ENGINEERING ECONOMICS
&
COSTING
Courses of Studies
Subject: Engineering Economics & Costing
Module I
Time Value of Money- Simple and Compound Interest, Time Value equivalent, Compound
Interest Factor, Cash Flow Diagram, Calculation of Time Value Equivalent
Present worth Comparison, Comparison of Assets with equal, unequal and infinite life, and
Future worth comparison, Payback Period Comparison
Module II
Internal Rate of Return, Comparison of IRR with other methods, Analysis of Public Projects,
Benefit Cost Analysis, Qualification of Project, Cost effectiveness Analysis
Module III
Depreciation, Computing Depreciation Charges, After Tax Economic Comparison, Break Even
Point, Linear and Non Linear Model, Sensitivity Analysis, Single and Multiple Parameter
Analysis,
Module IV
Fixed and Variable Cost, Product and Process Costing, Standard Costing, Cost Estimation,
Relevant Cost for decision-making, Cost Control and Cost Reduction Techniques.
Time Value of Money
Value of money means purchasing power of money or what a unit of money can purchase. Time
value of money says that money has a time value because it gives liquidity and an opportunity to
invest it and earn return on it. The return of money is known as interest. Whatever a rupee earn
today is not same at tomorrow. Money today valued more than the tomorrow
A sum of Rs 10000/- received today is not same, if it is received after 5 years. The value of the
money after 5 years is less. Rs 10000/- invested today will give a higher amount after 5 years.
When the interest is again reinvested it is called compounding. For example:
At 10% interest
Rs. 10,000/- becomes Rs. 11,000/- (Rs 10,000 x 110%) at the end of one year.
Rs. 11,000/- becomes Rs. 12,100/- (Rs. 11,000 x 110%) at the end of second year.
Otherwise Rs. 10,000/- becomes Rs. 12,100/- at the end of second year.
Now, suppose we want to get Rs 10000/- at the end of 2nd year. How much we should invest now
if the interest rate is 10%?
It is Rs. 12,000 x 100/121= Rs 8,264/Rs. 10,000/- after 2 years is Rs 8,264/- now. This concept of arriving at present investment from a
specified return after 2 years is called discounting.
This is very important for financial decision making because interest factor will be there for every
investment and decisions are always future oriented. Assets purchased today will give returns for
the future years and we will have to find out the value of such return in today’s worth by
discounting. If we discount the future returns only then it can be comparable against present
investment.
Conceptually money received at different times is different in value. Interest out of the investment
is reinvested. In financial decision making compounding and discounting of money may be
required to be done. Different projects give different returns and can be comparable only if time
value of money is considered.
Interest :
Everybody knows that if money is given to a person having no relationship of love and affection,
Interest will be received by the person giving the money. The amount given by the lender is called
principal and the amount paid back by the borrower is principal and interest. Interest is calculated
as a percentage of the principal.
The reasons for payment of interest are
i)
Lender collects it for maintaining the fund
ii)
Cover the risk of non – repayment by the borrower.
iii)
Compensate the alternative use of such fund.
iv)
Benefit given to the borrower for getting some return out of the fund.
Simple Interest :
This is charged straightway on the principal.
Interest, I = PiN
Where P = Principal, i = rate of interest & N = number of years.
Let us take an example:
A lends Rs 25000/- to B at an interest rate of 10% for 2 years.
B should pay an interest of 25000x10%x2=Rs. 5000 along with the principal at the end of the two
years.
Compound Interest :
In the above example the interest earned at the end of first year is 25000x10%x1= Rs 2500
This is available for reinvestment at the end of the first year. This is not part of the principal. When
we consider the reinvestment of the interest earned at a particular period it is called compound
interest.
Formula for compound interest = F=P(1+i)n
Example : In the above example if the interest is compounded annually interest amount will be
Ist year = 25000x10%x1=2500 on principal
2nd year= 25000x10%x1=2500 on principal
2nd Year = 2500x10%x1= 250 on interest
So the total amount of compound interest = Rs 5250
Nominal Interest & Effective Interest : Normally interest is always expressed on annual basis but
sometimes it is expressed on semi-annually,quarterly,periodically,weekly or even days basis. This
type of interest is known as Nominal interest.
Example: For half yearly-F=P(1+i/2)2
For Quarterly- F=p(1+i/4)4
For monthly- F=P(1+i/12)12
For days
- F=p(1+i/365)365
An effective interest rate is expressed on the basis of actual interest paid.
Effective interest =1. (1+r/n)n-1
= 2. F-P (where p-present value, F- future value)
P
For example : Rs 1000/- invested at a nominal interest rate of 8%, compounded half yearly will
give us
i)
4% interest for the 1st half year on Rs 1000/ii)
and 4% on interest of 1st half year and Rs 1000/-, compounded in the second half year.
It will give us 1000(1+.04)2= 108.16
Interest = 108.16-100= Rs 8.16
So we will observe in the above example nominal interest is Rs 8 and effective interest is Rs 8.16.
Continuous Compounding
In the above case interest is compounded half yearly. Like that it can be compared quarterly,
bimonthly, monthly, biweekly, weekly and daily. When interest is accumulated on hourly basis or
still smaller time duration it leads to infinity. This is called continuous compounding.
Formula. Lim (1+r/m)m-1
m-@
COMPOUND INTEREST FORMULA
Single Payment compound interest: F=P(1+i)n
Single Payment Present Worth:
P=F/(1+i)n
Equal Payment Sinking Fund Factor :
A continuous investment every year to find out a
specified future amount is called sinking fund factor.
A= F( i/((1+i)n-1))
Example : An amount of Rs 10000/- receivable after 5 years with an interest rate of 10% will give
us
A= 10000(0.1/((1+.1)5-1))=1638
Equal Payment Annuity Factor ( Series Compound Amount )
An uniform continuous specified investment every year will give us an annuity factor of the
investment
F= A( ((1+i)n-1)/i)
A continuous investment of Rs 2000/- every year for 5 years at the rate of 10% will give us
F =2000( ( 1+.01)5-1)/.01) = 12210.20
Equal Payment Capital Recovery Factor :
It finds out future installment to be paid to pay back a present loan when interest rate and
number of years is specified
Formula = A = P(i(1+i)n)/((1+i)n-1))
Example : An amount of Rs 10000/- payable now to be paid off in 5 years with an interest rate of
10% is
A = 10000 ((0.1(1+0.1)5)/((1+0.1)5-1))= 2638.
Equal Payment Series Present worth factor :
The present value of a uniform payment with a specified rate of interest and duration is found out
by the series present worth factor
Example : An amount of Rs 2000/- invested every year for period of 5 years at the rate of 10% will
give us
A= P (i(1+i)n/((1+i)n-1)= 2000(.1(1+.1)5/((1+.1)5-1= 7581.40
Arithmetic Gradient Conversion Factor :
Sometimes a continuous series of payment increases at an uniform rate. Present worth of such
payment can be found out by using the formula
A’+G((1/i-(n/((1+i)n-1))
Example : An initial amount of Rs 2000/- increasing every year at the rate of Rs 1000/- discounted
at the rate of 10% for five years is equivalent to
2000+( 1000(1/.1-(5/(1+.1)5-1)= 3810 to be invested every year for five years.
Geometric Gradient Conversion factor
P=A1(1-(1+i)n(1+g)-n
i-g
It can also be found out by the formula given above.
SL No Factor
1
Compound Amount
To Find
Future Worth(F)
2
Present Worth
Present Worth(P)
3
Sinking Fund
4
5
Series
Amount
Capital Recovery
6
Series Present Worth
7
Arithmetic Gradient Annuity
Conversion
Amount(A)
8
Geometric Gradient Annuity
Conversion factor
Amount(A)
Annuity
Amount(A)
Compound Future Worth(F)
Annuity
Amount(A)
Present Worth(P)
Given
Present
Amount(P)
Future
Amount(F)
Future
Amount(F)
Annuity
Amount(A)
Present
Worth(P)
Annuity
Amount(A)
Uniform
Gradient
Amount(G)
Uniform
Gradient
Amount(G)
Formula
F=P(1+i)n
P=
F
(1+i)n
A=F(1+i)n-1
i
F= A( i
)
(1+i)n-1
A = P(i(1+i)n)/((1+i)n1))
A= P (i(1+i)n/((1+i)n1)=
A’+G((1/i-(n/((1+i)n1))
P=A1(1-(1+i)n(1+g)-n
i-g
Cash Flow Diagrams :
Cash flow means both cash inflow and cash outflow. The cash flow diagram is the visual
representation of both cash inflow and cash outflow. The cash inflow means
income/benefits/profits whereas cash outflow means expenditures/losses. The difference
between cash inflow and cash outflow is known as Net cash flow
Cash inflow
Cash outflow
Cash inflow is received over a period of time . cash outflow is done once during the start of the
project over a period of time . Both the inflow and outflow can be experienced in drastically
different ways ;
1) Inflow may be uniform during the life of the project.
2) It may be more at the beginning and less towards the end.
3) It may be less at the beginning and increase gradually.
4) Cash outlay may be once before the beginning of the project.
5) It may also be invested in two to three years at the beginning.
6) The project may have huge investment at the beginning and later on intermittently smaller
amounts may be invested.
Types of Cash flow
There are five types of Cash flows.
1. Single payment cashflow
2. Uniform series cashflow
3. Linear Gradient cashflow
4. Geometric Gradient cashflow
5. Irregular series cashflow.
The project viability analysis does not represent the pattern of cash inflow or outflow. So a
pictorial diagram is necessary to provide the mode of cash flow.
It is explained by putting a horizontal straight line representing time. Cash inflow is
represented in upward direction vertically on the time line.
Let us take an example of Rs 200000/- invested in a project for which cash inflow is received in
five years amounting 40000, 30000,70000,60000,80000. This will be represented as shown in the
diagram. We must observe that the lengths of the individual lines are as per the volume of the
cash inflow and outflow. Same way when we consider loan received from a bank amounting
rs 200000 and installment of Rs 45000/- paid for five years, it will be presented as shown in
diagram 2. the cash inflow at the beginning is shown in upward direction and repayment of
loan is presented in downward direction. The interest factor may be written above the cash
flow diagram for providing more information.
Q1. An amount of Rs 10000/- is invested for a period of 15 months with an interest rate of 7%.
How much interest and future amount is due at the end of the period?
Q2. A shopkeeper borrowed Rs 40000/- on 1st January 2003 and Rs 50000/- on 1st July 2003
with an interest rate of 8%. How much he should pay on 31st December 2004 to pay off all his
dues? How much is the interest component of the above loan?
Q3. Raju , the lender gave loan of R0s 100000/- to Hari on 1st January 2004. He also extended a
loan of Rs 200000 to Rohan on 1st April 2005. What is the amount receivable by him on 31st
December 2006, if rate of interest is 12% ?
Q4. A sum of Rs 200000/- will command Rs 300000/- afer 5 years. Determine rate of interest if
simple interest is charged on the loan amount .
Q5. Find out the principal amount of an investment if the repayment amount alongwith the
interest is 45000/- ,when simple interest rate is 20% and number of years is 5 years.
Q6. For how many years an amount should be invested to give the repayment amount one and
half times when interest rate is 10% ?
Q7. Govind invested Rs 80000/- in cumulative deposit scheme for three years period with
interest rate of 10% . Find out the accumulated balance at the end of the period if interest is
cumulated annually.
Q8. In Q7. if nomial rate of interest is 10% and intererest is cumulated half yearly what will be
the interest component in the investment ?
Q9. An amount of Rs 20000/- is invested with 10% interest . Find out interest to be received if
it is compounded 1) annually 2)n Half Yearly 3) Quarterly 4) Bimonthly 5) and monthly for a
period of two years.
Q10. How much nominal interest will command an effective interest rate of 39.12% ?
Q11. A lender extends two options to a borrower. 1) 20% interest compounded annually 2)
18% interest compounded quarterly. Which option will be beneficial to the borrower ?
Q 12. An investment gives Rs 829.58 in 5 years with 5% interest . How much should be
received if the interest rate is 8% ?
Q13. How much interest will be received on an investment of Rs 10000/- for 2 years if the
interest is compounded continuously and nominal interest rate is 10%. ?
Q14. Jyoti is expecting the follwing returns in the coming 5 years .
Year
1
2
3
4
5
Amount(Rs)
20000
30000
25000
40000
50000
He wants to know an equivalent amount of money if it is received today .
Q15. How much should be invested uniformly for a period of 7 years to give a return of 20000 ?
Q16. Sanjeev invested Rs 5000/- in a recurring deposit with an interest rate of 12%.How much he
should get after 5 years if the interest is cumulated half yearly ?
Q17. Uma plans to invest Rs 25000/- every year for 4 years. He wants to know an equivalent
amount , he should accept from a banker if it is pledged with an interest of 8 % and the banker
charges Rs 500 as his administrative expenses .
Q 18. A sum of rs 75000/- is to be received in 5 years with an interest rate of 15 % . Find out the
equivalent uniform amount for the present worth of this 75000/Q19. Satya expecting the return of 8000/- in the first year from a coffee plantation. If the return
increases rs 2000 every year find out the uniform return he should expect from another venture if
interest rate is 14 % and time period is 5 years .
Q20.Draw a cash flow diagram of an investment if cash outlay is Rs 50000 and return in 5 years is
15000,18000,18000,20000,20000 respectively.
Equivalence
Two things or two situations are said to be equivalent only at a common base or when they
produce the same effect.
Time value Equivalent : Comparison of different investment proposals needed to be compared for
judging the best alternative available.
There are three type of equivalence
1. Present value equivalence
2. Future value equivalence
3. Annual value equivalence.
For example project A gives Rs 1100/- after one year and project B gives Rs 1000/- today. If the
interest rate is 8%
Rs 1000/- gives Rs 1080 after one year . When we compare both the projects project A is acceptable
because the return in money terms is higher .
Although through time value equivalent two alternatives are to be equated, seldom have such
situations arisen in real life. Rather what is desirable is deriving compounded or discounted
value of alternatives and compare it with the other to find the better one. Money value can be
expressed in several equivalence other than simple interest and compound interest.
Project Analysis
Engineers are involved in project selection and implementation throughout their career. Projects
are dissimilar in nature thereby giving discrete cash inflows. They will have to bring the cash
flows of different projects into common parameters to compare them. The usual way of comparing
the projects are done through finding out their present value by discounting the cashflows and
deciding the acceptability of the projects.
Example : Project A and B are having the following cashflows during a period of five years.
Year
Cash outflow 0
Cash Inflow 1
2
3
4
5
Project A
70000
25000
20000
18000
16000
14000
Project B
90000
30000
35000
35000
10000
5000
If the cost of capital ( prevalent interest expectation) is 12% the acceptability of the project can be
decided as follows :
The engineer has to do certain amount of estimation to determine the future return , interest rate,
project outlay before going ahead with the analysis. The interest expected by the investor is not
necessarily the present interest rate in the market. It is the minimum rate of interest expected from
the project. It depends on the following factors:
1) Type of industry : The industry can be divided into core sector, manufacturing services,
software and communication. The cost of capital may vary from 7% in core sector to 25% in
communication. So the engineer will determine the rate accordingly.
2) Location : In western and European countries products are very competitive. Hence the
entrepreneur should keep the cost of capital at low rate. In other part of the world a better
return may be expected.
3) Competition : Certain products are having more competitor than the other. As we observe
petroleum products are less competitive in India in comparison to consumer products.
Rate of return in products having more competition are less because the produce operate
in low margin.
Cash flow diagram ………….
Basing on the present worth comparison projects is selected. The project also gives cash inflow at
the end of its life period through salvage value (scrap value at the end of the project). Selection of
the project and salvage value will be discussed in next chapter.
Comparison of Assets with equal ,unequal and infinite life
When alternatives projects have the same life period it is called co terminated projects. But in real
life it is not possible to find out investment avenues having equal lives. In order to compare
projects having unequal lives certain methods are adopted.
Common multiple method : The project lives are brought into a least common multiple factor to
make them comparable.
Example :
Three projects are under consideration by the project division of a manufacturing unit. They have
the following cash flows.
Year
Project A
Project B
Project C
Cash Outflow 0
15000
35000
55000
Cash Inflow
25000
20000
20000
30000
25000
1
2
3
30000
The rate of interest considered is 10%. This method assumes that when life period of project is
over another project having the same life and investment comes to existence. Practically the same
project may not be repeated due to obsolescence of technology.
Study period Method : Here the shorter of the life period between the projects is considered for
study. The alternate projects act in full swing during the study period. This is an advantage of this
kind of analysis. The main problem lying with this method is , salvage value of asset having the
longer life should be considered at the end of the study period. It is not always possible to make
such estimation.
Example : If in the above problem we consider two projects B and C and the salvage value of
project C is 20000 at the end of 2nd year the selection of the project will be as follows :
Fixed duration method : Under this method project life is predetermined for all projects
irrespective of its life period . But it can not be applicable to projects having wide difference in
terms of life period.
Replacement Method : This method indicates a time span by which technology and requirement
necessitates the replacement of the asset. In case of all study period method the assets are
presumed to be sold off at the end of the project period. So like the study period method it is very
important to determine the salvage value of the asset.
Asset having infinite life : Railways, tunnels, dams, roads, embankments are constructed to last
for ever. The cash inflow involved in a project is called capitalized cost. It is determined as
Disbursement
Capitalized Cost = Principal Amount + -------------------Interest
Example :1 A dam was built at an initial cost of 100 crores and a sum of 5 crores is required for the
maintenance of the project. How much money is required for the total project if the interest rate is
10%.
Ans :
Example 2 : A project has a total cost of Rs 20 lakhs . How much should be invested in building
the project , if the interest rate is 12% and annual maintenance cost is 50000.
Ans :
Deferred Investment: Sometimes a project may be having alternatives of execution in short term
and long term basis . It may also happen to find out a short solution to a problem and later on go
for a long term solution. During epidemic Public Health Department may have to build
temporary sheds for immediate treatment of the patients. Although the construction of sheds is
not financially viable, due to urgent necessity it has to be constructed. Sometimes employment
generation is also a consideration while deciding on unviable projects. When the major investment
is delayed to accommodate the immediate solution it is called deferred investment proposal.
Example : Bhubaneswar Municipality authority is planning to set up a hospital in each of the eight
sector of the city. Each hospital has an initial capital outlay of Rs 1000000/- . The recurring
expenses of the project in each year for the hospital is Rs 125000/- . It is expected that a sum of Rs
50000/- can be collected as patient entry fees. United Nations has given a sanction of 16
dispensaries with a project cost of Rs 600000/- and overhead expenses of Rs 80000/- at each
dispensary. No collection will be made from the dispensaries. The two project proposals can be
evaluated as follows :
Ans………..
Example : An Engineer is given the responsibility of construction of a village road. Larsen and
Tubro has offered to construct it at a cost of Rs 2500000/- and to maintain it Rs 75000/- per year.
On the other hand the state government prefers to construct it in food for work programme at
initial capital cost of Rs 1000000/- and annual maintenance cost of Rs 250000/-. The central
government will compensate the differential amount invested extra in the second alternative. Find
out how much amount should be billed to the central government if interest rate is 10% ?
Future worth Comparison :
The concept of future worth comparison is common place in banking, insurance and retirement
benefits. Project evaluation is usually based on present worth comparison because execution of the
project is done at present. While future worth comparison are useful for requirement at a later
date. It is also useful for organizations procuring funds from outside sources.
Future worth comparison are done on the basis of compound interest formula.
FW= PW(1+i)n
Example : Mr Sudhansu has got offer from two employers as follows ;
Employer 1 : Rs 25000/- salary per month and retirement benefit of Rs 500000/- after 5 yearss.
Employer 2 : Rs 20000/- salary per month and Rs 800000/- retirement benefit after 5 years.
Which option is available for Mr Sudhansu if interest rate is 12%.
Example 2: Pradeep and Co, have taken a loan of Rs 5 lakhs from a bank. The interest rate of the
above loan is 15% . Another option is also available where they can borrow Rs 110000/- every year
at a interest rate of 10%. Which option should be adopted if all the fund is spent in the project ?
Payback Comparison Method :
Payback method of analysis determines the number of years required to get back the investment
in the project. It is the simplest method of determining the acceptability of a project. The cash
inflow of a project may be constant or variable. In case of constant cash flow
Investment
PBC = ----------------------------------------Constant Annual Cash flow.
Example : In a project Rs 120000/- is invested with a constant Annual return of Rs 10000/- per
year . Payback period is
Rs 1200000/PB = ------------------------------------------ = 10 years.
Rs 10000/Otherwise the investor can get back his investment in a span of 10 years.
In case of unequal cash flow the pay back period is found out by adding up the cash inflow.
Example 2 : A project require an investment of Rs 200000/- . Cash inflow from the project is
respectively Rs 40000/-, Rs 60000/-, Rs 80000/- Rs 80000/- & Rs 60000/- for 5 years.
An amount of Rs 40000/-+ Rs 60000/-+ Rs 80000/- = Rs 180000/- is recovered in three years.
Balance 20000/- can be recovered in Rs 20000/80000*12 = 3 months of the fourth year.
Hence payback period = 3 years 3months.
Selection procedure : Payback period may be compared with a predetermined period viewed as
ideal. It can also be used to compare among alternative projects. In general payback period is used
for preliminary screening of number of projects.
Merits :
1) It is easy to calculate and understand.
2) It is an improvement on evaluation through profit because it considers cash flow for the
purpose of analysis.
3) For preliminary elimination of projects payback period is very helpful.
Demerits :
1) It does not considers the entire life of the project.
2) As we observe for the example given above, the payback period is 3 years three months
although the project is giving cash inflow for five years.
3) It ignores the time value of money , thereby the pattern of investment.
Example : Two projects have the following cash flow.
Year
Project A:
Project B :
Amount in Rs.
1
2
3
4
5
20000 30000 40000 40000 50000
60000 50000 30000 20000 20000
As we observe project B is preferable because we get higher cash flow during the initial
years. But in payback period method, both are treated with same weightage.
Financial Viability of a project
In day to day business the managers take several decisions. Among all the decisions acceptability
of a project is most crucial, because it involves huge amount of money and the existence of
business depends on the project. The manager will have to decide whether the product will sale,
material will be available, personnel will be available to run the business, machinery and technical
know-how will be available and last but not the least whether the project will be profitable.
Profitability of a project is decided on the excess of income over the expenses. But in the initial
year of the project what is important for the project is how it can sustain in the market by having
enough cash resources. Secondly there are certain non cash expenses like depreciation which are
not actually incurred but shown as expenses for accounting purpose. So all non cash expenses
should be added and all non cash income should be deducted from the profit to determine the
viability of the project. It is important to remember cash- flow is important for financial viability of
the project and not profit.
Payback Period: It is a traditional method of defining the financial viability of a project.
1) It finds out the number of years required to recover the capital investment of a project.
2) The cash flow is considered in its actual value without considering the discounting factor.
3) It is expressed in number of years.
4) It is a simple method and a rough estimate of appraisal of a project.
5) It does not consider the salvage value of the asset.
6) Interest payment against the loan of the project is ignored while calculating the cash flow
of the project.
7) Cash flow for the project may be uniform or may vary.
8) The project will be accepted if the payback period is less than the ideal pay back period of
the project as conceived by the management. In case of alternative projects the shortest
project is considered as the accepted project.
Example 1 : A bridge is constructed over the Mahanadi river at a cost of Rs 50 crores. The
government estimates that an uniform collection of toll charges @ Rs 4 crores is possible in the
coming 25 years . Find out the payback period of the project.
Payback period = Rs 50 crores/ Rs 4 crores = 12.5 years.
Example 2. A brick kiln was installed at a project cost of Rs 10, 00,000/- . Find out the payback
period if the kiln gives a return of Rs 200000/- , Rs 400000/ , Rs 500000/- and Rs 400000/respectively in the first four years of its operation.
Return for the first two years = Rs 200000/- + Rs 400000/- = Rs 600000/The rest 400000/- can be recovered in Rs 400000/- / Rs 500000/- = .8 years.
So payback period = 2.8 years.
Example 3 : A project had an investment of Rs 1200000/- and Rs 800000/- for two years. From the
second year the project gave a return of Rs 800000/-, Rs 800000/-, Rs 100000/- and Rs 800000/- for
four years. The expenses incurred are Rs 200000/-, Rs 400000/-, Rs 600000/-, Rs 400000/including interest of Rs 50000/- and depreciation of Rs 50000/- every year. Find out the payback
period of the project.
Particulars
Year 1
Year 2
Year 3
Year 4
1.Revenue
8
8
10
8
2.Expenses
2
4
6
4
3.Depreciation
.5
.5
.5
.5
4.Interest
.5
.5
.5
.5
7
5
5
5
5.Net cash inflow(1-2+3+4)
Payback period = 3.2 year considering the recovery of the investment from year 1 onwards.
Internal rate of return :
The rate at which the discounted cash inflow of the project is equal to the discounted cash outflow
is called internal rate of return.(IRR)
Internal rate of return =
1) It is determined in terms of a rate of return.
2) The basic presumption is that the return derived from the project is reinvested in the
project again at the same rate.
3)
Otherwise the Net Present Value of the project is Zero if we consider the internal rate of
return.
4) Cash outflow is not discounted if it is invested at one point of time before return has
started to come. Otherwise cash outflow is also discounted to find out the zero net present
value.
5) The project will be accepted if the internal rate of return is more than the cost of capital of
the project. The minimum rate of return expected by the investor is defined as the cost of
capital of the project.
Net Present Value :
The difference between the discounted cash inflow and cash outflow of a project is termed as Net
Present Value. It takes into consideration the time value of money to find out the return on
investment.
Characteristics:
1) It is determined in terms of monetary value.
2) The basic presumption is that the return derived from the project is reinvested in the
project again at the cost of capital.
3) Cash outflow is not discounted if it is invested at one point of time before return has
started to come. Otherwise cash outflow is also discounted to find out the zero net present
value.
4) The project will be accepted if the net present value is positive. The minimum rate of return
expected by the investor is defined as the cost of capital of the project.
Method of calculation:
1) The minimum rate of return expected by the investor to adopt the project should be
determined. This rate of return is called the cost of capital. Often this rate is treated as the
prevailing interest rate in the market. But the investment analyst should understand that if
the individual is satisfied with the rate of interest why he should go for a venture by taking
risk. So a suitable rate which satisfies the expectation of the investor should be taken to
consideration.
2) The cash outflow in the project should be determined. It is also termed as cost of the project
. The cash outflow may be in terms of one time investment or spread over a period of time.
If the investment is done once for all it need not be discounted. But if it is spread over a
period of time the investment in later years are to be discounted considering the start of
investment as year Zero.
3) The return from the project is to be determined taking into consideration all the recurring
expenses and income. Here the difference cash outflow and expenses.
Misconception -- I R R lead to several misconception or wrong interpretation which may be
explained as follows.
When a project has got huge cash inflow at the end of the project period ,N P V & the I R R
give contradictory results.
Let us take as example -:
Two mutually exclusive projects are considered with the following cash flow.
X
0
-1000
1
100
2
350
3
600
4
850
X
-1000
1000
200
200
200
NPV
NPV
IRR
IRR
of
of
of
of
project
project
project
Project
x=
y=
x=
Y=
Rs 411.52
Rs 361.24
20%
25%
If we considered NPV as the deciding criteria of accept in the project x will be accepted where
as if IRR is considered Y will be accepted. This gives a contradictor decision for accepting the
project in this case usually NPV is considered as the deciding criteria as IRR is based on a
froctuating rate .
In certain cases there may be dual internal rate of return when the investment is no simple
usually the cash flow comes in the middle of the project . Although its occurence is observed
very often ,the conceptual background lead to misconception .
Explicit investment rate -:
The basic background behind calculation of IRR is the profit earned from the project
is reinvested again at the same rate as the project . But in practical term it is not possible . The
extra profit may not give the same return as the project . SoNPV is many times preferred over
IRR for the above resin.
Project with unequal lives :-
IRR does not take into consideration. The projects having different life periods.
Let us take an example.
0
-10,000
1
15,000
2
500
3
A
B
-10,000
5,000
4,000
6,000
4
3,000
Although these two projects are comparable in terms of their net cash flow , a finance manger
will always go for project A as he gets the return at an early date . The multiple project method
may be considered projects for a definite period of time but this is not a solution to give pragmatic
decision on acceptance of the project.
Social Project
Benefit cost analysis basically focus on the revenue and cost factor of the project.
Besides the minority factor several other factors are also important for deciding acceptability of
the project.
I) Impact on the target population -Every country plans to remove poverty ,so white considering the project it most
be seen that poor people are benefited most from the project rural electrification , sanitation
and cleaning in long areas , public distribution system are examples of projects where cost
effective should be adopted .
ii) Environmental factors – Day by day the worlds is going to polluted and destroy by the
toxic gases, generated from our commercial project. G o v t while going ahead should look into
the environmental factor and may decide against project if it is not environmentally suitable.
EX—clearing of river Ganga.
Conserving of Tajmahal.
Iii ) National security -- No project will be accepted under any circumstances it hampers
national security of the country.
Besides these measure points focus on under developed areas, protected Industries,
national and communal harmony also came into picture and part of the cost effective analysis.
2// Cost benefit analysis :Govt organization are engaged in social activities like building roads, dame ,
projects which are beneficial for the society at list. These projects cannot be considered on the
basis of commercial acceptability like NPV & IRR .We will have to find out the ratio of benefit
and cost which may not be greater them one always. But this type of analysis helps us to ran
the project in terms of their utility. Besides the
I ) Minimum investment --:
A resource in the hands of GOVT is usually scare. So GOVT will have to look into the
investment criteria with at most important projects having less investment are preferred by
GOVT agenesis . Even if the benefit are not ascribed over a long period of time .
Ii ) Maximum benefit --:
Irrigation project, roads and railways are analyzed on the basis of benefit derived from them.
Period of construction , investment involved , cost overrun are side line to give max m benefit to
me society .
Iii ) Aspiration level --:
Every social project has got certain label of expectation both by the people and the GOVT .
Political consideration also over shadow economic view point.
Ex—In our country many times facilities are developed in densely populated area because it
caters to huge no of people .
Iv ) Maximum advantage on benefit over cost --:
This criterion considers the volume of benefit gained by the project. Although this is not
justifiable when GOVT have surplus money to invest, this criterion may guide project proposals.
V) Benefit cost ratio:
It gives relativity and just decision making guideline as adopted in commercial organization.
vi) Incremental advantage:
Government planning is based on 10-15 years long turn perspective . Ex – Town planning of
BBSR should aim at a population 20lakhs and should not look into the immediate effect of the
project.
Depreciation
Depreciation is the reduction in value of asset due to wear and tear, obsolescence, and passage of
time.
Reason for depreciation:
Wear and tear: The value of assets decrease due to its constant use . The more the machinery is in
use more will be the wear and tear. The wear and tear of machinery in use for three shifts will be
much more than the machinery being use in a single shift. So in the Income Tax Act, more
depreciation is allowed on assets working for more number of shifts.
Exhaustion: Certain Assets loose their value with lapse of time as they are being used or
consumed or something is taken out of them i.e. mines. The minerals in mines will be exhausted
by constant extraction. So also will be the case with plantations.
Efflux ion of time: The lapse of time also affects the value of an asset. The value of some of the
assets is directly linked with lapse of time e.g. patents, lease hold property etc. A patent become
useless after the expiry of the period of patent.
Obsolescence: New innovation and technology also bring a fall in the value of assets. The
outdated technology becomes cheaper. The loss in the value of an asset on account of innovation
and newer technology is called obsolescence.
Other factors: Certain assets loose their value when their exposed to rain and weather. So an asset
purchased before five years and not in use will command depreciation every year as its value goes
down.
Permanent fall in the value of an asset: Many times the value of an asset declines permanently
which ought to be considered while determining the quantum of depreciation. However a
temporary decline can not be treated as depreciation.
Factor determining depreciation
Perfectly correct amount of depreciation chargeable is difficult to be determined. Following factors
should be kept in mind while determining the regular or casual amount of depreciation.
1. Value of Assets
2. Estimated working life of the asset
3. Repair and Renewal in the ordinary course of operation. The absence of repair can reduce
the effective life of an asset. This should be kept in mind.
4. Addition and Extension made during the year along with the date should be considered
for determining the depreciation.
5. Scrap of residual value of an asset should be reduced before determining the cost of an
asset.
6. Obsolescence is another factor to be considered.
7. The chance of obsolescence due to innovation and improvement in technology ought to be
considered.
8. The provision of Companies Act and Income Tax should also be kept in mind.
9. The interest that could have been earned had the amount not been invested in the asset.
10. The working hours for the asset.
11. The skill of the operator handling it.
12. A major overhaul which enhance the effective life of an asset.
Methods of depreciation
Over a period of time a number of methods computing the depreciation charge has been evolved.
Some of the important methods are discussed below.
1) Straight Line or Original Cost or Fixed Installment Method.
Under this method a fixed percentage calculated upon the original cost price of the asset is
written off each year. The percentage charge is determined on the basis of estimated life of an
asset.
Purchase value of Asset – Scrap Value
Depreciation = -------------------------------------------------------Life Period of the asset
The method is simple and very useful in the case of those assets whose life is known e.g lease,
patents etc. The calculation will undergo a change when addition or disposal of asset takes
place.
Example 1 : A Power Generating turbine was purchase on 1st July 2003 at a cost of Rs 500000/. What is the depreciation of the asset for the accounting year 2003-04, in straight line method if
scrap value is Rs 100000/- and life period of the asset is 10 years.
Rs 500000/- --- Rs 100000/Depreciation of the asset for one year =----------------------------------------- = Rs 40000/10 years
Depreciation during the year 2003-04 = Rs 40000 x 9/12= Rs 30000/( 1st July 2003- 31st March 2004)
Depreciation for the accounting year 2004-04 will be Rs 40000/Example 2 : A lease of a machine was acquired on 1st Sept. 2003 at a cost of Rs 1000000/- .
Another lease was acquired on 1st July 2004 at a cost of Rs 500000/- . In both the cases
depreciation rate is 5% . Find out the depreciation for the year 2003-04 & 2004-05.
For the year 2003-04 depreciation = Rs 1000000/- x 5% x 6/12 = Rs 25000/For the year 2004-05 Depreciation for asset no I = Rs 1000000/- x 5% = Rs 50000/Depreciation for asset no 2 = Rs 500000/- x 5% x 9/12= Rs 18750/--------------------Total Depreciation
Rs 68750/===========
Note : Depreciation rate may be specified or we will have to find out the depreciation rate. We
may have to find out depreciation for days.
Diminishing Balance or reducing balance method: The method is also known as written down
value method. Under this method, the depreciation is charged at a given fixed percentage on the
diminishing value of an asset. Each year’s depreciation is a fixed percentage but it is calculated on
the balance brought down on the asset account. This method of depreciation is commonly used in
case of Plant and Machinery. No separate calculations are required for the machines acquired
subsequently.
Example 3: Find out depreciation of buildings of a company if rate of depreciation is 10% on
purchase value of asset for Rs 200000/- purchased on 1st January 2003 and Rs 100000/- purchased
on 1st july 2003 if accounting year is considered as calendar year.
Depreciation for the year 2003 =
Asset No 1 - Rs 200000/-x 10%
=Rs 20000/Asset No 2- Rs 100000/- x10% x 6/12 = Rs 5000/----------------
Total Depreciation
= Rs 25000/---------------Residual value of the asset = Rs 300000/- --- Rs 25000/- = Rs 275000/Depreciation for the year 2004= Rs 275000/- x 10% = Rs 27500/The asset can not be reduced to zero after a long period although its value gets negligible after the
life period of the asset. The depreciation charge is higher during the early years and it reduces in
the subsequent years. This method is adopted for the purpose of Income Tax Act 1961 of India.
Annuity Method: The basic presumption behind this method is, if the money is invested in some
other place it could have given some alternative return/ interest. So the value of asset and the
interest amount is credited giving it an accumulated amount which may be used for purchase of a
same kind of asset at the end of the life period of the present asset. This method is used for asset
having long life. But it can not be used in case of intermittent addition of asset as the annuity is
considered uniformly at the time of the purchase of the asset.
Depreciation Fund Method /Sinking Fund Method: Usually Depreciation is charged on the asset
every year and the reduced value is shown in the books of accounts. But this method shows the
purchase value of asset in the Asset side of the balance sheet and the total depreciation charged is
shown as an accumulated balance in the liability side as depreciation fund. Otherwise at any point
of time the gross value of asset and the total depreciation is reflected in the books of account. The
amount charged every year as depreciation is same and inclusive of the principal amount and a
desired rate of interest. It is extracted from the sinking fund table. In books there are three
accounts. 1) Asset Account (at gross value) 2. Depreciation Fund Account (Increases each year
with the value of depreciation) 3. Depreciation Fund Investment Account (Accumulated Fund
invested in securities). At the end of the life period of the asset, the asset account is canceled
against the depreciation fund account and the balance in the depreciation fund investment
account is used for purchase of new asset. The drawback of this method is depreciation amount is
invested in other securities although the business may be in need of investment. Major advantage
is that at the time of replacement of asset money is available for purchase of asset.
Insurance Policy Method: An endowment policy is created and premium is given to the insurance
company every year which is the amount of depreciation. At the end of the life period of the asset
the money received is used to replace the asset. In case of the Depreciation fund the money
accumulated is invested in securities whereas in case of this method the amount of money is
invested in insurance and fund available at the end of the life of asset is known in advance.
Investment in the middle period is not possible and forecasting the life of the asset is very difficult.
Depletion Method : Reduction in the value of the asset due to extraction or excavation is
considered in this method. This is applicable in case of Oil wells, mines, quarries etc. A minimum
amount may be fixed as depreciation although no removal of material is done during a year.
Revaluation Method : Market value of the depreciated asset is determined at the end of each year
and on comparison with the book value the depreciation amount is determined. If the asset
appreciates no depreciation is provided. Revaluation is done by technically qualified valuers. This
method is used in case of assets having uncertain life period.
Accumulated Depreciation = Book Value of the Asset – Market Value of the Asset
Machine Hour Method : Life of the machine is determined in terms of hour. Every year the
working hour of the asset is found out and depreciation is charged on the basis of working
hour of the asset.
Purchase Value of Asset
Depreciation = ----------------------------------x No of working hour during the year
Estimated working hour of the Asset
Number of working hour is determined from the log book of the asset.
Example : A machine has a working life of 30000 machine hours and its value is Rs 1500000/- .
Find out depreciation for three years if no of hours worked by the machinery is 2500, 4000 & 5000
hours respectively for three years.
Depreciation per hour = Rs 1500000/- / 30000 hours = Rs 50/Depreciation for the first year
= 2500 x Rs 50/- = Rs 125000/Depreciation for the second year = 4000 x Rs 50/- = Rs 200000/Depreciation for the third year
= 5000 x Rs 50/-= Rs 250000/Mileage Method: This method is used in case of transport vehicles. Number of kilometers the
vehicle can run is determined in advance and depreciation is charged on the basis of total
kilometers run during the year.
Double Declining Method: This method is used in American Tax Laws. Here depreciation is
charged as in straight line method but the book value of the asset at the beginning of each year is
made double for the purpose of calculation.
Sum of Years’ digit method: In this case depreciation is based on the total of the digits of life
period of the asset. It can best be illustrated by an example:
An asset has a life period of 5 years with purchase value of Rs. 30000/-.
Depreciation for the first year is
`
Depreciation for the second year is
`
Depreciation for the third year is
5
---------------------x Rs 30000/- = Rs 10000/(1+2+3+4+5)
5-1
---------------------x Rs 30000/- = Rs 8000/(1+2+3+4+5)
5-2
---------------------x Rs 30000/- = Rs 6000/(1+2+3+4+5)
Break even Analysis:
Break even point is a point of no profit and no loss. This is a point where every businessman
wants to reach as soon as possible. We know
Revenue = Cost + profit
Cost may be divided into fixed cost and variable cost. Fixed cost is fixed in totality and changes
per unit as we increase or decrease the number of units produced. Variable cost is fixed per unit
and varies as the number of units produced changes. So
Revenue = Fixed Cost + Variable Cost+ profit
Break even analysis defines the relationship between cost and volume of production. So it may
also be termed as Cost Volume and Profit Analysis. The entrepreneur tries to get highest benefit
out of fixed cost by producing as much as possible from the available cost. So the cost per unit
comes down.
The last unit produced by the business is important as derives a higher level of profit. Addition of
the last unit is termed as marginal increase and hence break even analysis is termed as Marginal
Costing.
Break even analysis helps the management to take several managerial decisions
1)
2)
3)
4)
5)
6)
7)
The level of production to determine a point of no profit & no loss.
The amount of profit or loss the organization will make at a point of sales volume.
Impact of increase of fixed cost on the profitability of the company.
Volume of sales to derive a desired level of profit.
It helps to determine the lease or buy decision.
Impact of increase or decrease on per unit variable cost on the profitability of the product.
In case of multiple products it also helps to find out the amount of production to be made
on each type of product.
8) In certain cases the organization wants to sale at a lower price after achieving the desired
profit(dumping). BEP helps to find out to what extent the price can be reduced.
Assumptions of Break Even Analysis:
1)
2)
3)
4)
All costs are classified into two categories i.e Fixed Cost and Variable Cost.
Fixed Cost remains fixed in totality and variable cost remains fixed per unit.
Sales price remains constant throughout the analysis.
The analysis does not hold good for negative figures.
Diagramed representation of Break Even Analysis:
The X axis is represented by volume of output and Y axis is represented by fixed cost, variable
cost and sales revenue.
We will observe that the fixed cost remains constant irrespective of the volume of production
and it remains parallel to the X axis. The total cost is sum of variable cost and fixed cost and
starts from the origin of the fixed cost line. Sales revenue is directly proportional to the units of
production and starts from the origin. The
Calculation of Break Even Point :
Fixed Cost
Break even point in number of units =---------------------------------------Sales Price- variable cost per unit
Contribution = Fixed Cost + Profit = Sales Revenue- Variable cost
Profit Volume ratio (P/V ratio) = Contribution/ Sales
Change in profit or change in contribution
-------------------------------------------------------------------Change in Sales
Fixed Cost + profit
Sales to make a certain amount of profit (in amount) = --------------------------------P/V ratio
Fixed Cost + Profit
Sales to make certain amount of profit (in units)
= --------------------------------------Selling Price – Variable Cost per unit
P/V Ratio =
In the diagram above the X axis is represented by no of units produced and the Y axis represents
cost. As we know fixed cost does not change along with increase in unit of production it is parallel
to the X axis. Total cost is represented by the sum of fixed cost and variable cost. When the
production volume is zero the firm incurs only the fixed cost. As production increases the total
cost curve originating from the fixed cost line goes upwards tangentially. Sales value is directly
proportional to the number of units produced. So it is tangential to the origin. The total cost line
and the sales line intersects each other at P. This is called Break Even Point. Here the firm makes
no profit and no loss as the sales line intersects the total cost line. The area between the sales line
and total cost line above the break even point is called the profit area and the area lower to the
break even point is called the loss area.
Break Even Chart represents the dynamics of fixed cost variable cost and profit. Management can
take decisions on the level of production through the break even chart.
Example 1 :
Calculate the break even point from the following figures:
Fixed Cost = Rs 100000/Variable Cost = Rs 10 per unit
Selling Price = Rs 20 per unit.
Fixed Cost
Break Even Point =--------------------------Selling Price – Variable Cost
Rs 100000/= ---------------------= 10000 units
Rs 20- Rs 10
Break Even Point in Value = 100000x 20= Rs 200000/Example 2:
A limited incurs Rs 40000/- as fixed cost
P/V Ratio = 25%
Fixed Cost
Rs 40000/Break Even Point = --------------------= --------------------------= Rs 160000/P/V ratio
25%
Sales found out through this method are always expressed in value.
Example 3:
A foundry has the following expenses incurred during a year.
Fixed Cost = Rs 150000/Variable Cost = Rs 10 per unit
Sales Price = Rs 25 per unit
The foundry sales 25000 units of product during a year. What is the amount of profit it earns and
what is the break even point?
Solutions:
The break even point in the above example =
Fixed Cost
-------------------=
Selling Price – Variable Cost
Rs. 1500000/--------------------------= 10000 units
25-10
For 25000 units,
Fixed Cost = Rs 150000/Variable Cost = 25000x10= Rs 250000/Sales Value = 25000x 25= Rs 625000/Profit = Sales Value- Fixed cost – Variable Cost
= Rs 625000- Rs 150000- Rs 250000= Rs 225000
Example 4
Determine the P/V ratio & Sales volume to earn a profit of Rs 80000/- from the following figures
Sales = Rs 300000
Profit = Rs 45000
Variable Cost= 50%
Solutions:
Fixed Cost = Sales Value – Profit- Variable Cost = Rs 300000 – Rs 45000- (50% x 300000) =
Rs 105000
To earn a profit of Rs 80000/-sales value required =
Fixed Cost+Profit
--------------------P/V Ratio
Rs 105000+Rs 80000
= ---------------------------------- =
Rs 105000+Rs45000
---------------------Rs 300000
Rs 185000
---------------------= Rs 370000/50%
Example 5
A product is manufactured at a fixed overhead cost of Rs 4000 and variable cost of Rs 25 per unit.
Find out the P/V ratio if sales price is Rs 40 and units produced is 800 units. What will be the P/V
ratio if price is decrease by 20%?
Solution:
Sales in the above example= 40x 800= 32000
Total Variable Cost = 25x800= Rs 20000
Profit= Sales – Fixed Cost- Variable Cost= Rs 32000- 4000- 20000= Rs 8000/P/V ratio = Contribution/ Sales = (Fixed Cost + Profit)/ Sales
= (Rs 4000+Rs8000)/ 32000= Rs 12000/ Rs 32000= 36.75%
If the sales price is decreased by 20% it will be 40-(40*20%) = Rs 32
Sales Value = 32x800= Rs 25,600
Profit= 25600-24000= 1600
P/V ratio= (4000+1600)/32000= 21.88%
Example 6
A consumer durable company produces 10000 units every month. If fixed cost is Rs 20000, sales
price is Rs 80 per unit and proportion of variable cost to profit is 2 : 1 . Find out the margin of
safety.
Solution:
Fixed Cost = Rs 20000/Sales Value= Rs 80x 10000= Rs 80000/Variable Cost + Profit = 80000- 20000= 60000
If we divide the above figure between variable cost and profit at the ratio of 2:1 variable cost = Rs
40000 and profit = Rs 20000
Fixed Cost
Break even sales = -------------------Selling Price- Variable Cost
20000
=
Dumping
All business intends to attend break even sales and thereafter tries to increase the sales for higher
profit. As per the assumption of the break even analysis sales price remains same throughout. But
sometimes the manufacturer may want to dispose off its stock by selling at lower price. As per the
principle of one in hand is better than two in the bush the businessman may try to get whatever
available instead of piling up stock. Moreover a higher volume of profit at a lower rate is
advisable. This decision is called the dumping decision. The diagram below explains how a
dumping decision is taken. When the total revenue is more than the total cost the producer can go
ahead with the production.
Non Linear Break even Analysis
Sensitivity Analysis:
A project has certain basic parameters. They are
1) Cash inflow
2) Cash outflow
3) Project life period
4) Tax Rate
5) Pattern of Inflow and Outflow.
These parameters are likely to change due to several different type of technical, economic and
financial consideration. The fluctuations in net cash inflow due to change in one or more than one
of those parameters is called sensitivity analysis. Finding out different combinations of such
projections is called sensitivity analysis.
Reason for sensitivity:
1) Cost of Raw Material: It may depend on the availability of the material, rate of excise, sales
tax, freight etc.
2) Cost of the project: Project cost may vary due to the rate of taxes and duties, installation
expenses, insurance charges and time period taken to complete the project.
3) Fixed Overhead: With larger production the fixed overhead is better absorbed thereby
giving higher net cash inflow.
4) Variable Overhead: The major expenses including material cost are interest, salaries,
insurance on stock, sales tax etc.
5) Preliminary Expenses: Before the start of the project preliminary and preoperative
expenses like floating of capital, consultancy charges, documentation and project
evaluation are involved in the project. These expenses are likely to change depending on
the external and internal factors associated with the project.
6) Market Acceptability: The customer is the king. His preference, taste also determines the
volume of sales.
Single parameter sensitivity :
The economist changes one parameter in the analysis.
Example 1 : A project is having cash outlay of Rs. 200000/-. It produces 15000, 20000, 30000,
40000 and 20000 units for five years at 80% capacity utilization. The price per unit is Rs 3/- per
unit. Variable cost is Rs 1/- per unit. Fixed cost is Rs 80000/-. Find out the NPV of the project. If
capacity utilization reduces to 70% , what is the reduction in net cash inflow due to low capacity
utilization.?
Example 2 : Sharada & Co have started a foundry in Rs 20 lakhs investment. The financial
projections are given as follows .
Year
1
2
3
4
5
Particulars
No of Units produced
Price per Unit
Fixed Cost
(Excl. Depreciation)
Depreciation
Variable cost per Unit
Tax Rate
100000
10
150000
12
150000
14
200000
16
200000
16
200000
200000
200000
200000
200000
400000
5
38.5%
320000
6
38.5%
250000
6
38.5%
190000
6
38.5%
150000
8
38.5%
Compare the present projections with a situation when the tax rate has changed to 45%.
Multiple Parameter sensitivity :
Sometimes more than one parameter may also change in a given situation.
Example : In the above example find out the IRR of the project if capacity utilization is reduce by
20% of the production and variable cost increase by 10% every year. Whether the project is
acceptable in the new situation.
Basics of Cost Accounting
It may be defined as the subject relating to the maintenance, classification, allocation of individual
expenses relating to production process with a sole aim to make the information available for
reduction of cost on a product or take managerial decisions.
Characteristics:
1)
Information relating to production process is taken into account. Expenses like
Dividend, Income Tax, and Interest are kept aside for analysis in financial
management.
2)
It is based on analytical data for future decision making process.
3)
Actual and standard data are considered in this subject to provide base for comparison
and initiate cost saving measures.
4)
Statutory records are to be maintained for Certain specific companies are covered
under cost audit. Otherwise the records may be prepared as per the requirement of the
management.
5)
Cost records are presented only to the management and Board Industrial cost and
prices. Otherwise it is internal in nature.
Difference between cost accounting and costing;
Although both the terms look similar at the outset there is a small difference between cost
accounting and costing as regards their objective.
Cost Accounting
Costing
Major objective is to record the expenses It primarily helps in pricing a product,
for decision making purpose.
determining among alternatives and
allocation and apportionment of expenses.
Helps in presentation of cost data.
Helps in Analysis.
Profitability can be determined from the
cost accounting record
Objectives :
1) Maintaining more detailed information than the financial accounting for better control and
profitability,
2) Defining the expenses in different ways i.e on the basis of departments, products, areas for
fixing up accountability of managers.
1) Defining expenses in different heads of account for better control.
2) Allocating expenses to help in finding out profitability of individual products.
3) Reduction of wastage through proper information.
4) Determining prices.
5) Determining wage and incentive structure of Employees.
6) Decision on quantity to be purchased.
7) Stores Management.
8) Determining ideal standard, comparison with actual and finding out corrective action.
Methods of Costing:
Cost accounting provides a framework to analyze expenses in different ways. Depending on
the nature of business there may be different methods of maintaining cost records. Some of
them are explained as follows:
There are two basic types of accounting
1) Specific Order Costing- In this type of costing the work done can be identified to a specific
job or to a time frame and after the work is over the books are closed for this specific job.
Batch costing, Contract Costing and job costing are included in this type of costing
2) Operation costing : Here the process is continuous and costing system should be devised to
take care of the production process.
Specific Order Costing :
Job Costing: This is otherwise named as product costing. Suppose a printer has received an order
to print 50000 leaflets of social awareness for a NGO. This specific job needs a specific size and
quality of paper with a specific type of printing. It will have to be completed within a time frame.
So all the expenses of this job should be considered together to determine the profitability on this
specific job. In case of foundry, caterer, Event Management and Heavy Engineering Equipments
this type of costing can be adopted.
Contract Costing : The thrust of this costing system is time. The cost accountant determines all cost
involved during a time frame for a project. National Highway construction will go on for ten
years. But we can not wait till the end of the project to determine the justifiability of expenses
incurred. So we will have to prepare cost accounts taking the work in progress in to account. This
system is adopted in construction of bridges , dams, roads, stadiums , huge structures etc.
Batch costing : The costing system applied to biscuit manufacturing, match stick, consumer
products like jelly, jam, toothpaste ,soap etc. are accounted through batch costing system. Few
number of units manufactured in one cluster is categorized as one batch. The purpose of defining
the batch is to determine the persons involved in that batch and excessive cost or defects in
product can be easily traced. Batch no defines the age of the product.
Operation Costing :
Process Costing : Continuous manufacturing processes adopt this type of costing method. Textile
Industry, Paper Industry, Chemical Industry are few examples where process costing is applied.
Goods in terms of work in progress pass to the next process either on cost price or cost price with a
margin. All costs involved in one process accumulate its cost for purpose of calculation and
control. The individual processes may have their standard and budgeted expenses and target of
production.
Operation Costing: In this type of industries the unit of production are the major means of
allocation and control. Expenses pertaining to a particular time period is found out and divided in
the number of units produced during that period to find out the unit cost. Mines, quarries, Oil
wells adopt this costing method.
Service Costing: Transport Companies, Hospitals, Call Centers, servicing stations adopt this
method of costing system. It is different from other costing system by means of its unit of
production. Usually complex unit of production are adopted in this system like tonne- kilometer,
Patient- days, man-days etc.
Multiple Costing: The example of aero plane manufacture may be cited to explain this type of
costing system. It is a mixture of job costing and process costing. Different components of a
product are manufactured at different places and come to a single place for assembling. All
individual components are done in separate processes and a single aero plane is considered as a
job. Although automobile manufacturing is also covered under multiple costing due to their mass
production they may be termed as items adopting process costing.
Cost Unit: In costing system it is very important to identify expenses involved in a product.
Only then we may think of controlling the cost. The cost should be expressed in terms of
incurrence with the smallest unit of production. This is called cost unit. For example : In case
of a coal mine tonnage, power generating company – watt, transport company – tonnage kilometer, hospital – patient day, biscuit manufacturing – packet, Edible oil – liter, wheat
manufacturing – kilogram etc.
Some of the basic factor determining cost unit are as follows:
1) The most important is the nature of business for determining the cost unit of a business.
2) Volume of production; for example in case of a petrol tank liters may be the cost unit
whereas in case of oil wells tonnage is the smallest unit.
3) Management viewpoint : Suppose the management of a transport company wants to
control the salary expenses of the drivers it will make working days as the cost unit than
the tonnage kilometer.
4) Nature of operation : In a profit making hospital patient days may be the cost unit whereas
in a non profit making business unit for the purpose of controlling cost man days may be
the cost unit.
5) Area of operation : A distributor having large number of outlets may find individual outlet
as the cost unit whereas an unit having centralized business may find number of units as
the cost unit.
6)
Product and Process Costing
Product costing and process costing are two different methods of costing to take into account
the determination of the cost and exercise control on operation.
Product Costing :
Nature of process costing :
1) The production process is continuous with identical products.
2) Well defined cost centers enable determination of cost easy. A textile manufacturing unit
may have threading, weaving, bleaching, colouring and packing processes.
3) Finished product of one process becomes the raw material for the other.
4) There may be normal and abnormal losses at all levels.
5) Efficiency of each process is determined by preparing a separate account.
6) When material is transferred from one process to other either actual cost incurred or cost
plus a margin (transfer price) is adopted.
7) Normal or Abnormal loss or both may arise at any process or all process of production.
8) The cost accountant focus on the effective unit of production (units left out after the
normal and abnormal loss)
9) The waste products may be further processed to get some by products having realizable
value.
10) As identical units are produced it is not possible to trace individual unit during the
production
Chemical Units, Textile products, Soap, Distilleries, Paper, Biscuit, Oil refinery, Food products,
canning, paint, Dairy products follow the system of process costing.
Normal loss : During routine handling of products the material may loose some weight or
units. For example evaporation of chemicals, Leakage of oil, seepage salt may occur during
handling. It can not be avoided in spite of all care taken during handling. Loss units are
reduced from the total number of units to find out the effective units of production. But value
of the production is not reduced
Abnormal Loss: It is avoidable. Loss of units due to power failure, material jammed in the
machine, mismatch of quality parameters, loss due to breakdown of machine are examples of
abnormal loss. It has specific value in the process account and accounted separately. Units and
value both are reduced to get effective units of production.
Transfer Pricing : The basic purpose of preparation of process costing is to determine the
value of the product at semi finished stage after a process. It may be done by whatever value
addition done to the product in a specific process. Another way of determining the value of
the product is to add a certain percentage to the cost price or transfer it on the basis of market
price of the product.
Standard Costing
Management of an organization has certain expectation of performance from its employees. So
management tries to find out a framework of measurement for such performance. Sometimes
the management predetermines its performance parameters through budgets and this may be
determined by setting ideal standards. Usually standards are the average of the same type of
organization in the industry. Otherwise it tells us the level of performance in ideal condition.
The actual performance are compared with the standards and difference is analyzed for
corrective action.
Standard Costing is the analytical tool to determine the performance of an activity and person
vis a vis the ideal condition or performance in the industry.
Characteristics of Standard Costing :
1)
2)
3)
4)
It is primarily a control mechanism.
Standard Costing is used for analyzing performance regularly and continuously.
It is expressed in monetary terms.
Standard allow the normal wastes, normal breakdown and normal mistakes that may
accrue during the production process.
5) It is meant for measuring performance fixing responsibility and developing saving –
reward mechanism.
6) It relates to expenses only.
Steps in Standard Costing :
1) Fixation of standards - This is the determined through analysis of industry after analyzing
the production process, internal and external environment . Due concessions are allowed,
looking into the practical situation.
2) Determining the actual expenses – Financial Records are the major source of actual
expenses. The cost accounting system should be designed providing cost units to match the
standard costing system.
3) Comparing the actual with standard – This is called variance analysis. If the actual is less
than the standard the performance of the organization is favourable, and it becomes
unfavourable if the reverse happens. Variance should be found out at regular interval.
4) Review and Corrective measures – The apprising engineer should discuss the variance
with the shop floor foreman to understand the reason of such difference. If the later’ s
performance is good he should be rewarded and in case it is unfavourable punitive actions
should be taken. If the apprising engineer thinks that the standards allow laxity or too
tough to attain ,he may revise it .
Advantages of standard costing :
1) Efficiency can be assured by continuously monitoring through variance analysis.
2) Standard cost helps in determining cost involved in a product. So it can be used in
production and pricing policy.
3) The work of the engineer is reduced because figures are available to assess the
performance of the of the subordinates. He need not be associated through out the process
of production. This concept of only looking into variation is called management by
exception.
4) Variance analysis has become more important now a days due to the keen competition in
the economy. Every organization wants to get an edge over its competitors by producing
goods at a low cost.
5) As it is a saving – reward mechanism employees become efficient in the organization.
Inefficient employees may be relocated in insignificant positions or may be removed.
6) Sometimes standard costing is use as an analytical tool to take managerial decisions like
make or buy, own or hire decisions.
Components of variance:
Expenses in an organization constitute three major components. They are 1) material 2) labour
and 3) Overhead. The engineer tries to control cost in all the components finding out variance
separately by putting due emphasis on all of them.
Material Cost Variance:
It is derived from the following formula.
MCV= SQxSP-AQxAP
MCV = Matarial Cost Variance,
SQ= Standard Quantity
SP= Standard Price
AQ= Actual Quantity
AP = Actual Price,
Example :
In a bag of flour standard quantity of wheat consumed is 180 kg at a standard price of Rs 5/-.
Actual quantity consumed is Rs 210kg at a price of Rs 5.50.
Material Cost Variance = (180x5)-(210x5.50)= 900-1155= 255 (Unfavourable)
Material cost variance in a production process may vary either due to 1) change quantity
consumed or 2) change in price.
On the basis of these two reasons it may be defined as
1) Material Usage Variance = (SQ-AQ) x SP
2) Material Price Variance. = (SP-AP) x AQ
The production engineer of an organization gives the following details of his unit. Determine
the performance and comment on it.
Particulars
Quantity
Price
Standard
450
10
Actual
400
10.10
Material Price Variance = (SP-AP) x AQ = (10-10.10)x400= 40(Unfavourable)
Material Usage Variance = (SQ-AQ)x SP = (450-400) x 10 = 500(Favourable)
Material Cost Variance = (SQ-SP) – (AQX AP) = (450x10)-(400x10.10)
=460(Favourable)
Test = Price Variance + Usage Variance = Cost Variance
Or, 40(U)+500(F)= 460(F)
Interpretation:
Favourable price variance is the result of effective purchasing by the purchase manager.
Unfavourable price tells about the inefficiency of the purchase function. It may also happen
due to other factors like inflation, high transportation charges, high tax and duties, inability to
avail cash discounts, inability of taking advantage of the off season purchase . The engineer
should take care to find out the reason of variance and take corrective action as soon as
possible. If variance is too favourable the standard may be revised.
Unfavourable material usage variance is the indicator of inefficiency of the production
process. It may result from improper handling of machine, huge wastage, theft, defective
storing and wrong combination of raw material.
Labour Variance
It is determined by finding out the difference between standard labour cost and actual labour
cost.
LCV = SR x SH- AR x AH
LCV = Labour Cost Variance.
SR= Standard Rate
SH= Standard Hour
AR= Actual Rate
AH= Actual Hour
Labour variance may also arise due to variation in number of hours taken for a job or higher
rate paid to the workers. As per the reason of variation labour cost variance can be subdivided
into
1) Labour rate Variance = (SRxAH)-(ARxAH)
2) Labour efficiency variance = (SHxSR)-(AHxSR)
Example:
Find out labour variance from the following details:
Particulars
No of Hours
Rate per hour
Standard
30
4
Actual
20
5
Labour cost variance = SRxSH-ARxAH= (4x30)-(5x20) = 20(Favourable)
Labour rate Variance = SRxAH-ARxAH= (4x20)-(5x20)= 20(Unfavourable)
Labour efficiency variance = SHxSR-AHxSR= (30x4)-(20x4)= 40(Favourable)
Test : Labour Cost Variance= Labour rate Variance+ Labour efficiency variance
= 40(F)-20(U)= 20(F)
Idle Time Variance : It is a part of labour efficiency variance and represents the no of hours the
workers have been paid but no work is done by them.
Idle time variance = Idle time hours x Standard wage rate
In the above example if the idle time is 2 hours idle time variance is 2x4= 8
Efficiency variance will change as
SH x SR –AH X SR= (30x4)-(18x4)= 120-72= 48(F)
Now labour cost variance will be justified by three factors i.e
Labour Cost Variance = Labour Rate Variance +Labour Efficiency Variance + Idle Time
Variance= 20(U)+48(F)+8(U)= 20(F)
Interpretation :
Unfavourable labour rate variance may arise due to
1) More no of overtime hours given to the workers.
2) Change in wage structure due to demands by the trade union or legislation prescribed by
the government.
3) During temporary reduction of production no. of workers are not reduced.
The reason for negative efficiency variance is
1) Unskilled workers and lack of training.
2) Poor supervision, lack of proper maintenance of the machines, inefficient logistic
management. It is not possible to get efficiency if material and tools are not provided in
time.
3) Improper coordination of workers.
Cost Control and Cost Reduction
In present day business the world is going towards a very competitive environment.
Multinationals are coming to our country and providing goods at a very cheap rate. Indian
industry will have to work harder and produce goods at a very low cost to be competitive with
the foreign producers. So cost reduction and control has become necessity for every
organization.
Cost control centers around three major components of production
1) Material 2) Labour 3) Overhead.
Material cost Control:
It has two factors involved.
1) Purchase of material 2) Maintenance and storing of material.
The process of procurement of material starts from requirement by the manufacturing section
and advice for material comes from machine shop to the stores department.
The stores manager checks the records and if material is available sends it to the user
department. If it is not available asks to the purchase department to purchase the material.
Cost reduction is involved at each stage.
1) End user department
2) Stores department
3) Purchase department
The end user department tries to reduce the consumption of material per unit of finished
product by adopting various analysis. It tries to reduce the wastage of material.
Variance Analysis: variances are the difference between standard cost and actual cost. It may
arise due to price, Consumption or inefficiency in handling of material Consumption of
material is the responsibility of machine shop where as price variance is the responsibility of
purchase department .A proper standard should fixed so that the product becomes
competitive in the market.
ABC Analysis : It is otherwise known as always better control analysis. This is a technique
adopted in the stores department for better management of the stores. Material is divided into
three categories
Category
%of
value of
A
--5%
--75%
B
--15%
--20%
C
--80% --5%
Many items which are insignificant in value are huge in numbers whereas few items may
be having huge value. For example in the process of constructing a house cement brick, chips,
iron rod and sand are the major constituents. They cover major part of the cost. So more
emphasis should be given to them and any savings in A category leads to huge savings in
terms of money. A continuous evaluation will lead to produce goods at a very low cost. B
category is the next important category of material. The value involved is 20% and number of
items is 15% of the total numbers of items. In case of construction of house paint, varnish, nails
may be covered in this category. Importance given in stock control may be little less than the A
category but more than the C category. Numerous items having very little value but huge in
numbers are categorized in the last category of items.
VED
Analysis : Here the classification is made on the basis of importance of the material .
A small item having negligible money value may be very important for the production
process. For example a rope for starting the water pump is very vital although cost is low. Cap
of the tank is essential but can be managed for few days. Cover of the pump is desirable, So we
should keep more no. of units from the vital item for replacement at the time of need and
lesser from the other two categories, there by lots of saving can be made.
J I T (Just in time) inventory: This technique is adopted by the Japanese to reduce Cost.
Arrangement is made in such a way that raw material arrive at the production site just before
production, and lots of cost is saved by means of avoiding holding cost and storage space for
inventory.
E O Q (Economic Order in Quantity): This is the ideal Quantity one should purchase in one
order to avoid unnecessary cost on holding. There are two options for purchase of material. We
purchase huge Quantity and get trade discount or purchase low Quantity per order and save the
inventory carrying cost. To find out a balance between the two an ideal quantity per order should
be determined
2co
EOQ =
-------I
C = Annual consumption.
O = Cost per order.
I = Interest rate.
Example :
Level Setting: To reduce the inventory, different levels are defined like maximum level,
minimum level, average level, and reorder and danger level. The purpose of setting the levels,
to watch the inventory continuously and reduce the cost keeping it within the limit.
Perpetual Inventory System: This process is adopted to keep a continuous watch on the
inventory. On daily basis physical stock is verified. Records are maintained and obsolete,
scrap, redundant material are removed to give maximum cost benefit to the stores control
system.
While the above methods are used for material control, variance analysis is primarily used
for control of labour cost and overhead cost. Wages may be paid on piece rate basis or time
rate basis depending on the requirement of the organization. Incentive schemes must be
designed to get maximum output from the labour cost.
Budget and Budgetary control: Budgets are financial plans meant for controlling the expenses
of an organization . Before the start of a year, A budget is fixed providing details of all the cost
involved like material , labour and overhead . When actual expenses are incurred, It is
compared with the budget and variances are found out . The reason of variances are analyzed,
corrective steps are taken for better cost control.
There are several other methods like six sigma analysis, Total quality management, Quality
circle, kaizen which involves all the member of the organization for reduction of cost.
Different between ------Cost control
(I )
Cost reduction
Cost Estimation
Cost estimation is based on both engineering and economics. The cost analyst must be familiar
with the physical and operational characteristics of the proposed program at an engineering level of
detail so that the likely costs can be estimated through standard techniques such as analogy or
parametric estimation. The analyst needs to work intensively with the most knowledgeable people
that will be directly involved in the project (frequently, this is the systems engineers and other
technical specialists) that understand the concepts, the physical nature, and operational properties of
the proposed program; ask probing and open-ended questions that enable analysis of the program’s
likely costs and risks; and then synthesize an accurate cost estimate from all the diverse data.
Cost estimation defined here is concerned with deriving the likely costs of a specific future activity
or program. The intent is to provide a realistic cost estimate so the decision-maker can judge the
relative merits of the proposal against its costs. One of the most difficult cost issues is uncertainty.
Since the new investments are unique and have no exact historical antecedents, there can be
substantial uncertainty associated with predicting the likely actual costs. The analyst needs to
understand and apply these uncertainties and risks to derive probabilistic measures of cost
outcomes (i.e., the most optimistic estimate to the most pessimistic estimate of life cycle costs).
Most importantly, the analyst must always prepare a risk-adjusted cost estimate, i.e., a cost
estimate that reflects the uncertainty associated with what the actual costs are likely to be.
1.0 Understand The Proposed Program And Existing Estimates: The cost estimating team must
develop and document an in-depth understanding of the proposed new program, including the
Reference Case (sometimes called the "do nothing" alternative), the Capital Investment Plan (CIP)constrained alternative, and the set of remaining feasible alternative approaches to be evaluated. A
cost analysis to support an initial investment decision always must include life cycle cost estimates
(LCCE) for the Reference Case, a CIP-constrained alternative, and other feasible alternatives. A
more detailed life cycle cost analysis for the selected or preferred alternative will be undertaken to
establish the program’s baseline cost. For replacement programs, there may be a need to update the
costs of the reference system to support a cost-effectiveness analysis to support the development of
the business case.
This understanding of the program can be gained by review and analysis of appropriate program
documentation (e.g., Requirements Document), by discussions with project subject matter experts
(SMEs), and by a review of previous cost estimates relating to the program (if any exist).
Frequently, this understanding is documented in a "Technical Description", which serves as a
summary of the characteristics of the program and its alternatives in sufficient detail to enable the
subsequent development of cost estimates for the Reference Case and each alternative.
The Reference Case is considered the "baseline" that is to be compared to all the alternatives. The
objective of the entire analysis is to derive the marginal costs of each "do something" alternative,
i.e., the degree to which the costs of each alternative exceed the costs of the Reference Case. The
decision-maker needs to know how costs and benefits will behave in the future as a consequence of
doing something different from the Reference Case. Like the Reference Case, the CIP-constrained
alternative must always be included. It is the program that fits the available CIP funding profile.
In all investment analyses in which cost-benefit studies are needed, a similar technical and
operational description document will be needed to enable benefit analysis to be completed. In
these cases, the benefits analysis team and the cost estimating team should work collaboratively
with the Integrated Product Team to develop a mutually-useful technical description that meets all
needs, ensures consistency in input assumptions and data for all teams, and minimizes the
duplication of effort.
The technical description generally will cover these areas:
a. Technical Data
- System overview
- Description of the Reference Case
- Description of the CIP-constrained alternative
- Description of the remaining feasible set of alternatives to be estimated
- System functional relationships
- System configuration (hardware and software)
- System technical and operational performance characteristics
- Concept of operations
- System activity rates
- System requirements
- System facility requirements
- System Interfaces
b. Programmatic Data
- Major risks threatening cost growth
- Predecessor and successor systems
- Quantity requirements, number of systems
- Locations and site-specific system placements
- System implementation and deployment schedules and milestones
- Transition plan
- Acquisition strategy
- System development plan
- Assumed economic service lift
Output Product: A technical memorandum summarizing the data described above.
2.0 Cost Analysis Planning: With an understanding of the program, the cost estimating team then
develops a cost analysis plan and a tailored work breakdown structure (WBS) for each alternative
that is to be cost-estimated.
Once the WBS is established, a cost estimating methodology must be identified for each element.
Numerous methodologies are available and the analyst selects an appropriate one.
Before the actual cost estimating begins, a cost analysis plan should be developed and agreed upon.
Like any plan, it describes the tasks needed to complete the cost estimate, the deliverable products
of the analysis, the schedules and resource requirements for each task, and the roles and
responsibilities of each organization or person in completing the effort. The content of the cost
analysis plan should include:
a. The objectives of the effort
b. Identification of the estimates to be developed, including the Reference Case, the CIPconstrained alternative, and the set of remaining feasible alternatives to be evaluated
c. The cost estimation tasks required to be completed
d. The methodologies to be used to derive a cost estimate for each WBS element.
e. The deliverables and products to be completed and the expected completion dates
f. Schedules and resource requirements for each task
g. Roles and responsibilities of each team member/organization
The tailored WBS for each alternative forms the framework for the cost estimation effort.
Each tailored WBS is based on the specific work packages that would be needed to implement and
operate the proposed alternative. The total life cycle cost is derived by summing the costs of all of
the WBS elements.
Normally, the cost estimating team needs to work with project personnel to develop a complete
WBS for each alternative representing all needed tasks. The tailored WBS selects those WBS
elements from the FAA Standard WBS, which will be appropriate for that particular alternative,
and augments the WBS (if needed) to the appropriate level to develop a realistic cost estimate. The
level of WBS depth will depend upon the relative maturity and understanding of the new program.
Generally, the tailored WBS should be created only to the level that is sufficient to understand risk,
to permit accurate cost estimation, and to serve later as the baseline for earned value management.
In some cases, several FAA standard WBS elements may not be used at all .
Output Product: A cost analysis plan accepted by all team members. If appropriate, this plan may
be included as a part of the Investment Analysis Plan (IAP), rather than published as a separate
document. Appended to the plan should be tailored WBS for each alternative, each based on and
drawn from the FAA Standard WBS.
3.0 Collect Data For Each WBS Element: The total cost of any WBS element is based on the
extent of work required to be performed, which is usually driven by the value of certain workrelated physical parameters. For example, for software development, the number of source lines of
code (SLOC) to be developed is a strong predictor of the required workload and thus the likely cost
of that WBS element. A simpler example is the cost of program management support, which might
be estimated as a function of the number of staff hours times the dollar rate per hour.
Cost risk is based on the possible range of physical input parameters associated with a particular
WBS element. Since the objective always is to create a risk-adjusted cost estimate, the needed data
includes not only the project office point estimate value of each quantifiable physical parameter,
but also the possible range from best case to worst case values. In some cases, this range may be
very small or even zero, when there is little or no uncertainty as to the required effort. Generally,
relatively few WBS elements have the most uncertainty in cost. These typically include WBS
elements that relate to such items as software development, system integration (especially
integration of commercial off-the-shelf (COTS) products), system performance requirements (e.g.,
human factors, safety, and security requirements), and test and evaluation.
Therefore, data collection is focused predominantly on the identification and quantification of the
possible range of physical parameters for each WBS element. The cost analyst’s primary source for
this data is project SMEs. In addition, a comprehensive risk assessment is frequently conducted to
identify major risk cost drivers.
There are several probability distribution techniques available to estimate cost distributions. A
common technique that is typically used to derive the probabilistic cost distributions and estimates
is a triangular distribution. The triangular distribution method relies on three basic parameters (best
case, point estimate, worst case) to establish a probability density function which will be used to
statistically quantify the cost risk associated with the program with stochastic models. In every
case, the rationale for the selected values should be documented in the BOE.
Output Product: Point estimates for all cost-driving physical parameters and the associated
Cumulative Distribution Functions (CDF).
4.0 Complete Cost Estimate: With the risk ranges and CDFs of physical input parameters known,
the next step is use the methodologies established in the planning phase to develop the statistical
distribution of costs for each WBS element and to compute the statistically derived risk-adjusted
constant rupee LCCE.
This is normally accomplished by using an analytical tool such as Monte Carlo simulation to
randomize the physical parameters according to the range specified by the analyst. Available tools
for this purpose provide a CDF as an output, from which the analyst selects a high-confidence total
LCCE (i.e., 80% confidence that the cost will not be exceeded in actual investment performance).
There is a need to establish high- confidence Facilities and Equipment (F&E) and high-confidence
Operations and Maintenance (O&M) cost estimates in order to develop the life cycle cost
Acquisition Program Baseline (APB) for the Joint Resources Council (JRC) approval.
Output Product: Risk-adjusted LCCE and WBS elements, including a CDF for the life cycle cost
in constant dollars.
5.0 Time-Phase The Life Cycle Cost In Then-Year Rupees: The previous step provides a total,
constant dollar LCCE. It is necessary to allocate the total across an annualized fiscal funding profile
and inflate the estimate to then-year dollars for the APB and various financial plans. Total WBS
costs should be spread across fiscal years according to the risk-adjusted schedule funding
requirements for each WBS element. The cost estimating team should get agreement on the
proposed spreading of costs, or the process of spreading the costs, from the Product Team that will
be responsible for program implementation.
Output Product: Time-phased life cycle cost financial profiles in then-year dollars for APB,
Integrated Program Plan (IPP), and financial plans (e.g., CIP).
6.0 Conduct Internal Review: As discussed previously, the cost estimate results are driven by the
input data and assumptions on quantifiable parameters. The analyst should conduct a quality
assurance review of the input data and the results with other Investment Analysis Team (IAT)
members, and coordinate with AFZ and ASD personnel to ensure the data gathered was correct. If
the results "don’t look right", there may be a need to re-validate and re-verify the assumptions and
input data used to generate the estimate. If needed, the analyst should re-run the tool with corrected
assumptions and input data so as to assure the team that the results are correct. Similar, additional
sensitivity and "what if" estimates may be generated to test the robustness of the recommended
option in the light of different assumptions.
Output Product: Refined WBS life cycle costs, CDF, if iterations are performed.
7.0 Conduct External Review and Coordinate: The cost estimate must be reviewed and approved
by all the major stakeholders prior to its finalization and presentation to the FAA decision-makers.
If necessary, re-estimates may be needed or required using different data and assumptions to
accommodate any comments received during the JRC pre-briefs. The stakeholders begin with the
members of the IAT first, and then expand with other stakeholders and impacted parties.
Coordination and review is necessary to ensure quality control, to verify that the correct input data
has been used, and to forge consensus on the results of the cost estimation.
Output Product: Resolution of any issues.
8.0 Complete Final Report And Documents: This last step records the effort and results of all
previous steps, both to prepare for an FAA decision meeting and to populate the historical
databases of all investment analyses. The best approach is to begin and to continue preparation of
the BOE very early in the cost estimation effort, so as to ensure its accuracy and completeness and
to minimize the need for a last-minute effort to complete it. In all likelihood, the BOE will be
reviewed and scrutinized subsequently by numerous persons and groups in and out of the FAA
(e.g., General Accounting Office (GAO), Office of Management and Budget (OMB), Department
of Transportation (DOT) Inspector General (IG), etc.). Therefore, the BOE must be written in easyto-understand, layman’s language. Each stakeholder/reader will have various interests, but all will
require a well-documented, high-quality final report so as to understand and to judge the
effectiveness of the investment decision. The preparation of a final report is critical to the
credibility of the cost estimation effort. It must provide an "audit trail" that can be followed easily
and understood by inside and outside interest groups and stakeholders.
Output Products: Final BOE. Input to the JRC briefing. Cost analysis section of the Investment
Analysis Report.
3rd semester B.Tech Examination
November 2004
Engineering Economics and costing
Full Marks -70
Time Three Hours
Answer Question number 1 and any five from the remaining questions.
The figures in the right hand margin indicates marks
Q1. Answer the following questions
2x10
i)
Define sinking fund and capital recovery factor.
ii)
How many years will it take for the balance left in the savings account to
increase from Rs 1000 to Rs 1500 if the interest is received at the nominal rate of
6% compound rate semiannually through out the period ?
iii)
How would you determine cash flows of a firm from the firm’s P & L account ?
iv)
What do you mean by amortization of an asset ?
v)
State the causes of deterioration in the value of an asset.
vi)
Define the concept of gross and net profitability index used for evaluation of an
investment proposal.
vii)
Classify cost accounting to their variability in respect of volume of production.
viii) Distinguish between waste and scrap.
ix)
Define the concept of labour turnover
x)
State any two important advantage of standard costing.
Q2. Let us assume that a firm purchased a machine three years ago for Rs 50000/-. Its useful life
was five years with no salvage value. It is depreciated on a straight line basis. What would be the
net cash flow from the sale of the machine if the firm wants to replace it assuming the sale price to
be i) Rs 60000/- ii) Rs 30000/- iii) Rs 20000/- iv) Rs 10000/- ? The firms normal tax rate is assumed
to be 55% and the capital gain tax is 30% ?
10
3) Assess the impact of the depreciation method i) Straight line method ii) Double Declining
Balance Method and iii) Sum of the years’ Digit method--- on the cash flow stream which
has purchased a machine forRs 20000/- with economic life of 4 years with no salvage
value. The gross cash proceeds and cash expenses are Rs 13000/- and Rs 3000/respectively for four years. The tax rate is 55% . Calculate net cash flow for the firm for four
years.
4) Project X involves an initial outlay of Rs 32400/- . Its working life is expected to be three
years . The cash stream generated by it are expected to be as follows.
Year
Cash Inflow
(Rs)
1
16,000
2
14,000
3
12,000
Calculate the internal rate of return assuming the minimum rate of return to be 14% .
Would be the project be selected ?
7+3
5) Distinguise between cost accounting and costing . What are the type of costing that are used in
Industries ?
5+5
6) What principles would guide you in selecting cost units in an undertaking ? Mention the
dangers that should be avoided.
5+5
7) a) Company X has an overall P/V ratio of 60%. If the marginal cost of a certain product is
assessed as Rs 12 what would be its selling price ?
b) A factory produce two products A and B. The cost of production and gross profit in respect of
each for March, 2004 are given below
A
B
Per unit
Per Unit
Rs.
Rs.
Direct Material Cost
100
350
Direct Wages
200
100
Variable overhead
100
50
Fixed Overhead
400
200
--------Cost of production
800
700
Gross Profit
200
300
-------Sales Price
1000
1000
------------Comment on the profitability of the products and state which product will give more profit during
heavy demand.
5+5
Q8) What is essential difference between
a)Budgetary Control and Standard Costing.
b) Standard and estimating costing.
5+5