed below:

a. Halsey premium plan

This plan was originated by F.A. Haley. Under this scheme, an hourly rate is guaranteed to all workers. A standard time is fixed unit, job or operation on the basis of time and mention studies and the worker is paid the agreed hourly rate of wages for the actual time taken plus a fixed percentages of bonus on the time saved. The amount of bonus or premium payable to the workers in one-half of the wages of the time saved.

Requirements for calculating total wages or total earning of the worker under. Halsey premium plan are:

ST = standard time or normal time allowed

TT = time taken

SR = standard time rate of wages

Time saved (TS = ST –TT)

Advantages of Halsey premium plan

The advantages of Haley premium plan are mentioned below:

i. It is simple to understand and operate.

ii. Every worker is guaranteed minimum wages and even the inefficient worker feel secured.

iii. It encourages efficiency among worker by inducing them to finish their job before the standard time.

iv. The benefit from the time saved is shared equally by have employer and the workman.

v. Generally workers do not oppose this method of wages, payment as it rewarded time saved rather than increase output.

Disadvantages of Halsey premium plan

The disadvantages of Halsey premium plan are mentioned below:

i. Workers are paid only half of the wages on the time saved. So the worker may oppose this method.

ii. The worker may perform to work in hurry by neglecting the quality of output to save time and earn higher bonus.

iii. The standard time fixed for finished a job may not be scientific.

b. Rowan premium plan

This plan was originated by David rowan. This plan guarantees an hourly rate to all workers. A worker is paid the fixed rate per hour for the actual time spent on the job plus a premium or bonus based on the time saved. The amount of premium or bonus is not a fixed percentage of the wages of time saved but it various according to the extent of the time saved. The amount of bonus or premium payable under this plan depends on the percentage of time saved by the workers. The bonus is calculated the such percentage out of the basis wages.

Formula for to calculated total wages or total earning of the worker under, Rowan premium plan:

Basis wages = time taken x standard time rate = TT x SR

Bonus = time saved/ standard time

Total wages under rowan plan = basis wages = bonus = TT x SR = TS/SR

Effective wages rate under rowan plan = total wages/TT

Advantages of rowan premium plan

The advantages of rowan premium plan are mentioned below:

i. This plan guarantees minimum wages and provides incentive for efficiency.

ii. It does not induce to rush through work for increase bonus earning because the bonus increase at a decreasing rate with higher levels of efficiency. Thus, an automate check for limiting production of inferior quaintly of goods is ensured.

iii. The per unit fixed cost decrease with the increase in production

iv. The per unit fixed cost decrease with increase in production

v. Under this method, the per unit cost decrease due to decrease in per unit labor cost.

Disadvantages of Rowan premium plan

The disadvantages of Rowan premium plan are mentioned below:

i. As the bonus is to be shared by employees and employees, it is not welcomed by employees. They expect full benefit for their extra efficiency.

ii. The calculation earnings under this method is comparatively complicated and time consuming.

iii. The preparation of Lanzhou budget and estimated product labor cost are made difficult by the varying labor costs under this plan.

iv. Payment under this plan is much less than that under the Halsey plan by way of bonus below 50% of the time saved.

Why rowan plan is better than Halsey plan?

• In the Halsey plan, bonus is usually set at 50% of the time saved. It does not serve as a strong incentive. On the other hand under the Rowan plan, bonus is that proportion of the wages of the time taken which the time save bears to the standard time; it serves as a strong incentive for increasing the efficiency.

• In the Rowan plan, the quality of work is not affected much. The worker is not induced to rush through the work because bonus increases at a decreasing rate at higher levels of efficiency. In the Halsye plan. A worker is induced to rush through the because he get extra wages for every 50% of the time saved.

• The effective labor rate per hour in the Rowan plan is higher up to 50% of the time saved and falls there after whereas in the Halsey plan, the effective labor rate per hour up to 50% of the time saved and can be double thereafter. Usually, worker are not able to save more than 50% of the time allowed, so worker prefer the Rowan plan for earning more wages

Overhead: Definition, Importance and Classification

Cost pertaining to a cost centre or cost unit may be divided into two portions direct and indirect. The indirect portion of the total cost constitutes the overhead cost which is the aggregate of indirect material cost, indirect wages and indirect expenses. CIMA defines indirect cost as “expenditure on labor, materials or services which cannot be conveniently identified with a specific saleable cost per unit.”

Indirect costs are those costs which are incurred for the benefit of a number of cost centers or costs units. Indirect cost, therefore, cannot be conveniently identified with a particular cost centre or cost unit but it can be apportioned to or absorbed by cost centres or cost units.

Broadly speaking, any expenditure over and above prime cost is known as overhead. In general terms, overheads comprise all expenditure incurred for or in connection with the general organisation of the whole or part of the undertaking i.e. the cost of operating supplies and services used by the undertaking including the maintenance of capital assets. The terms ‘burden’, ‘supplementary costs’, ‘on costs’, ‘indirect expenses’ are used interchangeably for overhead.

Importance of Overhead Costs:

In various five-year plans, industrialisation was given due importance. The result is that a large number of establishments have grown up both in the public and private sectors for mass production for which use of improved and costlier and special type of machines has become absolutely necessary. With the increasing trend towards plant automation, heavy expenditure is being incurred which cannot be charged directly to any particular unit and can be called as cost common to all units of production.

Overhead expenses being a significant proportion of the total cost have assumed an added importance and require analysis for purposes of cost ascertainment and control by function and for guidance in certain managerial decisions by the extent of the variability with production.

Overhead costs cannot be allocated but have to be suitably apportioned and then absorbed by suitable methods. The cost accountant is required to pay so much attention to the accounting of overhead cost as prudence choice of various bases used for apportionment and absorbing the overheads in the cost of products has to be made by him.

Are High Overhead Costs an Indication of Inefficiency?

These days we find that overhead expenses are increasing in every organisation. Some people may have the feeling that high overhead costs are an indication of inefficiency. But this is not correct.

High overhead costs do not indicate inefficiency if it is accompanied by:

(i) Large scale production or mass production;

(ii) Increase in efficiency and productivity of labor;

(iii) Less human efforts will be required because of automatic machines but more machine expenses will have to be incurred;

(iv) More depreciation, maintenance expenditure and similar other items because of more use of machinery;

(v) Improved methods of managerial control like work study, production control, cost and management accountancy techniques may reduce the direct cost but will increase the overhead costs.

Classification of Overhead Costs:

Cost classification is the process of grouping costs according to their common characteristics and establishing a series of special groups according to which costs are classified.

Thus, it involves two steps:

i) The determination of the class or groups in which the overhead costs are subdivided,

(ii) The actual process of classification of the various items of expenses into one or the other of the groups.

The method to be adopted for the classification of overhead costs depends upon the type and size of the business, nature of the product or services rendered and policy of the management.

The various classifications are:

(i) Functional classification,

(ii) Classification with regard to behaviour of the expenditure,

(iii) Element-wise classification,

(iv) Classification according to nature of expenditure.

A concern may adopt one or more of the above classifications. For example, the overhead expenses in a concern may be first divided according to functions i.e. manufacturing, administration, selling and distribution groups. The expenses pertaining to one group say manufacturing may further be classified into fixed, variable and semi-variable.

Each of these groups may then be grouped into the elements i.e. indirect material, indirect labor and indirect expenses and under each element, the expenses may be further subdivided according to their nature i.e. depreciation, salary, repairs and maintenance etc.

I. Functional Classification of Overhead:

When overhead expenses are classified with reference to major activity divisions of a concern, it is called functional classification of overhead. This classification is necessary for the segregation of the cost of each of the principal functional division of the concern and for having separate methods of accounting and control for the diverse nature of expenses in each division.

The main groups forming the basis of the classification are:

(a) Manufacturing Overhead,

(b) Administration Overhead,

(d) Distribution Overhead, and

(e) Research and Development Expenses

II. Classification with Regard to Behaviour of Expenditure:

Under this overheads are classified with reference to their tendency to vary with production/sales volume or activity level. Some expenses vary directly with the rise and fall in output, some remain constant in spite of change in the level of activity of the concern whereas there are some other items which are constant only upto a certain level and then change their character to become variable or which vary with volume of output but less than proportionately.

Based on this behaviour, the expenses may be classified into:

(a) Fixed overhead,

(b) Variable overhead,

This classification is not absolute but is one of convenience. All costs are variable in the long run. This classification is important for cost control and decision making.

(a) Fixed Overhead:

Fixed overhead cost (also called period cost and policy cost) is the cost which accrues in relation to the passage of time and which, within certain limits tends to be unaffected by fluctuations in the level of activity. These expenses remain fixed in total amount with increases or decreases in the volume of output or productive activity for a given period of time. Fixed overhead cost per unit decreases as production increases and increases as production declines.

Examples of fixed expenses are rent of building, storage space etc., depreciation of plant and machinery, depreciation of buildings, pay and allowances of space etc., depreciation of plant and machinery, depreciation of buildings, pay and allowances of directors, managers, secretaries, accountants etc., office expenses, like stationery and postage etc., bank charges, legal expenses, salaries of the works manager, interest on capital, if included in costs.

Fixed overhead costs are not always wholly fixed in nature:

If a concern increases its capacity, it has to go in for additional equipment and buildings and appoint some more staff to meet the changed requirements of production. It will result in more fixed overhead expenses.

Fixed overhead costs remain constant only within the limit of plant capacity and any appreciable change in plant capacity affects the fixed overheads. The definition that fixed overheads remain constant in spite of increase or decrease in the level of activity will hold true only in short period during which no appreciable change in capacity occurs.

Fixed overheads have to be incurred during a particular period whether there is more or less production or no production at all. Fixed overhead expenses are thus period costs representing a constant amount of expenditure during a particular period. Sometimes, they are also termed as shutdown or stand-by costs.

Fixed overhead costs are constant in total amount during an accounting period but fluctuate per unit as production changes. The fixed overhead cost per unit decreases with increase in production as the same amount is spread over a larger number of units. On the other hand, it increases when production falls either due to capacity remaining unused or due to inefficiency in production.

Fixed overhead falls under the category of non-controllable cost from the management control point of view as there is practically no scope of reduction of the amount of expenditure by the action of any executive once certain facilities are installed. However, it is desirable to have most effective utilisation of plant capacity in order to reduce the fixed cost per unit to the minimum.

(b) Variable Overhead:

It is a cost which tends to follow (in the short-term) the level of activity. Variable overheads costs vary in total in direct proportion to the volume of output. These costs per unit remain relatively constant with changes in production. Thus variable costs fluctuate in total amount in direct proportion to the volume of output but tend to remain constant per unit as production activity changes. Examples are indirect material, indirect labor, spoilage, tools, defective work loss, lubricants, idle time, lighting and heating expenses and commission to salesmen.

The variable overhead costs seldom reveal the characteristic of perfect variability i.e. an expenditure which varies directly with variation in the volume of output. They simply tend to vary rather than vary directly in direct proportion to output.

We come across three types of variable overhead expenses in actual practice:

(i) A 100% variable expenses. For all production the variable expenditure per unit of production is constant.

(ii) The expenses per unit of production are lower at lower ranges of output but gradually increase as production goes up.

(iii) The expenses per unit of production are more at lower ranges of output but gradually decrease with the increase in production,

(c) Semi-variable Cost (also called mixed cost or semi fixed cost) is a cost, containing both fixed and variable elements and which is thus partly affected by fluctuation in the level of activity. These costs are partly fixed and partly variable. For example, telephone expenses include a fixed portion of annual charge plus variable charge according to calls, thus the total telephone expenses are semi-variable.

Similarly if the salesmen are entitled for a fixed salary plus a commission beyond a certain level of sales, salesmen compensation is a semi-variable overhead having a fixed element constant at all the levels and a variable element which comes into operation after a specified level of sales is achieved.

Semi-variable overheads are of two types:

(a) The first type shows semi-variable costs where variable element operates at all the levels as shown in the graphs given below:

(i) Semi-variable Costs:

Variable element operates at all the levels.

(b) The second type shows semi-variable costs where variable element comes into operation after a certain level of activity level as shown in the graph given above:

(ii) Semi-variable Costs:

Variable element comes into operation after a certain range. These costs are the costs which increase in steps. These remain constant over various small ranges of output, but increase by discrete amounts as activity moves from one range to the next. Examples are canteen staff wages, supervisor’s salary etc.

Necessity of Classification for Overhead into Fixed and Variable:

The necessity (or advantages) for classifying the overhead into fixed and variable arises from the following:

(а) Fixation of Selling Price:

This distinction is helpful in determining the price policy of a concern. Sometimes, different prices are charged for the same article in different markets to meet varying degrees of competition. However, the lowest selling price of an article in any market should atleast cover prime cost plus variable overheads. The corresponding fixed overheads may or may not be recovered if it is not practical to do so. Such fixed overheads may be recovered from sales in more favorable markets.

If the selling price in a market does not cover the variable overheads, it is better not to sell goods in that market. Similarly, in times of trade depression, it will be profitable for a manufacturer to sell his goods below the total cost, provided the selling price is in excess of variable cost. In this way he can recover a part of his fixed expenses and thus minimize his loss.

(b) Framing the Flexible Budget:

Segregating the fixed overhead from the variable overhead will be helpful in framing the flexible budget for various levels of capacity utilization. The behavior of the cost will also be forcefully brought out.

(c) Effective Cost Control:

Fixed expenses are incurred by management decisions and as such can be controlled by the top management while the variable expenses can be controlled by the lower levels of management. By segregating these, the lower levels of management will know the types of expenditure which is within their control.

(d) Helps Management Decisions:

In management decisions regarding the utilization of capacity, this segregation will be found useful. After all the concept of fixed or variable expenditure is in relation to a particular rate of output. For example, supervisory salary may have to be doubled, if a new shift is to be started.

In such cases, the management has to see whether the production of the second shift will be able to bear such an increase in the cost of production Similarly decisions like fixation of price during depression, for export, for some special order or the extra amount to be spent if an additional activity is undertaken or an alternative course is adopted, can be taken easily after classification of expenses into fixed and variable.

(e) Marginal Costing and Break-even Charts:

For the technique of marginal costing, preparation of break-even charts and study of cost-volume-profit relationship, segregation of cost into fixed and variable is quite essential.

(f) Method of Absorption of Overheads:

Different methods may be adopted for determination of absorption rates for fixed and variable overheads. The fixed overhead rate serves as a measure of utilisation of the facilities while the extent of idle capacity is indicated by under absorption.

In short, classification of overhead into fixed and variable is highly helpful to the management for the efficient running of the factory. It is not only helpful for cost finding but also for cost control and managerial decision-making.

The classification of costs into fixed and variable is not perfect as it is based on one assumption that costs are influenced only by volume is not true. But there are many other factors which influence costs as production specification, product mix, method of production, technology, plant and equipment, productivity, organisation structure, management policies and price indices etc. Moreover the linearity assumption is far from the actual reality.

III. Element-wise Classification:

This classification of overhead is done according to the nature and source of expenditure and follows naturally from the definition of overhead.

According to this classification, the total expenses are broken up into:

(i) Indirect Materials;

(ii) Indirect Labor; and

(iii) Indirect Expenses

IV. Classification of Overhead According to Nature of Expenses:

In order to have effective analysis of the expenses in detail, each of the manufacturing, administration, selling and distribution overhead cost is classified into smaller sub-divisions so that expenses of similar nature can be grouped together under one head. This is achieved through Standing Order Numbers or Syllabus of Work Order Numbers and Cost Account Numbers. It may be made clear that standing order numbers are conventionally applied to factory overheads headings whereas cost account numbers are customarily applied to administration, selling and distribution and research development expenses.

The compilation of numbers is similar in both types of numbers. These numbers are so called as they are listed on a permanent type of schedule or manual. Each standing order number denotes particular type of expenditure so that items of expenses of similar nature when incurred are suitably classified in one of these. A schedule or manual is maintained in the factory for enlisting all the standing order numbers.

There is a positive need for having separate standing order numbers for fixed and variable overheads especially when departmental overheads are charged to products separately for fixed and variable overheads. Thus, there are two rates, one for fixed and the other for variable overhead.

Separate rates are used for the following four reasons:

1. Fixed costs being policy costs may not be recovered from costs under certain circumstances (as depression) but variable costs are to be recovered fully under normal circumstances.

2. Responsibility centres at higher management level are for controlling fixed costs but variable cost overheads responsibility centres are at shop level.

3. Different bases may have to be adopted (sometimes labor hour basis or direct material cost basis) for recovering overheads from cost.

4. Marginal cost may be applied with benefit to have vital managerial basis.

The number of standing order numbers in a factory will depend on the size of factory, types of expenses and the extent of control necessary. A large variety or a number of types of expenditure in a factory will have larger number of standing orders. For better control it is desirable to have smaller sub-division of the expenses.

The essential requirements for an effective system of standing order numbers are:

1. These numbers should be clearly defined in order to understand the classification and correctly classify each item of expense.

2. No ambiguity should be there as the schedule or manual for which suitable remarks against the standing order numbers to assist in properly classifying each item of expenses is necessary.

3. System of standing order numbers should be according to the needs of the concern. It should not be too detailed in order to avoid increased cost of clerical labor. The classification should not be too broad so as to lose its clarity and become useless for control purposes.

4. Code should be used for each heading as it helps to find items in a convenient way avoiding confusion and ultimately facilitating the collection of overheads.

Allocation and Apportionment of Overhead to Cost Centres

When all the items are collected properly under suitable account headings, the next step is allocation and apportionment of such expenses to cost centres. This is also known as departmentalisation of overhead. Departmentalisation of production overheads is the process of identifying production overhead expenses with different production/service departments or cost centres. It is done by means of allocation and apportionment of overheads among various departments.

Thus, it involves:

(i) Allocation and apportionment of overheads among production and service departments and

(ii) Reapportionment of service departments overheads among production departments.

A factory is administratively divided into sub-divisions known as departments for running it smoothly and efficiently. This sub-division is done in such a manner that each department represents a division of activity of the concern such as repairs department, power department, tools department, stores department, cash department, cost department etc.

Following factors must be taken into consideration while organising a concern into a number of departments:

(i) Every manufacturing process is divided into its natural divisions in order to maintain natural flow of raw materials from the time of the purchase till its conversion into finished goods and sale.

(ii) For ensuring smooth flow of production, the sequence of operations is taken into consideration while determining the location of the various departments.

(iii) For physical control on production and maintaining efficiency of the concern, division of responsibility must be taken into consideration while organising departments. Division of responsibility as far as possible should be clear, without ambiguity and dual control.

Types of Departments:

In a manufacturing concern, there are three types of departments:

(a) Manufacturing or producing departments

(b) Service departments

(а) Producing Departments:

A department where actual process of manufacturing is carried on is called manufacturing or producing department. It covers direct manufacture and is engaged in converting raw materials into finished goods by performing some manual and/or machine operations on any part of the product.

The number of such departments and their number will depend upon the nature of industry, type of work performed and the size of the factory. For example, in Steel Rolling Mill, Hot Mill, Cold Mill, Pickling Shop, Annealing Shop, Hardening, Polishing and Grinding are the producing departments.

(b) Service Departments:

Service department is an auxiliary and is not directly engaged in production though its existence is very essential for smooth and efficient running of production departments. Such departments are not directly engaged in the conversion of raw materials into finished goods. Such departments (as electricity or repairs and maintenance) render a particular type of service for the benefit of other departments.

The number of departments in a factory and the names to be assigned to them depends upon size of the factory, nature of industry and the nature of service rendered. The service departments, common to most concerns are stores, cost office, personnel department, planning and progress department, tool room, hospital and dispensary, machine maintenance and electrical maintenance section etc.

(c) Partly Producing Departments:

A department may normally be a service department but sometimes does some productive work, so it becomes partly producing department. For example, a carpentry shop which is mainly responsible for the repairs and upkeep of sundry fixtures and fittings may occasionally be required to manufacture packing boxes for direct charge to outturn, will be a partly producing department.

Allocation of Overhead Expenses:

Allocation is the process of identification of overheads with cost centres. An expense which is directly identifiable with a specific cost centre is allocated to that centre. So it is the allotment of whole item of cost to a cost centre or cost unit or refers to the charging of expenses which can be identified wholly with a particular department. For example, the whole of overtime wages paid to the workers relating to a particular department should be charged to that department.

Similarly, the cost of repairs and maintenance of a particular machine should be charged to that particular department wherein the machine is located. Power, if separate meters are provided at each cost centre and fuel oil for boilers are other examples of allocation. So, the term allocation means the allotment of the whole item without division to a particular department or cost centre.

Apportionment of Overhead Expenses:

Cost apportionment is the allotment of proportions of items to cost centres or cost units on an equitable basis. The term refers to the allotment of expenses which cannot identify wholly with a particular department. Such expenses require division and apportionment over two or more cost centres or units.

So cost apportionment will arise in case of expenses common to more than one cost centre or unit. It is defined as the allotment to two or more cost centres of proportions of the common items of cost on the estimated basis of benefit received. Common items of overheads are rent and rates, depreciation, repairs and maintenance, lighting, works manager’s salary etc.

Bases of Apportionment:

Suitable bases have to be found out for apportioning the items of overhead cost to production and service departments and then for reapportionment of service departments costs to other service and production departments. The basis adopted should be such by which the expenses being apportioned must be measurable by the basis adopted and there must be proper correlation between the expenses and the basis.

Therefore, the common expenses have to be apportioned or distributed over the departments on some equitable basis. The process of distribution is usually known as ‘Primary Distribution’.

Following are the main bases of overhead apportionment utilised in manufacturing concerns:

(i) Direct Allocation:

Overheads are directly allocated to various departments on the basis of expenses for each department respectively. Examples are: overtime premium of workers engaged in a particular department, power (when separate meters are available), jobbing repairs etc.

(ii) Direct Labor/Machine Hours:

Under this basis, the overhead expenses are distributed to various departments in the ratio of total number of labor or machine hours worked in each department. Majority of general overhead items are apportioned on this basis.

(iii) Value of Materials Passing through Cost Centres:

This basis is adopted for expenses associated with material such as material handling expenses.

(iv) Direct Wages:

According to this basis, expenses are distributed amongst the departments in the ratio of direct wages bills of the various departments. This method is used only for those items of expenses which are booked with the amounts of wages, e.g., workers’ insurance, their contribution to provident fund, workers’ compensation etc.

(v) Number of Workers:

The total number of workers working in each department is taken as a basis for apportioning overhead expenses amongst departments. Where the expenditure depends more on the number of employees than on wages bill or number of labor hours, this method is used. This method is used for the apportionment of certain expenses as welfare and recreation expenses, medical expenses, time keeping, supervision etc.

(vi) Floor Area of Departments:

This basis is adopted for the apportionment of certain expenses like lighting and heating, rent, rates, taxes, maintenance on building, air conditioning, fire precaution services etc.

(vii) Capital Values:

In this method, the capital values of certain assets like machinery and building are used as basis for the apportionment of certain expenses.

Examples are:

Rates, taxes, depreciation, maintenance, insurance charges of the building etc.

(viii) Light Points:

This is used for apportioning lighting expenses.

(ix) Kilowatt Hours:

This basis is used for the apportionment of power expenses.

(x) Technical Estimates:

This basis of apportionment is used for the apportionment of those expenses for which it is difficult, to find out any other basis of apportionment. An assessment of the equitable proportion is carried out by technical experts. This is used for distributing lighting, electric power, works manager’s salary, internal transport, steam, water charges etc. when these are used for processes.

Principles of Apportionment of Overhead Costs:

The determination of a suitable basis is of primary importance and the following principles are useful guides to a cost accountant:

(i) Service or Use or Benefit Derived:

If the service rendered by a particular item of expense to different departments can be measured, overhead can be conveniently apportioned on this basis. Thus, the cost of maintenance may be apportioned to different departments on the basis of machine hours or capital value of the machines, rent charges to be distributed according to the floor space occupied by each department.

(ii) Ability to Pay Method:

Under this method, overhead should be distributed in proportion to the sales ability, income or profitability of the departments, territories, basis of products etc. Thus, jobs or products making higher profits take a higher share of the overhead expenses. This method is inequitable and is not generally advisable to relieve inefficient units at the cost of efficient units.

(iii) Efficiency Method:

Under this method, the apportionment of expenses is made on the basis of production targets. If the target is exceeded, the unit cost reduces indicating a more than average efficiency. If the target is not achieved, the unit cost goes up, disclosing thereby the inefficiency of the department.

(iv) Survey Method:

In certain cases it may not be possible to measure exactly the extent of benefit wick the various departments receive as this may vary from period to period, a survey is made of the various factors involved and the share of overhead costs to be borne by each cost centre is determined.

Thus, the salaries of foreman serving two departments can be apportioned after a proper survey which may reveal that 30% of such salary should be apportioned to one department and 70% to the other department. The cost of lighting, when not metered, may similarly be apportioned on a survey of the number and wattage of light points and the hours of use in each cost centre.

Advantages of Departmentalization of Overhead Expenses:

Departmentalisation of overhead expenses has the following advantages:

1. Allocation and apportionment of overhead expenses to the respective departments facilitate control of overhead cost by means of budgets predetermined.

2. Apportionment of service department cost to production and other service departments facilitates control of the uses made of the services rendered to respective departments.

3. Absorption of overhead costs in the products produced by departmental overhead rates facilitates ascertainment of cost as the overhead costs of the respective departments are taken into consideration in determining the overhead rates.

4. The basis used in the predetermination of the departmental overhead rates may be used for control of actual basis in comparison to the quantity predetermined.

5. Analysis of under or over absorption of overhead discloses the reasons for variances which indicate the remedial measures to be taken.

6. For working out correctly the cost of work-in-progress. If the overhead is not departmentalized, the cost of work-in-progress will be loaded with a proportion of overhead of all the departments including those in which the product is yet to be processed.

Unit IV

Unit or Output Costing

One operation costing method of costing by units of production and is adopted where production is uniform and a continuous affair, units of output are identical and the cost units are physical and natural. The cost per unit is determined by dividing the total cost during a given period by the number of units produced during that period.

This method of costing is generally adopted where an undertaking is engaged in producing only one type of product or two or more products of the same kind but of varying grades or quality. The industries where this method of costing is used are dairy industry, beverages, collieries, sugar mills, cement works, brick works, paper mills etc. In all these cases, work is a natural unit of cost e.g., a tonne of coal, a quintal of sugar, a tonne of cement, 1,000 bricks, 1 kg of paper and soon.

Collection of Costs:

The cost in such industries is collected under the following headings:

(i) Material:

As there will be only one product and the process of manufacture is also simple, the raw material, if any, is directly charged to the production of the period in total. The items of stores issued for maintenance and other purposes are analysed by cost centres through the requisition slips. Normal loss of material is adjusted by inflating the issue price of materials.

(ii) Labour:

The labour costs are collected periodically through payrolls which are prepared separately for each section of the work. The purpose of such analysis is only to localise the cost to specific cost centres or to departmental managers, so that the cost can be effectively controlled. Labour—direct and indirect—should be identified separately. The direct labour cost is collected separately and forms a part of prime cost whereas indirect labour is charged to the factory overheads.

(iii) Overheads:

These are classified into three broad categories: factory overheads, administration overheads and selling and distribution overheads. These are usually charged at a predetermined rate.

Tenders or Quotations:

Very often a producer in response to an advertisement in the press is required to submit a tender or to quote prices for the supply of the commodities he produces or for completing a job. A tender has to be prepared very carefully as the receipts of orders depend upon the acceptance of quotations or tenders supplied by the manufacturer. The preparation of tenders requires information regarding prime cost, works, administration and selling overheads and profit of the preceding period.

The manufacturer has to ascertain and find out the possible changes in prices of material, rates of wages and other costs. He has to ascertain the amount of variable, semi-variable and fixed overheads on the basis of past experience. He must also have a reasonable amount of profit by taking into consideration the market condition.

In preparation of estimates or tenders, overheads are generally not given. They are estimated as percentages i.e. works overheads on wages and administration, selling and distribution overheads on works cost basis.

Importance of output costing

A cost sheet is used to determine total and unit cost of a product under the unit cost method. The followings are the importance;

Simple: This method is very simple and easy to understand.
Determination of cost: It helps to determine the total and unit cost if production for a given period of time.
Fixation of selling price: It helps to determine the selling price of the product.
Elements of cost: It provides the detail information of the cost under different heading incorporating step-wise cost as well as total cost.
Comparison: It facilitates to compare the current cost with the previous period.
Corrective measures: It enables to find out the causes of variation if any and take corrective measures.
Tender sheet: It helps in the preparation of tender sheet for submitting tender price with fair degree of accuracy and reliability.
Decision making: It facilitates for making different types of decisions and formulation policy of the manufacturing concern.

Limitation of unit costing

Cost sheet is very importance method for determining the unit cost or total cost of production.
Not applicable for heterogeneous products: manufacturing concerns engaged in manufacturing different types of product cannot apply this method.
Not applicable for service sector: Services oriented concern like school, college, and hospital cannot apply this method.

Operating Costing: Definition, Unit and Classification

IMA defines the method “Operating costing applies where standardized services are provided by an undertaking’.

Such undertakings are: transport concern (shipping, air, railways and motor transport etc.), catering establishments (hotels, hostel, canteen etc.) and public utility undertakings like gas, electricity, steam generating, hospitals, theatres, schools, laundries etc. In many factories utility services like motor transport, power house, hospital and canteen are departmentally run divisions which provide services to the producing departments of the factory.

Operating costing is used by concern running diverse nature of activities, the cost system is obviously different from that for manufacturing concerns. In this system a suitable cost-unit is adopted, which is not a job or process but is related to service rendered e.g. ton-kilometer, passenger-kilometer of transport services, unit of electricity or kilowatt hour, cubic meter of gas etc.

Unit of Cost:

It is quite important to find out a proper unit of cost in case of operating cost so that the cost per unit can be ascertained. In certain cases the unit is obvious. For example in case of hospital it will be bed, in case of water works it will be 1000 litres, in case of electricity it will be a unit or kwh and in case of a retail store it will be the sale per Rs. 100 In case of transport concerns, however, the unit is likely to be composite. It may be a passenger-km. or ton-km signifying the effort which is made in carrying a passenger one kilometre or a ton of goods one km. Following are composite units based on two or more factors.

Classification of Cost:

Operating costs are classified and accumulated under the following three heads:

(a) Fixed or Standing Charges:

These are expenses which are more or less fixed in nature. For example in case transport service garage charges, insurance, taxes, license and depreciation are standing cost. In case of Hospital the depreciation pertaining to the cost of building, equipment, beds, beds insurance etc. are fixed charges. These expenses are constant and are incurred irrespective of the extent of service.

(b) Maintenance Charges:

These are costs of semi-variable nature and include expenditure on repairs, maintenance, tyres, tubes, accessories and spares.

These are variable cost. For example in case of hospital, the cost of medicine, diet, laundry etc. will represent the running charges. In case of transport service petrol or diesel, lubricating oil, wages of driver or cleaner are operating or running charges.

Features of Operating Costing

The basic features of operating costing are presented below.

1. Uniform service is provided to all the customers.

2. The costs are classified into fixed and variable.

3. The fixed and variable cost classification is necessary to ascertain the cost of service and the unit cost of service.

4. There is no physical stock of article if an undertaking renders a service.

5. If a cost center is operating for an undertaking, there is no sale of service but render the service. In other words, if a cost center is operating for public, it sells its service to the public.

6. The cost unit may be simple in certain cases or composite or compound in other cases like transport undertakings.

7. Total costs are averaged over the total amount of service rendered.

8. The costs are collected from the authentic documents like daily log sheet, operating cost sheet, boiler house cost sheet, canteen cost sheets etc.

9. Operating cost is the cost of rendering service.

10. Operating costing is the method of ascertaining costs.

11. The productive enterprises can quote prices by ascertaining cost data.

Application of Operating Costing

Operating costing is applied by an organization, which provides service to the public as a whole instead of manufacturing an article, and sells the same. For example, Transport undertaking electricity, theatre, hospitals, schools and the like. Similarly, the same type of an organization or cost center renders service to production departments. For example, Electricity, powerhouse, canteen and the like.

The service cost in operating cost should be find out to understand whether an organization or cost center render services to others or sell the services to the general public. If the services are sold, the operating expenses and the extent of services rendered are taken into consideration to find out the service cost. On the other hand, if the services are sold, the service expenses should be apportioned to the production department on a suitable basis.

Generally, the basis may be the extent of service availed by the production departments. It may also become necessary to compare the cost of such a service with the cost of an outside service for deciding whether it is profitable to buy a service from outside rather than make the same available from within an organization.

Objectives of Operating Costing

The objectives of operating costing are listed below:

1. To supply the information through which the efficiency in rendering service is improved.

2. To provide a basis for fixing accurate quotation and fare.

3. To ensure that the services are provided in proper time.

4. To control the fuel consumption and its expenses.

5. To ensure that the service equipments are properly maintained.

6. To provide cost comparison between own service and alternative service i.e. hiring.

7. To compare the cost of one service center with another.

8. To determine the apportionment cost if the services are provided within an organization.

9. To decide the price that can be charged for use of vehicle.

10. To control the cost of maintenance and repairs.

11. To select efficient and suitable routing of vehicles to reduce the costs to production departments that uses the service.

12. To avoid the under utilization of capacity and idle time of the work force.

13. To absorb the fixed costs proportionately and systematically that is allocated to the units of services.

Process Costing: Meaning, Features and Definitions

‘Process costing is a method of costing used to ascertain the cost of production of each process, operation or stage of manufacture where processes are carried on having one or more of the following features:

(i) Where the product of one process becomes the material of another process or operation,

(ii) Where there is simultaneous production at one or more process of different products, with or without by product,

(iii) Where, during one or more processes or operations of a series, the products or materials are not distinguishable from one another, as for instance, when finished products differ finally only in shape or form’.

Principles of Process Costing

The principles of process costing are briefly presented below.

1. The whole factory operation is divided into several operations or production centers, each performing standard operations.

2. All the items of process costing i.e. materials, labour and overheads are collected in process wise.

3. The records are maintained in process wise as the number of units produced, the total costs incurred and the cost per unit.

4. The total cost of one process is transferred to next process along with the number of units transferred to next process for further processing.

5. The cost per unit is calculated by dividing the number of units produced in a process into the total costs incurred for processing the same number of units in a specified period.

6. Likewise, the cost of finished product is calculated by dividing the total production cost into the number of units produced.

Thus, in the process cost accounting system, the cost is determined for completed production and work-in-progress also.

Features of Process Costing

The process costing has the following features.

1. The production is carried on continuously and passing two or more processes.

2. Only homogeneous products are produced.

3. The production will be stopped if the plant and machinery is shut down for repairs.

4. The management has clearly defined process cost centers and the accumulation of costs such as cost of material, cost of labour and overheads by the cost centre.

5. The accurate accounting records are maintained in process wise as the number of units produced completely, the number of units partly produced and total costs incurred.

6. The finished product of one process becomes the raw material of the next process or operation and so on until the final product is obtained.

7. Some losses may arise in all the processes due to avoidable and unavoidable reasons. Such losses may be normal and/or abnormal.

8. Accounting treatment of normal losses and abnormal losses are studied in this method of costing.

9. Sometimes, abnormal gain is also available in certain processes.

10. Accounting treatment of such abnormal gain is also studied in this method of costing.

11. Sometimes, goods are transferred from the process to next process at transfer price instead of cost price.

12. The transfer price is compared with market price to know the level of efficiency or losses occurring in a particular process.

13. All the input units cannot be converted into finished products in all the processes for a specified period. Some may be in process. At the same time, the calculation of effective unit rate is carried on in this method of costing. Therefore, accurate average cost is obtained.

14. Sometimes, more than one product is produced. All the products are having equal value and importance. If so, these products are called joint product.

15. In certain cases, more than one product is produced. One product has more value and gets more important than others. If so, more value product is main product and less value product is by-product.

16. Main product may not require any further processing. But, by-products may require further processing before they can be sold.

17. Both main product and by-products are valued under this method of costing.

18. Joint cost is apportioned to both main product and by-products on suitable basis.

19. A main product of one firm may be a by-product of another firm.

20. Output is uniform. Hence, the cost per unit of production can be ascertained only by averaging the expenditure incurred during a particular period.

21. Work in progress is converted into finished products through the cost of equivalent production.

Objectives of Process Costing

The chief objectives of process costing are listed below.

1. To determine the unit cost.

2. To determine the method of allocation of manufacturing costs incurred during a given period.

3. To allocate the accumulated materials, labour and factory overhead costs to process cost centers.

4. To express incomplete units in terms of completed units.

5. To give accounting treatment to process losses such as waste, scrap, defective goods and spoiled goods.

6. To differentiate the main product from by-product and joint product.

7. To give accounting treatment to joint product and by-product.

8. To calculate the cost of main product accurately.

Application of Process Costing

Generally, an industrial unit follows the process costing system where there are at least two production processes. In other words, the industrial units, which are following single production process, can apply operation-costing system instead of process costing system

Moreover, an industrial unit can apply operation costing system instead of process costing system even though these industrial units are not able apply process costing system and having at least two production processes.

The following are the examples of industries where process costing is applied.

Chemical works, Steel, Soap making, Oil refining, Box making, Textiles, Distillation process, Rubber, Paper mills, Paints, Beer, Coke works, Ink and Varnishing, Meat products factory, Milk diary, Biscuit works, Food products, Canning factory.

Process costing deals with the flow of units and costs through several stages or operations. As such, when the homogeneous products are produced through continuous process, a process costing system is usually appropriate.

Contract costing: Meaning, Features & Procedure

Contract Costing is otherwise called as terminal costing. It is one of the methods of Job Costing. Contract costing is also prospered just like job costing. A separate number is allotted to each contract and records are also maintained for each contract separately. The cost unit is each contract account.

The contract costing method is used mostly by builders, civil contractors, ship builders, and construction and mechanical engineering firms. Generally, the contract is undertaken at the site of contract i.e. customer and according to the specifications of customer. More over, the period inquired to complete a contract is fairly long time or usually more than one year.

The main purpose of preparing contract account is the ascertainment of cost of each contract separately and profit on each contract.

Features of Contract Costing

The following are the features of contract costing.

1. A contract is undertaken according to the specific requirements of customers.

2. Generally, the duration of a contract is long period.

3. The contract is undertaken only at the site of the customer.

4. Contract work mainly consists of construction activities.

5. The specific order costing principles are applied in contract costing.

6. The size of a contract is usually large or bigger than jobs.

7. It requires a long time to complete a contract.

8. Each contract is an independent one, quite distinct from another.

9. A distinctive number is assigned to each contract to differentiate the contract from one another.

10. A separate account is maintained and prepared for each contract to find out the profit earned from each contract separately.

11. If a contract is not completed at the end of the accounting period, only a portion of profit is transferred to profit and loss account on the basis of stage of completion of a contract.

12. There is no problem of under absorption and over absorption of overheads.

13. Every conceivable expenditure is charged to the concerned contract.

14. If the materials, plants and other inputs are transferred from one contract to another, the transfer may be affected by giving debit and credit to the respective contracts.

15. The proportion of indecent costs to total cost of a contract is very small.

16. A contractor may appoint a sub — contractor(s) for the execution of the work of the main contract.

17. The contractee i.e. the customer pays money only on the basis of the work certified by the architect, engineer or surveyor.

18. Escalation clause may be incorporated in the agreement of the contract. It so, the contractor is protected from any rises in the prices of materials, labour and other inputs.

Procedure of Contract Costing

In contract costing, most of the expenses are direct in nature as in the form of materials, labour, expenses, plant, sub-contract charges and the like. Only a small portion of amount is charged as overheads which are apportioned on suitable basis. Accounting treatment of costs of contract costing is briefly explained below.

1. Materials

The value of materials used is debited in the concerned contract account. Materials may be specifically purchased from the open market, issued from the stores, transfer from other contracts or supplied by the contractee himself. If materials are returned to stores, the value of materials is credited in the concerned contract account.

Sometimes, materials may be transferred from one contract to another. If so, the value of materials is debited in the receiving contract account and credited in the transferring contract account. Whenever the materials are purchased from the open market, the values of materials are debited in the concerned contract account.

Similarly, if materials are issued from stores, the concerned contract account is debited and the stores control account is credited. Sometimes, some materials may be stolen or destroyed by fire, the value of materials is credited in the concerned contract as stores account and the same is transferred to profit and loss Account.

2. Labour

Generally, the contract is carried on only at the site of the contractee i.e., customer not within the company premises. Hence, labour is engaged at site to work on the contract. The amount paid to workers is wages which is directly debited in the concerned contract account. The details of information regarding wages are obtained from the records of time sheet and wages sheet. Equitable base method is usually adopted to apportion the wages of supervisors working on two or more contracts.

Likewise, the overheads are also apportioned on suitable basis. The accrued wages and outstanding expenses are calculated at the end of the accounting period and debited in the concerned contract account.

3. Direct Expenses

The direct expenses are debited in the concerned contract account as and when they are incurred. Examples of direct expenses are hire charges paid for the plant procured from outside, sub-contractor’s charges, architect’s fees, electricity, insurance and the like.

4. Plant and Machinery

The plant and machinery is treated in two ways. Under first method, the full value of plant and machinery is debited in the concerned contract account if the plant and machinery is specifically purchased for the contract. At the end of contract, the plant and machinery may be sold out in the market if it is not required further. If so, the sale proceeds are credited in the concerned contract account.

Sometimes, the plant and machinery may be required further, if so, the depreciated value or revalued amount of plant and machinery is credited in the concerned contract account. The net effect is that the contract account is debited with the amount of depreciation.

Under second method, the contract account is debited with the amount of depreciation of plant and machinery. The plant and machinery may be purchased specifically from the open market or issued from the stores. The amount of depreciation is calculated on the basis of daily use or hourly basis. Sometimes, a plant is procured on hire basis, if so, only hourly charges are debited in the contract account.

5. Overheads

Indirect costs cannot be directly charged to any contract account. These costs are apportioned to all the contract accounts only on the suitable basis. These are called as overheads. The term overheads includes payment made to engineers, supervisors, architects, managers, store keeper, central office, administrative expenses like staff salaries, telephone expenses, postage, rent, stationery, advertisement expenses etc.

Job Costing: Meaning, Advantages and Limitations

Job costing is a method of costing applied in industries where production is measured in terms of completed jobs. Industries where job costing is generally applied are Printing Press. Automobile Garage, Repair workshops, Ship Building, Foundry and other similar manufacturing units which manufacture to customers’ specific requirements.

Job costing is a method of costing whereby cost is compiled for a job or work order. The production is against customer’s orders and not for stock. The cost is not related to the unit of production but is a cost for the job, e. g printing of 5000 ledger sheets, repairs of 50 equipment’s, instead of printing one sheet or repair of one equipment.

The elements of cost comprising Prime Cost viz. direct materials, direct labour and direct expenses are charged directly to the jobs concerned, the overhead charged to a job is an apportioned portion of the departmental overhead.

Advantages of Job Order Costing:

(i) Profitability of each job can be individually determined.

(ii) It provides a basis for estimating the cost of similar jobs which are to be taken in future.

(iii) It provides the detailed analysis of the cost of material, labour and overheads for each job as and when required.

(iv) Plant efficiency can be controlled by confining attention to costs relating to individual jobs.

(v) Spoilage and defective work can be identified with a specific job and responsibility for the same may be fixed on individuals.

(vi) By adopting pre-determined overhead rates in job costing, we can get all advantages of budgetary control.

(vii) Job costing is essential for cost-plus contract where contract price is determined directly on the basis of cost.

Limitations of Job Order Costing:

(1) It is expensive to operate as it requires considerable detailed clerical work.

(2) With the increase in the clerical work the chances of errors are increased.

(3) Job order costing cannot be efficiently operated without highly developed production control system. The job costing requires intricate factory organization system.

(4) The costs as ascertained are historical as they compiled after incidence and therefore does not provide control of cost unless it is used with standard costing system.

Batch Costing: Meaning, Need and Types

Batch costing is a form of specific order costing. Job costing refers to costing of jobs that are executed against specific orders whereas in batch costing items are manufactured for stock. A finished product may require different components for assembly and may be manufactured in economical batch lots.

When orders are received from different customers, there are common products among orders; then production orders may be issued for batches, consisting of a predetermined quantity of each type of product. Batch costing method is adopted in such cases to calculate the cost of each such batch.

Cost per unit is ascertained by dividing the total cost of a batch by number of items produced in that batch. In order to do that a Batch Cost Sheet is prepared. The preparation of Batch Cost Sheet is similar to that of Job Cost Sheet. This method is mainly applied in biscuits manufacture, garments manufacture, spare parts and component manufacture, pharmaceutical enterprises etc.

Types of Costs in Batch Costing:

There are two types of costs involved in Batch Costing:

(i) Set up costs

(ii) Carrying costs.

If the batch size is increased, set up cost per unit will come down and the carrying cost will increase. If the batch size is reduced, set up cost per unit will increase and the carrying cost will come down. Economic Batch quantity will balance both these opponent costs.

Difference Between Job Costing and Batch Costing:

In case of job costing, work is undertaken as an identifiable unit and cost of each job is ascertained separately. Such a method of costing is suitable in case of motor workshop, printing press and where manufacture of products is according to customers’ specific requirements.

Batch costing is extension of job costing. Job costing refers to costing of jobs that are executed against specific orders whereas in batch costing items are manufactured for stock. In batch costing a batch may represent a number of small orders passed through the factory in batches. Each batch is treated as a unit of cost and is separately costed. Cost per unit is ascertained by dividing the total cost of the batch by number of items produced in that batch.

Integral Accounting: Advantages, Principles and Essential Features

Integrated (or Integral Accounts) is the name given to a system whereby cost and financial accounts are kept in the same set of books. Obviously then there will be no separate set of books for costing and financial purposes. According to CIMA, ‘It is a system in which the financial and cost accounts are interlocked to ensure that all relevant expenditure is absorbed into the Cost Accounts’.

Integrated Accounts will have to afford full information required for costing as well as for financial accounts. In other words, information and data should be recorded in such a way as to enable the firm to ascertain the cost (together with the necessary analysis) of each product, job, process, operation or any other identifiable activity.

It should be possible to ascertain marginal cost, variances, abnormal losses and gains; in fact, all information that management requires from a system of costing for doing its work properly. It should also be possible to have accounts to see that the firm maintains full control over its assets and liabilities and to enable the firm to prepare the Profit and Loss Account and the Balance Sheet as required by law or for income-tax purposes at the end of each year.

Usually, financial accounts require expenditure and revenue to be recorded according to its nature rather than the benefit derived from it. Thus all salaries paid are recorded together. But for costing purposes, there must be detailed analysis functionally, that is, according to the identifiable unit of cost classification of expenses. Integrated Accounts record transactions so as to be able to collect and analyses information both ways.

Advantages of Integral Accounting:

1. There is no need to reconcile the profit ascertained by the cost accounts with that of financial accounts since only one profit and loss account is prepared from the information recorded in the cost accounts.

2. There is no duplication of recording and effort as in non-integral system and as such this system is simple and economical.

3. This system tends to co-ordinate the functions of different sections of the Accounts Department since all efforts are integrated and directed towards achievement of one aim that is providing a high level of efficiency.

4. The accounting procedures can be simplified and the system can be centralised with the object of achieving a greater control over the organisation.

5. The system creates conditions which are eminently suitable for the introduction of mechanised accounting.

6. There is no possibility of overlooking any expense under the system.

7. As cost accounts are posted straight from the books of original entry, there is no delay in obtaining the data.

8. There is automatic check on the correctness of the cost data. It ensures that all legitimate expenditure is included in Cost Accounts and reliable and proved data is provided to the management for its decisions.

9. Integrated accounting widens the outlook of the accountant and his staff and they can take broader view of things.

10. From psychological point of view, it shows the complimentary status of cost and financial accountant which need to be considered as separate watertight compartments.

Principles of (or Pre-Requisites for) an Integral Accounting System:

Following principles should be taken into consideration while designing such a system:

1. The degree of integration must be determined. Some undertakings find it satisfactory merely to integrate upto the stage of prime cost or factory cost while other concerns integrate the whole of the records in which cost and financial accounts cannot be distinguished.

2. The degree of integration will determine the classification of expenditure. The expenditure is classified here according to function as office expenses, selling expenses etc. and not according to nature. However, control accounts are maintained for each element of cost. A suitable coding system should be available to serve the accounting purposes of financial and cost accounts.

3. Full details of items posted to the control accounts are supplied to the cost office at convenient intervals. This information is then dealt with by the cost office in accordance with the system of costing in force.

4. The amount of detail recorded in the ledger is usually kept to a minimum, full information regarding each department or process being contained in tabulators prepared by the cost office. These tabulations are sometimes referred to as third entries to emphasise that they are not part of double entry system.

5. For preparation of interim accounts, there must be an agreed routine for treatment for accruals, prepaid expenses and other necessary adjustments.

6. There should be perfect co-ordination between the staff responsible for the financial and cost aspects to ensure an efficient processing of accounting documents.

7. A suitable coding system must be made available so as to serve the accounting purposes of financial and cost accounts.

Essential Features of Integral Accounting:

Following are the essential features of an integral accounting system:

1. This system records financial transactions not normally required for cost accounting besides recording internal costing transactions. That is why accounts for capital expenditure, sundry debtors and creditors, share capital, cash and bank transactions, prepayments and accruals are opened.

2. Stores transactions are recorded in the Stores Control Account. This account is debited with the cost of stores purchased, corresponding credit being given to cash or sundry creditors depending whether the purchase is made for cash or on credit.

3. Wages Control Account is debited with the wages paid, contra credit is taken in Cash or Bank Account.

4. Overhead expenses are debited to the Overhead Control Account, corresponding credit being given to Cash or Bank Account or the sundry creditors.

5. Transactions relating to material, labour and overheads are posted in the Stores, Wages and Overhead Control Account after making suitable cost analysis and at the end of the period transfer of the totals is made to the Work-in-Progress Account by crediting various control accounts. The day to-day cost analysis made for this purpose is known as making third entry. These entries do not mean entries in the same sense as entry of transactions in the ledger but such entries are simply a sort of cash analysis.

6. All advance payments are credited and accruals debited to the respective control accounts by contra entries in the prepayments and accrual accounts.

7. Capital Asset Account is debited and respective control accounts are credited in the process of cost analysis for capital expenditure.

Non-Integral Accounting System

Non-integral system is a system of accounting under which two separate sets of account books are maintained—one for cost accounts and the other for financial accounts. In other words, cost accounts are maintained separately from financial accounts.

Since separate ledgers are maintained for cost and financial accounts in this system, the cost accountant is responsible for recording of the cost accounting transactions and the financial accountant is responsible for financial transactions.

Non-integral system of accounting is also known as non-integrated system or Inter-locking system or Cost Ledger Accounting system. CIMA, London defines Non-integral system as a system in which the cost accounts are distinct from financial accounts, the two sets of accounts being kept continuously in agreement by the use of control accounts or made readily reconcilable by other means.

Basic Features of Non-Integral System:

(i) Separate ledgers are maintained for cost and financial accounts.

(ii) Like financial accounting, it is also based on double entry system.

(iii) There are no personal accounts because cost accounts do not show relationship with outsiders.

(iv) Cost accounts are concerned with impersonal accounts i.e., real and nominal accounts.

(v) In real accounts, only stocks are shown in cost accounts.

(vi) Transactions affecting the nominal accounts are recorded separately in detail. Thus cost accounting department is concerned mainly with the ascertainment of income and expenditure of business,

(vii) Under this system one main ledger (i.e., Cost Ledger) and various subsidiary ledgers are maintained,

(viii) Since the system is not properly integrated, some items may appear in financial ledgers only, while some other items appear only in cost ledger,

(ix) The profit or loss disclosed by the two sets of accounts for a particular period will never be the same and as such a reconciliation of costing profit or loss with that of financial accounts is essential.

Ledgers under Non-Integral Accounts:

(a) The principal financial ledgers are:

(i) General Ledger:

It contains all real, nominal and personal accounts except trade debtors and trade creditors account.

(ii) Debtors Ledger:

It has personal accounts of trade debtors.

(iii) Creditors Ledger:

It has personal accounts of trade creditors.

(b) The principal cost ledgers are:

(i) Cost Ledger:

It is the principal ledger in cost books which controls all other ledgers in the costing department. It contains all impersonal accounts and is similar to General Ledger of financial accounts.

(ii) Stores Ledger:

It is a subsidiary ledger. It contains all stores accounts.

(iii) Work-in-Progress Ledger:

It is a subsidiary ledger. It contains a separate account for each job in progress. Each such account is debited with the materials costs, wages and overheads chargeable to the jobs and credited with the cost of work completed. The balance in this account shows the cost of uncertified work.

(iv) Finished Goods Ledger:

It is a subsidiary ledger. It contains accounts of completely finished goods and jobs. The cost ledger is made self-balancing by opening a control account for each of the above subsidiary ledgers.

International Financial Management

MBA FM-01

Question from Unit I

Q.1: How did the US position of the balance of payments influence the whole international monetary system under the Bretton Woods system?

Q.2: Recapitulate the historical development in international monetary system.

Q.3: What is the role of World Bank and International Monetary System?

Q.4: Discuss the salient features of different international markets.

Q.5: What is the role of financial intermediaries in foreign exchange market?

Question from Unit II

Q.1: Who are the major participants in a foreign exchange market?

Q.2: How do spot and forward markets differ from each other?

Q.3: Explain the theory of purchasing power parity (PPP) and Mint power parity theory with suitable numerical examples.

Q.4: What are the basis of currency forecasting and also discuss the methods for forecasting exchange rates?

Q.5: Explain the Interest Rate Parity and International Fisher Effect of international foreign exchange rate theory in detail.

Question from Unit III

Q.1: What type of exchange exposures is a multinational enterprise subjected to?

Q.2: What are the internal techniques of hedging?

Q.3: Which external techniques of exchange risk management are you familiar with?

Q.4: Explain the different types of risks in foreign exchange market?

Q.5: How transaction, consolidation and economic exposure is to be evaluated?

Question from Unit IV

Q.1: Discuss the various money market instruments in detail?

Q.2: What are the various capital market instruments and how these are traded in foreign exchange market?

Q.3: What are the Innovations in International Financial Instruments?

Q.4: How does balance of payment accounting establish a link between national economy and international activities?

Q.5: What economic factors affect balance of payments?

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