INDUSTRIAL MANAGEMENT

AND ENGINEERING
ECONOMICS (EC T82)
B.Tech. / IV Year/VIII Semester/ECE

Mrs.B.Navalakshmi
Assistant Professor/ECE

Achariya College of Engineering Technology

(Approved by AICTE and affiliated to Pondicherry University)
An ISO 9001:2008 Certified Institution
Achariyapuram, Villianur, Puducherry – 605 110.
www.acet.edu.in
(For internal circulation only)
 EC T82 –INDUSTRIAL MANAGEMENT AND ENGINEERING ECONOMICS

SYLLABUS

COURSE OBJECTIVE

 To explore the knowledge about Industrial Economics and their applications.

 To analyze the Interest formulae, their applications and the methods of comparison.
 To understand the concepts of Depreciation, General Management and Financial
Management.

COURSE OUTCOME

On successful completion of the module students will be able to:

 Apply fundamental knowledge to understand Industrial Economics and its impact on
engineering.
 Investigate and solve engineering problems like Interest formulae and understand
their applications.
 Apply formulae and solve problems of Depreciation, General Management and
Financial Management.

UNIT – I
Introduction to Economics:– Flow in an Economy, Law of supply and Demand, Concept of
Engineering Economics – Engineering Efficiency, Economic Efficiency, Scope of
Engineering Economics, Elements of costs, Marginal Cost, Marginal Revenue, Sunk cost,
Opportunity cost, Break-Even Analysis, P/V ratio, Elementary Economics Analysis-Function,
Aims, Value Engineering procedure, Interest Formulas and their Applications – Time Value
of Money, Single Payment Compound Amount Factor, Single Payment Present Worth Factor,
Equal Payment Series, Compound Amount Factor, Equal Payment Series Sinking Fund
Factor, Equal Payment Series Present Worth Factor, Equal Payment Series Capital Recovery
Factor, Uniform Gradient Series Annual Equivalent Factor, Effective Interest Rate, Examples
in all the methods. (12)

UNIT – II

Methods of Comparison of Alternatives: Present Worth Method (Revenue Dominated Cash

Flow Diagram, Cost Dominated Cash Flow Diagram), Future Worth Method (Revenue
Dominated Cash Flow Diagram, Cost Dominated Cash Flow Diagram), Annual Equivalent
Method (Revenue Dominated Cash Flow Diagram, Cost Dominated Cash Flow Diagram),
Rate of Return Method, Examples in all the methods. (12)
 UNIT – III

Depreciation: Introduction, Straight Line Method of Depreciation, Declining Balance

Method of Depreciation, Sum-of-the-Years-Digits Method of Depreciation, Sinking Fund
Method of Depreciation/Annuity Method of Depreciation, Service Output Method of
Depreciation, Evaluation of Public Alternatives- Introduction, Examples, Inflation Adjusted
Decisions – Procedure to Adjust Inflation, Examples on comparison of alternatives and
Determination of Economics Life of asset. (12)

UNIT – IV

General Management: Basic concepts of management – Scientific management – Henry

Fayal‘s principles of management – Types and functions of management. Types of
organization – characteristics, merits and demerits. Types of industrial ownership –
characteristics, merits and demerits. (12)

UNIT-V

Financial Management: Fixed and variable costs – cost ladder – Break even analysis
(simple problems) – Types of capital – working capital – Sources of finance (internal and
external) - Evaluation of investments – Present Worth Method, Future Worth Method,
Annuity Method and Rate of return Methods (simple problems) – Preparation of balance
sheet and profit and loss statements. (12)

Text Books:
1. O.P. Khanna, ―Industrial Engineering and Management‖, DhanpatRai& sons,1999.
2. R.PannerSelvam, ―Production and Operations Management‖, PHI Learning, 2002.

Reference Books:
1. MartandTelsang – Industrial Engineering and Production Management, S.Chand andCo.,
1998.
2. Shailendra Kale– Production and Operations Management, McGraw Hill, India 2013.
 TABLE OF CONTENTS

UNIT PAGE
TITLE
NO. NO.
1.1 INTRODUCTION 1
1.1.1. Flow in an Economy 1
1.1.2. Law of Supply and Demand 2
1.2. Concept of Engineering Economics 4
1.2.2. Definition and Scope of Engineering Economics 7
1.3. Elements of Costs 7
1.4. Other Costs/Revenues 8
1.4.1. Marginal Cost 8
1.4.2. Marginal Revenue 8
1.4.3. Sunk Cost 8
1.4.4. Opportunity Cost 9
1.5. Break-Even Analysis 9
UNIT – I (Introduction to Economics)

1.6. Profit/Volume Ratio (P/V Ratio) 12

1.7. Elementary Economic Analysis Introduction 14
1.8. Examples For Simple Economic Analysis 15
1.8.1. Material Selection for a Product/Substitution of Raw Material 15
1.8.2. Design Selection for a Product 19
1.8.3. Building Material Selection 22
1.8.4. Process Planning /Process Modification 23
INTEREST FORMULAS AND THEIR APPLICATIONS 26
1.9. Make or Buy Decision 26
1.9.2. Criteria for Make Or Buy 26
1.9.3. Approaches for Make Or Buy Decision 27
1.9.4 Break-even Analysis 30
1.10. Value Engineering 31
1.10.2 When to apply value analysis 32
1.10.3 Value Analysis vs. Value Engineering 32
1.11. Function 34
1.11.1. Classification of the functions 34
1.12. Aims 35
1.13. Value Engineering Procedure 36
1.14. Time Value Of Money 38
1.15. Interest Formulas 40
1.15.1. Single-Payment Compound Amount 41
1.15.2. Single-Payment Present Worth Amount 42
1.15.3. Equal-Payment Series Compound Amount 43
1.15.4. Equal-Payment Series Sinking Fund 44
1.15.5. Equal-Payment Series Present Worth Amount 46
1.15.6. Equal-Payment Series Capital Recovery Amount 47
1.15.7. Uniform Gradient Series Annual Equivalent Amount 48
 1.15.8 Effective Interest Rate 51
1.16 Bases For Comparison Of Alternatives 52
2.1 Present worth Method 53
2.1.1 Introduction 53
(Methods of Comparison of

2.1.2 Revenue-Dominated Cash Flow Diagram 53

2.1.3 Cost-Dominated Cash Flow Diagram 54
2.2 Future worth Method 61
2.2.1 Introduction 61
Alternatives)
UNIT – II

2.2.2 Revenue-Dominated Cash Flow Diagram 61

2.2.3 Cost-Dominated Cash Flow Diagram 62
2.3 Annual Equivalent Method 70
2.3.1 Introduction 70
2.3.2 Revenue-Dominated Cash Flow Diagram 70
2.3.3 Cost-Dominated Cash Flow Diagram 71
2.4. Rate of Return Method 77
2.4.1. Introduction 77
2.4.2 Revenue-Dominated Cash Flow Diagram 77
2.4.3 Cost-Dominated Cash Flow Diagram 77
3.1 Introduction 84
3.2 Methods of Depreciation 84
3.3 Straight Line Method Of Depreciation 84
3.4.1 Declining Balance Method Of Depreciation 86
3.4.2. Sum-Of-The-Years-Digits Method Of Depreciation 87
(Depreciation)

3.4.5 Sinking Fund Method of Depreciation 89

UNIT-III

3.4.6. Service Output Method of Depreciation 91

3.8 Evaluation of Public Alternatives 92
3.8.1 Introduction 92
3.9 Inflation Adjusted Decisions 96
3.9.1 Introduction 96
3.9.2 Procedure to Adjust Inflation 96
3.9.3. Comparison of alternatives and Determination of Economics Life of asset. 96
3.10.2 Economic Life Determination without Inflationary Effect 100
3.10.3 Economic Life Determination with Inflationary Effect 100
4.1. Introduction of Management 104
4.1.1. Various definitions of Management 104
Management)
UNIT - IV

4.1.2. Importance of Management 104

(General

4.1.3. Management Vs Administration 105

4.1.4. Basic Concepts of Management 105
4.1.5. Scientific Management 106
4.1.7. Benefits 107
4.2. Henry Fayol’s Principles of Management (1841-1925) 109
 4.3 Types of Management 114
4.3.1. Different Types (Styles) of Management) 119
4.3.2. Functions of Management 120
4.4. Types of Organization 122
4.4.1. Formal Organization 123
4.5. Types of Ownership 128
5.1 Fixed and Variable Cost 134
(Financial Management)

5.1.1 Variable Cost 134

5.1.2 Fixed Cost 134
5.2 Break Even Analysis 135
5.2.1. CVP Analysis 135
UNIT - V

5.2.2. Assumptions Of Break-Even Analysis 139

5.3 Types of Capital 142
5.4. Sources of Finance 149
5.5.1. Internal Sources 149
5.5.2. External Sources 150
5.5.3 Factors Affecting Choice of Source of Finance 153
5.5. Evaluation of Investments 153
`
EC T82 –INDUSTRIAL MANAGEMENT AND ENGINEERING ECONOMICS

UNIT – I

INTRODUCTION

Economics is the science that deals with the production and consumption of goods
and services and the distribution and rendering of these for human welfare.
The following are the economic goals.
· A high level of employment
· Price stability
· Efficiency
· An equitable distribution of income
· Growth
Flow in an Economy
The flow of goods, services, resources and money payments in a simple
economy are shown in Fig. 1.1. Households and businesses are the two major entities
in a simple economy. Business organizations use various economic resources like
land, labour and capital which are provided by households to produce consumer
goods and services which will be used by them. Business organizations make payment
of money to the households for receiving various resources. The households in turn
make payment of money to business organizations for receiving consumer goods and
services. This cycle shows the interdependence between the two major entities in a
simple economy

Fig. 1.1 Flow of goods, services, resources and money payments in a simple economy

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Law of Supply and Demand

An interesting aspect of the economy is that the demand and supply of a product
are interdependent and they are sensitive with respect to the price of that product. The
interrelationships between them are shown in Fig. 1.2.
From Fig. 1.2 it is clear that when there is a decrease in the price of a product, the
demand for the product increases and its supply decreases. Also, the product is more
in demand and hence the demand of the product increases. At the same time, lowering
of the price of the product makes the producers restrain from releasing more
quantities of the product in the market. Hence, the supply of the product is decreased.
The point of intersection of the supply curve and the demand curve is known as the
equilibrium point. At the price corresponding to this point, the quantity of supply is
equal to the quantity of demand. Hence, this point is called the equilibrium point.
Factors influencing demand
The shape of the demand curve is influenced by the following factors:
· Income of the people
· Prices of related goods
· Tastes of consumers
If the income level of the people increases significantly, then their purchasing
power will naturally improve. This would definitely shift the demand curve to the
north-east direction of Fig. 1.2. A converse situation will shift the demand curve to the
south-west direction.

If, for instance, the price of television sets is lowered drastically its demand would
naturally go up. As a result, the demand for its associated product, namely VCDs
would also increase. Hence, the prices of related goods influence the demand of a
product.

Over a period of time, the preference of the people for a particular product may
increase, which in turn, will affect its demand. For instance, diabetic people prefer to
have sugar-free products. If the incidence of diabetes rises naturally there will be
increased demand for sugar-free products.

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Fig. 1.2 Demand and supply curve

Factors influencing supply
The shape of the supply curve is affected by the following factors:
· Cost of the inputs
· Technology
· Weather
· Prices of related goods

If the cost of inputs increases, then naturally, the cost of the product will go up. In
such a situation, at the prevailing price of the product the profit margin per unit will
be less. The producers will then reduce the production quantity, which in turn will
affect the supply of the product. For instance, if the prices of fertilizers and cost of
labour are increased significantly, in agriculture, the profit margin per bag of paddy
will be reduced. So, the farmers will reduce the area of cultivation, and hence the
quantity of supply of paddy will be reduced at the prevailing prices of the paddy.
If there is advancement in technology used in the manufacture of the product in
the long run, there will be a reduction in the production cost per unit. This will enable
the manufacturer to have a greater profit margin per unit at the prevailing price of the
product. Hence, the producer will be tempted to supply more quantity to the market.
Weather also has a direct bearing on the supply of products. For example, demand for
woollen products will increase during winter. This means the prices of woollen goods
will be incresed in winter. So, naturally, manufacturers will supply more volume of
woollen goods during winter.

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Again, take the case of television sets. If the price of TV sets is lowered
significantly, then its demand would naturally go up. As a result, the demand for
associated products like VCDs would also go up. Over a period of time, this will lead to
an increase in the price of VCDs, which would result in more supply of VCDs.

Concept of Engineering Economics

Science is a field of study where the basic principles of different physical systems
are formulated and tested. Engineering is the application of science. It establishes
varied application systems based on different scientific principles.
From the discussions in the previous section, it is clear that price has a major role
in deciding the demand and supply of a product. Hence, from the organization‘s point
of view, efficient and effective functioning of the organization would certainly help it to
provide goods/services at a lower cost which in turn will enable it to fix a lower price
for its goods or services.
The following section discusses the different types of efficiency and their impact on
the operation of businesses and the definition and scope of engineering economics.
Types of Efficiency
Efficiency of a system is generally defined as the ratio of its output to input. The
efficiency can be classified into technical efficiency and economic efficiency.
 Technical efficiency
It is the ratio of the output to input of a physical system. The physical system
may be a diesel engine, a machine working in a shop floor, a furnace, etc.
Technical efficiency (%) = Output. 100
Input
The technical efficiency of a diesel engine is as follows:

Heat equivalent of mechanical

energy produced
Technical efficiency (%)= . 100
Heat equivalent of fuel used

In practice, technical efficiency can never be more than 100%. This is mainly due to

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frictional loss and incomplete combustion of fuel, which are considered to be

unavoidable phenomena in the working of a diesel engine.
 Economic efficiency
Economic efficiency is the ratio of output to input of a business system.

‗Worth‘ is the annual revenue generated by way of operating the business and ‗cost‘
is the total annual expenses incurred in carrying out the business. For the survival
and growth of any business, the economic efficiency should be more than 100%.
Economic efficiency is also called ‗productivity‘. There are several ways of
improving productivity.
 Increased output for the same input
 Decreased input for the same output
 By a proportionate increase in the output which is more than the proportionate
increase in the input
 By a proportionate decrease in the input which is more than the proportionate
decrease in the output
Through simultaneous increase in the output with decrease in the input
Increased output for the same input.In this strategy, the output is increasedwhile
keeping the input constant. Let us assume that in a steel plant, the layout of the
existing facilities is not proper. By slightly altering the location of the billet-making
section, and bringing it closer to the furnace which produces hot metal, the scale
formation at the top of ladles will be considerably reduced. The molten metal is
usually carried in ladles to the billet-making section. In the long run, this would give
more yield in terms of tones of billet produced. In this exercise, there is no extra cost
involved. The only task is the relocation of the billet-making facility which involves an
insignificant cost.
Decreased input for the same output. In this strategy, the input is decreased
toproduce the same output. Let us assume that there exists a substitute raw material
to manufacture a product and it is available at a lower price. If we can identify such a
material and use it for manufacturing the product, then certainly it will reduce the
input. In this exercise, the job of the purchase department is to identify an alternate

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substitute material. The process of identification does not involve any extra cost. So,
the productivity ratio will increase because of the decreased input by way of using
cheaper raw materials to produce the same output.
Less proportionate increase in output is more than that of the input.Considerthe
example of introducing a new product into the existing product mix of an organization.
Let us assume that the existing facilities are not fully utilized and the R&D wing of the
company has identified a new product which has a very good market and which can
be manufactured with the surplus facilities of the organization. If the new product is
taken up for production, it will lead to—an increase in the revenue of the organization
by way of selling the new product in addition to the existing product mix and an
increase in the material cost and operation and maintenance cost of machineries
because of producing the new product.
When proportionate decrease in input is more than that of the output. Let
usconsider the converse of the previous example, i.e. dropping an uneconomical
product from the existing product mix. This will result in the following:
 A decrease in the revenue of the organization
 A decrease in the material cost, and operation and maintenance cost of
machinery
If we closely examine these two decreases, we will see that the proportionate decrease
in the input cost will be more than the proportionate decrease in the revenue. Hence,
there will be a net increase in the productivity ratio.
Simultaneous increase in output and decrease in input. Let us assume thatthere
are advanced automated technologies like robots and automated guided vehicle
system (AGVS), available in the market which can be employed in the organization we
are interested in. If we employ these modern tools, then:
 There will be a drastic reduction in the operation cost. Initially, the cost on
equipment would be very high. But, in the long run, the reduction in the
operation cost would break-even the high initial investment and offer more
savings on the input.
 These advanced facilities would help in producing more products because
they do not experience fatigue. The increased production will yield more
revenue.
In this example, in the long run, there is an increase in the revenue and a decrease in

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the input. Hence, the productivity ratio will increase at a faster rate.

Definition and Scope of Engineering Economics

Definition
Engineering economics deals with the methods that enable one to take
economic decisions towards minimizing costs and/or maximizing benefits to business
organizations.
Scope
The issues that are covered in this book are elementary economic analysis,
interest formulae, bases for comparing alternatives, present worth method, future
worth method, annual equivalent method, rate of return method, replacement
analysis, depreciation, evaluation of public alternatives, inflation adjusted investment
decisions, make or buy decisions, inventory control, project management, value
engineering, and linear programming.

Elementsof Costs
Cost can be broadly classified into variable cost and overhead cost. Variable cost
varies with the volume of production while overhead cost is fixed, irrespective of the
production volume.
Variable cost can be further classified into direct material cost, direct labour cost,
and direct expenses. The overhead cost can be classified into factory overhead,
administration overhead, selling overhead, and distribution overhead.
Direct material costs are those costs of materials that are used to produce the
product. Direct labour cost is the amount of wages paid to the direct labour involved
in the production activities. Direct expenses are those expenses that vary in relation to
the production volume, other than the direct material costs and direct labour costs.
Overhead cost is the aggregate of indirect material costs, indirect labour costs and
indirect expenses. Administration overhead includes all the costs that are incurred in
administering the business. Selling overhead is the total expense that is incurred in
the promotional activities and the expenses relating to sales force. Distribution
overhead is the total cost of shipping the items from the factory site to the customer
sites.
The selling price of a product is derived as shown below:

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(a) Direct material costs + Direct labour costs + Direct expenses = Prime cost
(b) Prime cost + Factory overhead = Factory cost
(c) Factory cost + Office and administrative overhead = Costs of production
(d) Cost of production + Opening finished stock – Closing finished stock = Cost of
goods sold
(e) Cost of goods sold + Selling and distribution overhead = Cost of sales
(f) Cost of sales + Profit = Sales
(g) Sales/Quantity sold = Selling price per unit
In the above calculations, if the opening finished stock is equal to the closing finished
stock, then the cost of production is equal to the cost of goods sold.

Other Costs/Revenues
The following are the costs/revenues other than the costs which are presented in
the previous section:
 Marginal cost
 Marginal revenue
 Sunk cost
 Opportunity cost
Marginal Cost
Marginal cost of a product is the cost of producing an additional unit of that
product. Let the cost of producing 20 units of a product be Rs. 10,000, and the cost of
producing 21 units of the same product be Rs. 10,045. Then the marginal cost of
producing the 21st unit is Rs. 45.

Marginal Revenue
Marginal revenue of a product is the incremental revenue of selling an
additional unit of that product. Let, the revenue of selling 20 units of a product be Rs.
15,000 and the revenue of selling 21 units of the same product be Rs. 15,085. Then,
the marginal revenue of selling the 21st unit is Rs. 85.
Sunk Cost
This is known as the past cost of an equipment/asset. Let us assume that an
equipment has been purchased for Rs. 1,00,000 about three years back. If it is
considered for replacement, then its present value is not Rs. 1,00,000. Instead, its

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present market value should be taken as the present value of the equipment for
further analysis. So, the purchase value of the equipment in the past is known as its
sunk cost. The sunk cost should not be considered for any analysis done from
nowonwards.
Opportunity Cost
In practice, if an alternative (X ) is selected from a set of competing alternatives
(X,Y ), then the corresponding investment in the selected alternative is not available for
any other purpose. If the same money is invested in some other alternative (Y ), it may
fetch some return. Since the money is invested in the selected alternative (X ), one has
to forego the return from the other alternative (Y ). The amount that is foregone by not
investing in the other alternative (Y ) is known as the opportunity cost of the selected
alternative (X ). So the opportunity cost of an alternative is the return that will be
foregone by not investing the same money in another alternative.
Consider that a person has invested a sum of Rs. 50,000 in shares. Let the
expected annual return by this alternative be Rs. 7,500. If the same amount is
invested in a fixed deposit, a bank will pay a return of 18%. Then, the corresponding
total return per year for the investment in the bank is Rs. 9,000. This return is greater
than the return from shares. The foregone excess return of Rs. 1,500 by way of not
investing in the bank is the opportunity cost of investing in shares.

Break-Even Analysis
The main objective of break-even analysis is to find the cut-off production
volume from where a firm will make profit. Let
s = selling price per unit v = variable cost per unit
FC = fixed cost per period
Q = volume of production
The total sales revenue (S) of the firm is given by the following formula:
S=s´Q
The total cost of the firm for a given production volume is given as
TC = Total variable cost + Fixed cost = v ´ Q + FC
The linear plots of the above two equations are shown in Fig. 1.3. The intersection
point of the total sales revenue line and the total cost line is called the break-even
point.

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The corresponding volume of production on the X-axis is known as the break-

even sales quantity. At the intersection point, the total cost is equal to the total
revenue. This point is also called the no-loss or no-gain situation. For any production
quantity which is less than the break-even quantity, the total cost is more than the
total revenue. Hence, the firm will be making loss.
For any production quantity which is more than the break-even quantity, the total
revenue will be more than the total cost. Hence, the firm will be making profit.

Profit = Sales – (Fixed cost + Variable costs) = s ´ Q – (FC + v ´ Q)

The formulae to find the break-even quantity and break-even sales quantity
Break-even
quantity=

The contribution is the difference between the sales and the variable costs. The
margin of safety (M.S.) is the sales over and above the break-even sales. The formulae
to compute these values are

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Contribution = Sales – Variable costs

Contribution/unit = Selling price/unit – Variable cost/unit
M.S = Actual sales – Break-even sales
= Profit x sales
Contribution

M.S. as a per cent of sales = (M.S./Sales) ´ 100

Example 1.1 Alpha Associates has the following details:
Fixed cost = Rs. 20,00,000
Variable cost per unit = Rs. 100
Selling price per unit = Rs. 200
Find
(a) The break-even sales quantity,
(b) The break-even sales
(c) If the actual production quantity is 60,000, find (i) contribution; and
(ii) margin of safety by all methods.
Solution
Fixed cost (FC) = Rs. 20,00,000
Variable cost per unit (v) = Rs. 100
Selling price per unit (s) = Rs. 200

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Profit/Volume Ratio (P/V Ratio)

Example 1.2Consider the following data of a company for the year 1997:Sales = Rs.
1,20,000
Fixed cost = Rs. 25,000 Variable cost = Rs. 45,000
Find the following:

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(a) Contribution
(b) Profit
(c) BEP
(d) M.S.
Solution
(a)Contribution = Sales – Variable costs
= Rs. 1,20,000 – Rs. 45,000
= Rs. 75,000

(b)Profit = Contribution – Fixed cost

=Rs. 75,000 – Rs. 25,000
=Rs. 50,000

(c) BEP
Contribution
P/V ratio =
Sales

Example 1.3Consider the following data of a company for the year 1998:
Sales = Rs. 80,000
Fixed cost = Rs. 15,000
Variable cost = 35,000

Find the following:

(a) Contribution
(b) Profit
(c) BEP

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(d) M.S.
Solution
(a) Contribution = Sales – Variable costs
= Rs. 80,000 – Rs. 35,000
= Rs. 45,000
(b) Profit = Contribution – Fixed cost
= Rs. 45,000 – Rs. 15,000
= Rs. 30,000

Elementary Economic Analysis Introduction

Whether it is a business situation or a day-to-day event in somebody‘s personal
life, there are a large number of economic decisions making involved. One can manage
many of these decision problems by using simple economic analysis. For example, an
industry can source its raw materials from a nearby place or from a far-off place. In
this problem, the following factors will affect the decision:
 Price of the raw material
 Transportation cost of the raw material
 Availability of the raw material
 Quality of the raw material
Consider the alternative of sourcing raw materials from a nearby place with the
following characteristics:
 The raw material is more costly in the nearby area.
 The availability of the raw material is not sufficient enough to support the
operation of the industry throughout the year.
 The raw material requires pre-processing before it is used in the production
process. This would certainly add cost to the product.

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 The cost of transportation is minimal under this alternative.

On the other hand, consider another alternative of sourcing the raw materials from
a far-off place with the following characteristics:
 The raw material is less costly at the far off place.
 The cost of transportation is very high.
 The availability of the raw material at this site is abundant and it can
support the plant throughout the year.
 The raw material from this site does not require any pre-processing before
using it for production.
Under such a situation, the procurement of the raw material should be decided in
such a way that the overall cost is minimized.
The above example clearly highlights the various components of cost that are
involved in each of the alternatives of the decision-making process as well as a method
of taking a suitable decision.

Examples For Simple Economic Analysis

In this section, the concept of simple economic analysis is illustrated using
suitable examples in the following areas:
 Material selection for a product
 Design selection for a product
 Design selection for a process industry
 Building material selection for construction activities
 Process planning/Process modification
Material Selection for a Product/Substitution of Raw Material
The cost of a product can be reduced greatly by substitution of the raw materials.
Among various elements of cost, raw material cost is most significant and it forms a
major portion of the total cost of any product. So, any attempt to find a suitable raw
material will bring a reduction in the total cost in any one or combinations of the
following ways:
 Cheaper raw material price
 Reduced machining/process time
 Enhanced durability of the product
Therefore, the process of raw material selection/substitution will result in finding

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an alternate raw material which will provide the necessary functions that are provided
by the raw material that is presently used. In this process, if the new raw material
provides any additional benefit, then it should be treated as its welcoming feature.
This concept is demonstrated with two numerical problems.
Example 1.4 In the design of a jet engine part, the designer has a choice ofspecifying
either an aluminium alloy casting or a steel casting. Either material will provide equal
service, but the aluminium casting will weigh 1.2 kg as compared with 1.35 kg for the
steel casting.
The aluminium can be cast for Rs. 80.00 per kg. and the steel one for Rs. 35.00
per kg. The cost of machining per unit is Rs. 150.00 for aluminium and Rs. 170.00 for
steel. Every kilogram of excess weight is associated with a penalty of Rs. 1,300 due to
increased fuel consumption. Which material should be specified and what is the
economic advantage of the selection per unit?

Solution
(a) Cost of using aluminium metal for the jet engine part:
Weight of aluminium casting/unit = 1.2 kg
Cost of making aluminium casting = Rs. 80.00 per kg
Cost of machining aluminium casting per unit = Rs. 150.00
Total cost of jet engine part made of aluminium/unit
= Cost of making aluminium casting/unit +
Cost of machining aluminium casting/unit
= 80 *1.2 + 150 = 96 + 150
= Rs. 246

(b) Cost of jet engine part made of steel/unit:

Weight of steel casting/unit = 1.35 kg
Cost of making steel casting = Rs. 35.00 per kg Cost of machining
steel casting per unit = Rs. 170.00
Penalty of excess weight of steel casting = Rs. 1,300 per kg
Total cost of jet engine part made of steel/unit= Cost of making steel casting/unit
+Cost of machining steel casting/unit +Penalty
for excess weight steel casting

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= 35 *1.35 + 170 + 1,300(1.35 – 1.2)

= Rs. 412.25

DecisionThe total cost/unit of a jet engine part made of aluminium is less than that
for an engine made of steel. Hence, aluminium is suggested for making the jet engine
part. The economic advantage of using aluminium over steel/unit is Rs. 412.25 – Rs.
246 = Rs. 166.25
Example 1.5 A company manufactures dining tables which mainly consistof a
wooden frame and a table top. The different materials used to manufacture the tables
and their costs are given in Table 1.1.
Table 1.1 Data for Example 1.5

Description of item Quantity Cost

Wood for frame and Rs.

legs 0.1 m3 12,000/m3
Table top with
sunmica finish 1 Rs. 3,000
Leg bushes 4 Rs. 10/bush
Nails 100 g Rs. 300/kg
Total labour 15 hr Rs. 50/hr

In view of the growing awareness towards deforestation and environmental

conservation, the company feels that the use of wood should be minimal. The
wooden top therefore could be replaced with a granite top. This would require
additional wood for the frame and legs to take the extra weight of the granite top.
The materials and labour requirements along with cost details to manufacture a
table with granite top are given in Table 1.2.
Table 1.2 Data for Example 1.5
Description of item Quantity Cost
Wood for frame and legs 0.15 m3 Rs. 12,000/m3
Granite table top 1.62 m2 Rs. 800/m2

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Leg bushes 4 Rs. 25/bush

Nails 50 g Rs. 300/kg
Total labour 8 hr Rs. 50/hr

If the cost of the dining table with a granite top works out to be lesser than that
of the table with wooden top, the company is willing to manufacture dining tables with
granite tops. Compute the cost of manufacture of the table under each of the
alternatives described above and suggest the best alternative. Also, find the economic
advantage of the best alternative.
Solution (a) Cost of table with wooden top
Cost of wood for frame and
legs = 12,000 *0.1 = Rs. 1,200
Cost of wooden top = Rs. 3,000
Cost of bushes = 10 *4 = Rs. 40
= 300 *(100/1,000) =
Cost of nails Rs. 30
Cost of labour = 50 *15 = Rs. 750

Total = Rs. 5,020

(b) Cost of table with granite top

Cost of wood for frame and
legs = 12,000 *0.15 = Rs. 1,800
Cost of granite top = 800 *1.62 = Rs. 1,296
Cost of bushes = 25 *4 = Rs. 100
= 300
Cost of nails *(50/1,000) = Rs. 15
Cost of labour = 50 *8 = Rs. 400

Total = Rs. 3,611

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The cost of a table with granite top works out to be less than that of a table with a
wooden top. Hence, the table with granite top should be selected by the manufacturer.
(c) Economic advantage
Cost of a table with wooden top = Rs. 5,020
Cost of a table with granite top = Rs. 3,611
Economic advantage of table
with granite top = Rs. 1409

Design Selection for a Product

The design modification of a product may result in reduced raw material
requirements, increased machinability of the materials and reduced labour. Design is
an important factor which decides the cost of the product for a specified level of
performance of that product.
The elementary economic analysis applied to the selection of design for a
product is illustrated with two example problems.

Example 1.6 Two alternatives are under consideration for a taperedfastening pin.
Either design will serve the purpose and will involve the same material and
manufacturing cost except for the lathe and grinder operations.
Design A will require 16 hours of lathe time and 4.5 hours of grinder time per
1,000 units. Design B will require 7 hours of lathe time and 12 hours of grinder time
per 1,000 units. The operating cost of the lathe including labour is Rs. 200 per hour.
The operating cost of the grinder including labour is Rs. 150 per hour. Which design
should be adopted if 1,00,000 units are required per year and what is the economic
advantage of the best alternative?
Solution
Operating cost of lathe including labour = Rs. 200 per hr Operating cost
of grinder including labour = Rs. 150 per hr
(a) Cost of design A
No. of hours of lathe time per 1,000 units = 16 hr
No. of hours of grinder time per 1,000 units = 4.5 hr
Total cost of design A/1,000 units

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= Cost of lathe operation per 1,000 units

+ Cost of grinder operation per 1,000 units
= 16 *200 + 4.5 *50
= Rs. 3,875

Total cost of design A/1,00,000 units = 3,875 *1,00,000/1,000

= Rs. 3,87,500
(b) Cost of design B
No. of hours of lathe time per 1,000 units = 7 hr
No. of hours of grinder time per 1,000 units = 12 hr
Total cost of design B/1,000 units
= Cost of lathe operation/1,000 units
+ Cost of grinder operation/1,000 units
= 7 *200 + 12 *150
= Rs. 3,200
Total cost of design B/1,00,000 units = 3,200 *1,00,000/1,000
= Rs. 3,20,000

DECISION The total cost/1,00,000 units of design B is less than that of design A.
Hence, design B is recommended for making the tapered fastening pin.

Economic advantage of the design B over design A per 1,00,000 units

= Rs. 3,87,500 – Rs. 3,20,000
=Rs. 67,500

Example 1.7(Design selection for a process industry).The chief engineerof refinery

operations is not satisfied with the preliminary design for storage tanks to be used as
part of a plant expansion programme. The engineer who submitted the design was
called in and asked to reconsider the overall dimensions in the light of an article in the
Chemical Engineer, entitled ―How to size future process vessels?‖
The original design submitted called for 4 tanks 5.2 m in diameter and 7 m in height.
From a graph of the article, the engineer found that the present ratio of height to
diameter of 1.35 is 111% of the minimum cost and that the minimum cost for a tank

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was when the ratio of height to diameter was 4 : 1. The cost for the tank design as
originally submitted was estimated to be Rs. 9,00,000. What are the optimum tank
dimensions if the volume remains the same as for the original design? What total
savings may be expected through the redesign?
Solution
(a) Original design
Number of tanks = 4
Diameter of the tank = 5.2 m
Radius of the tank = 2.6 m
Height of the tank = 7 m
Ratio of height to diameter = 7/5.2 = 1.35
Volume/tank = (22/7)r2h = (22/7)(2.6)2 ´ 7
= 148.72 m3

(b) New design

Cost of the old design = 111% of the cost of the new design (optimal design)
Optimal ratio of the height to diameter = 4:1
h : d = 4 : 14d = h
d = h/4
r = h/8

Therefore,
Diameter of the new design = 1.81 *2
= 3.62 m
Cost of the new design = 9,00,000 *(100/111)
= Rs. 8,10,810.81
Expected savings by the redesign = Rs. 9,00,000 – Rs. 8,10,810.81
= Rs. 89,189.19

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Building Material Selection

As discussed in the introduction to this chapter, the sourcing of raw materials
will have a significant effect on the cost of any product. Hence, it is assumed that the
price of raw material is location dependent. While sourcing a raw material, the cost of
transportation is to be considered in conjunction with the price of the raw material.
This concept is demonstrated with a numerical example.
Example 1.8 In the design of buildings to be constructed in Alpha State, thedesigner
is considering the type of window frame to specify. Either steel or aluminium window
frames will satisfy the design criteria. Because of the remote location of the building
site and lack of building materials in Alpha State, the window frames will be
purchased in Beta State and transported for a distance of 2,500 km to the site. The
price of window frames of the type required is Rs. 1,000 each for steel frames and Rs.
1,500 each for aluminium frames. The weight of steel window frames is 75 kg each
and that of aluminium window frame is 28 kg each. The shipping rate is Re 1 per kg
per 100 km. Which design should be specified and what is the economic advantage of
the selection?
Solution
Distance between Alpha State and Beta State = 2,500 km
Transportation cost = Re 1/kg/100 km

(a) Steel window frame

Price of steel window frame/unit = Rs 1,000 Weight of steel
window frame/unit = 75 kg
Total cost of steel window frame/unit
= Price of steel window frame/unit
+ Transportation cost of steel window frame/unit
= 1,000 + (75 *2,500 *1)/100
= Rs. 2,875

(b) Aluminium window frame

Price of aluminium window frame/unit = Rs. 1,500
Weight of aluminium window frame/unit = 28 kg
Total cost of aluminium window frame/unit

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= Price of aluminium window frame/unit +Transportation cost of aluminium

window frame/unit
= 1,500 + (28 *2,500 *1)/100
= Rs. 2,200

DECISION The total cost/unit of the aluminium window frame is less than that of
steel window frame. Hence, aluminium window frame is recommended.
The economic advantage/unit of the aluminium
window frame over the steel window frame = Rs. 2,875 – 2,200
= Rs. 675

Process Planning /Process Modification

While planning for a new component, a feasible sequence of operations with the
least cost of processing is to be considered. The process sequence of a component
which has been planned in the past is not static. It is always subject to modification
with a view to minimize the cost of manufacturing the component. So, the objective of
process planning/process modification is to identify the most economical sequence of
operations to produce a component.
The steps in process planning are as follows:
1. Analyze the part drawing to get an overall picture of what is required.
2. Make recommendations to or consult with product engineers on product design
changes.
3. List the basic operations required to produce the part to the drawing or
specifications.
4. Determine the most practical and economical manufacturing method and the
form or tooling required for each operation.
5. Devise the best way to combine the operations and put them in sequence.
6. Specify the gauging required for the process.
Steps 3–5 aim to determine the most practical and economical sequence of
operations to produce a component. This concept is demonstrated with a numerical
problem.

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Example 1.9 The process planning engineer of a firm listed the sequencesof
operations as shown in Table 1.3 to produce a component.
Table 1.3 Data for Example 1.9

SequenceProcess sequence

1 Turning – Milling – Shaping – Drilling

2 Turning – Milling – Drilling
3 All operations are performed with CNC machine

The details of processing times of the component for various operations and their
machine hour rates are summarized in Table 1.4.
Table 1.4 Machine Hour Rates and Processing Times (minutes) for Example 1.9

Find the most economical sequence of operations to manufacture the component.

Solution (a) Cost of component using process sequence 1. The processsequence 1 of
the component is as follows:
Turning – Milling – Shaping – Drilling
The calculations for the cost of the above process sequence are summarized in
Table 1.5.

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Table 1.5 Workings for Process Sequence 1

(b) Cost of component using process sequence 2. The process sequence 2of the
component is as follows:
Turning – Milling – Drilling
The calculations for the cost of the above process sequence are given in Table 1.6.

Table 1.6 Workings for Process Sequence 2

(c) Cost of component using process sequence 3. The process sequence 3 of the
component is as follows:
Only CNC operations
The calculations for the cost of the above process sequence are summarized in Table
1.7
Table 1.7 Workings for Process Sequence 3

Mr. S. BALAJI., AP/ECE/ACET Page No. 25

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INTEREST FORMULAS AND THEIR APPLICATIONS

Make or Buy Decision

Introduction
In the process of carrying out business activities of an organization, a
component/product can be made within the organization or bought from a
subcontractor. Each decision involves its own costs. So, in a given situation, the
organization should evaluate each of the above make or buy alternatives and then
select the alternative which results in the lowest cost. This is an important decision
since it affects the productivity of the organization. In the long run, the make or buy
decision is not static. The make option of a component/productmay be economical
today; but after some time, it may turn out to be uneconomical to make the same.
Thus, the make or buy decision should be reviewed periodically, say, every 1 to 3
years. This is mainly to cope with the changes in the level of competition and various
other environmental factors.

Criteria for Make Or Buy

In this section the criteria for make or buy are discussed.
Criteria for make
The following are the criteria for make:
1. The finished product can be made cheaper by the firm than by
outsidesuppliers.
2. The finished product is being manufactured only by a limited number
ofoutside firms which are unable to meet the demand.
3. The part has an importance for the firm and requires extremely closequality
control.
4. The part can be manufactured with the firm‘s existing facilities andsimilar to
other items in which the company has manufacturing experience.
Criteria for buy
The following are the criteria for buy:
1. Requires high investments on facilities which are already available at
suppliers plant.
2. The company does not have facilities to make it and there are more profitable
opportunities for investing company‘s capital.

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3. Existing facilities of the company can be used more economically to make

other parts.
4. The skill of personnel employed by the company is not readily adaptable to
make the part.
5. Patent or other legal barriers prevent the company for making the part.
6. Demand for the part is either temporary or seasonal.

Approaches for Make Or Buy Decision

Types of analysis followed in make or buy decision are as follows:
1. Simple cost analysis
2. Economic analysis
3. Break-even analysis
Simple Cost Analysis
The concept is illustrated using an example problem.
Example 1:
A company has extra capacity that can be used to produce a sophisticated fixture
which it has been buying for Rs. 900 each. If the company makes the fixtures, it will
incur materials cost of Rs. 300 per unit, labour costs of Rs. 250 per unit, and variable
overhead costs of Rs. 100 per unit. The annual fixed cost associated with the unused
capacity is Rs. 10,00,000. Demand over the next year is estimated at 5,000 units.
Would it be profitable for the company to make the fixtures?
Solution We assume that the unused capacity has alternative use.

Cost to make
Variable cost/unit = Material + labour + overheads
= Rs. 300 + Rs. 250 + Rs. 100
= Rs. 650
Total variable cost = (5,000 units) (Rs. 650/unit)
= Rs. 32,50,000

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The cost of making fixtures is less than the cost of buying fixtures fromoutside.
Therefore, the organization should make the fixtures.
Economic Analysis
The following inventory models are considered to illustrate this concept:
 Purchase model
 Manufacturing model
The formulae for EOQ and total cost (TC) for each model are given in the following
table

where
D = demand/year
P = purchase price/unit
Cc = carrying cost/unit/year
Co = ordering cost/order or set-up cost/set-up
k = production rate (No. of units/year)
r = demand/year
Q1 = economic order size
Q2 = economic production size
TC = total cost per year

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Example 2:
An item has a yearly demand of 2,000 units. The different costs in respect of make
and buy are as follows. Determine the best option.

Solution
Buy option
D = 2,000 units/year
Co = Rs. 120/order
Cc = Rs. 1.60/unit/year

= Rs. 16,876.36
Make option
Co = Rs. 60/set-up
r = 2,000 units/year
Cc = Re 1/unit/year
k = 8,000 units/year

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Result: The cost of making is less than the cost of buying. Therefore, the firm should
go in for the making option.

Break-even Analysis
The break-even analysis chart is shown in Fig.
TC = total cost
FC = fixed cost
TC = FC + variable cost
B = the intersection of TC and sales (no loss or no gain situation)
A = break-even sales
C = break-even quantity/break-even point (BEP)
The formula for the break-even point (BEP) is

Fig 1.9. Break-even chart.

Example 3There are three alternatives available to meet the demand of a particular
product. They are as follows:
(a) Manufacturing the product by using process A
(b) Manufacturing the product by using process B
(c) Buying the product
The details are as given in the following table:

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The annual demand of the product is 8,000 units. Should the company make
the product using process A or process B or buy it?
Solution
Annual cost of process A = FC + VC X Volume
= 5,00,000 + 175 X 8,000
= Rs. 19,00,000
Annual cost of process B = FC + VC X Volume
= 6,00,000 + 150 X 8,000
= Rs. 18,00,000
Annual cost of buy = Purchase price/unit X Volume
= 125 X 8,000
= Rs. 10,00,000
Since the annual cost of buy option is the minimum among all the alternatives, the
company should buy the product.

Value Engineering
Introduction
Value analysis is one of the major techniques of cost reduction and cost prevention. It
is a disciplined approach that ensures necessary functions for minimum cost without
sacrificing quality, reliability, performance, and appearance. According to the Society
of American Value Engineers (SAVE),
Value Analysis is the systematic application of recognized techniques which
identify the function of a product or service, establish a monetary value for the
function and provide the necessary function reliably at the lowest overall cost.
It is an organized approach to identify unnecessary costs associated with any product,
material part, component, system or service by analysing the function and eliminating
such costs without impairing the quality, functional reliability, or the capacity of the
product to give service.

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When to apply value analysis

One can definitely expect very good results by initiating a VA programme if one or
more of the following symptoms are present:
1. Company‘s products show decline in sales.
2. Company‘s prices are higher than those of its competitors.
3. Raw materials cost has grown disproportionate to the volume of production.
4. New designs are being introduced.
5. The cost of manufacture is rising disproportionate to the volume of
production.
6. Rate of return on investment has a falling trend.
7. Inability of the firm to meet its delivery commitments.
Value Analysis vs. Value Engineering
Often the terms value analysis and value engineering are used synonymously. Though
the philosophy underlying the two is same, i.e. identification of unnecessary cost, yet
they are different. The difference lies in the time and the stage at which the techniques
are applied.
Value analysis is the application of a set of techniques to an existing product with a
view to improve its value. It is thus a remedial process. Value engineering is the
application of exactly the same set of techniques to a new product at the design stage,
project concept or preliminary design when no hardware exists to
that bad features are not added. Value engineering, therefore, is a preventive process.
Value
The term ‗value‘ is used in different ways and, consequently, has different meanings.
The designer equates the value with reliability; a purchase person with price paid for
the item; a production person with what it costs to manufacture, and a sales person
with what the customer is willing to pay. Value, in value investigation, refers to
―economic value‖, which itself can be divided into four types: cost value, exchange
value, use value, and esteem value. These are now briefly described.
Cost value. It is the summation of the labour, material, overhead and all other
elements of cost required to produce an item or provide a service compared to a base.
Exchange value. It is the measure of all the properties, qualities and features of the
product, which make the product possible of being traded for another product or for
money. In a conventional sense, exchange value refers to the price that a purchaser

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will offer for the product, the price being dependent upon satisfaction (value) which he
derives from the product. Value derived from the product consists of two parts ―use
value‖ and ―esteem value‖, which are now described.
Use value. It is known as the function value. The use value is equal to the value of the
functions performed. Therefore, it is the price paid by the buyer (buyer‘s view), or the
cost incurred by the manufacturer (manufacturer‘s view) in order to ensure that the
product performs its intended functions efficiently. The use value is the fundamental
form of economic value. An item without ―use value‖ can have neither ―exchange
value‖ nor ―esteem value‖.
Esteem value. It involves the qualities and appearance of a product (like a TV set),
which attract persons and create in them a desire to possess the product. Therefore,
esteem value is the price paid by the buyer or the cost
incurred by the manufacturer beyond the use value.
Performance
The performance of a product is the measure of functional features andproperties that
make it suitable for a specific purpose. Appropriate performancerequires that (a) the
product reliably accomplish the intended use of work or service requirement
(functional requirements), (b) the product provide (safety requirements), (c) the product
give trouble-free service cover during its specified life span (reliability requirements),
(d) service and maintenance work can be carried out on the product with ease and
with simple tools (maintainability requirements), and (e) appearance of the product
creates an impression on the buyer and induces in him or her the desire to own the
product (appearance requirements). Performance and cost must be interwoven.
Desired performance at the least cost should be achieved by selecting appropriate
materials and manufacturing operations, which is the measure of value. Therefore, the
value of the product is the ratio of performance (utility) to cost. Thus,

Value can be increased by increasing the utility for the same cost or by decreasing the
cost for the same utility. Satisfactory performance at lesser cost through identification
and development of low cost alternatives is the philosophy of Value analysis.

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Function
Function is the purpose for which the product is made. Identification of the
basic functions and determination of the cost currently being spent on them are the
two major considerations of value analysis.
Function identifies the characteristics which make the product/component/
part/item/device to work or sell. ―Work functions‖ lend performance value while ―sell
functions‖ provide esteem value. Verbs like ―support‖, ―hold‖, ―transmit‖, ―prevent‖,
―protect‖, ―exhibits‖, ―control‖, etc., are used to describe work functions, while
―attract‖, enhance‖, ―improve‖, ―create‖, etc., are used to describe ―sell‖ functions. For
example, in a ―bus driver cabin‖, the functional analysis of some of the parts are given
in Table
Table 1.11 Functional Analysis of Some Parts of a Bus Driver Cabin

Classification of the functions

more important than others. Functions can be classified into the following three
categories:
1. Primary function
2. Secondary function
3. Tertiary function
Primary functionsare the basic functions for which the product is specially designed
to achieve. Primary functions, therefore, are the most essential functions whose non -
performance would make the product worthless, e.g. a photo frame exhibits
photographs, a chair supports weight, a fluorescent tube gives light.
Secondary functionsare those which, if not in-built, would not prevent the device
from performing its primary functions, e.g., arms of a chair provide support for hands.
Secondary functions are usually related to convenience. The product can still work

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and fulfill its intended objective even if these functions are not in-built and yet they
may be necessary to sell the product.
Tertiary functionsare usually related to esteem appearance. For example, Sunmica
top of a table gives esteem appearance for the table. Let us consider a single example
of painting a company bus to explain all
the above three functions. Here, the primary function of painting is to avoid corrosion.
The secondary function is to identify the company to which the bus belongs by the
colour of the paint (e.g. blue colour for Ashok Leyland Ltd.). The tertiary function is to
impart a very good appearance to the bus by using brilliant
colours.

Aims
The aims of value engineering are as follows:
1. Simplify the product.
2. Use (new) cheaper and better materials.
3. Modify and improve product design.
4. Use efficient processes.
5. Reduce the product cost.
6. Increase the utility of the product by economical means.
7. Save money or increase the profits.
The value content of each piece of a product is assessed using the following questions:
1. Does its use contribute to value?
2. Is its cost proportionate to its usefulness?
3. Does it need all its features?
These three questions pertain to the function of the part which may decide
the elimination of parts.
 _ Is there anything better for the intended use?
 _ Can company or vendor standard be used?
 _ Can a usable part be made by a lower-cost method?
 _ Is it made with the proper tooling, considering volume?
 _ Does the part yield suitable profit?
 _ Can another vendor furnish the same at a lower cost?

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Value Engineering Procedure

The basic steps of value engineering are as follows:
(a) Blast (i) Identify the product.
(ii) Collect relevant information.
(iii) Define different functions.

(b) Create (iv) Different alternatives.

(v) Critically evaluate the alternatives.

(c) Refine (vi) Develop the best alternative.

(vii) Implement the alternative.
Step 1: Identify the product. First, identify the component for study. In future, any
design change should add value and it should not make the product as obsolete one.
Value engineering can be applied to a product as a whole or to sub-units.
Step 2: Collect relevant information. Information relevant to the following must be
collected:
 Technical specifications with drawings
 Production processes, machine layout and instruction sheet
 Time study details and manufacturing capacity
 Complete cost data and marketing details
 Latest development in related products
Step 3: Define different functions. Identify and define the primary, secondary and
tertiary functions of the product or parts of interest. Also, specify the value content of
each function and identify the high cost areas.
Step 4: Different alternatives. Knowing the functions of each component part and its
manufacturing details, generate the ideas and create different alternatives so as to
increase the value of the product. Value engineering should be done after a brain
storming session. All feasible or non-feasible suggestions are recorded without any
criticism; rather, persons are encouraged to express their views freely.
Basic principles of brain storming
Some of the important principles of brain storming which are useful in value analysis
are now listed.

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(i) A quality idea comes from quantity of ideas. If the number of ideas generated is
more, the more good solutions do turn up.
(ii) Creative ideas emerge from unconventional thinking. This is possible when
members of the group ―talk off the top of their heads‖ and voice weird ideas as they
flash through their minds, regardless of how stupid or impractical they may appear.
Often, non-technical personnel can prove to be the greatest innovators in technical
areas since their viewpoints are objective and they do not know that some of their
ideas are technically not feasible at all. So it is preferable to include one or two non -
technical persons in the study team.
Members are to be told by the team leader in the beginning of the session itself, not to
breathe a word of criticism of even the most weirdest idea.
(iii) Spontaneous evaluation of ideas curbs imaginative thinking and retards
the flow of creative ideas. The group should not evaluate the alternatives suggested
by its member immediately since immediate evaluation may curb imaginative thinking
and slow down the flow of creative ideas.
(iv) Hitch-hiking on the ideas often lead to better ideas. Participants have to
improve upon ideas of other members either directly or by combining more ideas in
addition to contributing ideas of their own. A brilliant idea may not be a practical one
initially, or it may look to be silly or useless but discussions can convert it into a
valuable one.
(v) Creativity is a regenerative process and the recording of ideas as they
emerge helps serve as a catalyst to generate more ideas.Memory may not retain
all ideas or recall them when they are needed. So, a stenographer may be asked to
record ideas simultaneously. A tape recorder can also be used for this purpose or even
ideas can be written on a blackboard. These recorded ideas can
be reviewed at some later date.
(vi) When ideas cease to flow, short diversions enable the mind to rebound
with new ideas after recuperation.Members of the syndicate may reach a stage
where new ideas do not come. At such a stage, short diversions—rest, favourite sport,
hobby, lunch or tea break, etc.—may be taken during which members are advised to
sleep over the ideas and report fresh after the break. Such short diversions enable
mind to recoup and rebound with new ideas.

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Step 5: Critically evaluate the alternatives. Different ideas recorded under step 4
are compared, evaluated and critically assessed for their virtues, validity and
feasibility as regards their financial and technical requirements. The ideas technically
found and involving lower costs are further developed.
Step 6: Develop the best alternative. Detailed development plans are made for those
ideas which emerged during step 5 and appear most suitable and promising.
Development plans comprise drawing the sketches, building of models, conducting
discussions with the purchase section, finance section,
marketing division, etc.
Step 7: Implement the alternative. The best alternative is converted into a proto-
type manufacturing model which ultimately goes into operation and its results are
recorded.

Time Value Of Money

If an investor invests a sum of Rs. 100 in a fixed deposit for five years with an
interest rate of 15% compounded annually, the accumulated amount at the end of
every year will be as shown in Table 1.12
Table 1.12 Compound Amounts
(amount of deposit = Rs. 100.00)

Year end Interest Compound amount

(Rs.) (Rs.)

0 100.00
1 15.00 115.00
2 17.25 132.25
3 19.84 152.09
4 22.81 174.90
5 26.24 201.14

The formula to find the future worth in the third column is

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Where
P = principal amount invested at time 0,
F = future amount,
i = interest rate compounded annually,
n = period of deposit.
The maturity value at the end of the fifth year is Rs. 201.14. This means that
the amount Rs. 201.14 at the end of the fifth year is equivalent to Rs. 100.00 at time 0
(i.e. at present). This is diagrammatically shown in Fig. 1.10. This explanation
assumes that the inflation is at zero percentage

Fig. 1.10 Time value of money.

Alternatively, the above concept may be discussed as follows: If we want Rs.
at the end of the nth year, what is the amount that we should deposit now
at a given interest rate, say 15%? A detailed working is shown in Table 1.13.

Table 1.13 Presentworth Amounts(Rate of interest = 15%)

End of year Present worth Compound amount

(n) after n year(s)

0 100
1 86.96 100
2 75.61 100
3 65.75 100
4 57.18 100
5 49.72 100
6 43.29 100
7 37.59 100
8 32.69 100
9 28.43 100
10 24.72 100

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The formula to find the present worth in the second column is

From Table 2.2, it is clear that if we want Rs. 100 at the end of the fifth year, we
should now deposit an amount of Rs. 49.72. Similarly, if we want Rs. 100.00 at the
end of the 10th year, we should now deposit an amount of Rs. 24.72.
Also, this concept can be stated as follows:
A person has received a prize from a finance company during the recent festival
contest. But the prize will be given in either of the following two modes:

1. Spot payment of Rs. 24.72 or

2. Rs. 100 after 10 years from now (this is based on 15% interest rate compounded
annually).

If the prize winner has no better choice that can yield more than 15% interest rate
compounded annually, and if 15% compounded annually is the common interest rate
paid in all the finance companies, then it makes no difference whether he receives Rs.
24.72 now or Rs. 100 after 10 years.
On the other hand, let us assume that the prize winner has his own business wherein
he can get a yield of 24% interest rate (more than 15%) compounded annually, it is
better for him to receive the prize money of Rs. 24.72 at present and utilize it in his
business. If this option is followed, the equivalent amount for Rs. 24.72 at the end of
the 10th year is Rs. 212.45. This example clearly demonstrates the time value of
money.

Interest Formulas
While making investment decisions, computations will be done in many ways. To
simplify all these computations, it is extremely important to know how to use interest
formulas more effectively. Before discussing the effective application of the interest
formulas for investment-decision making, the various interest formulas are presented
first.
Interest rate can be classified into simple interest rate and compoundinterest rate.
In simple interest, the interest is calculated, based on the initial deposit for every

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interest period. In this case, calculation of interest on interest is not applicable. In

compound interest, the interest for the current period is computed based on the
amount (principal plus interest up to the end of the previous period) at the beginning
of the current period.
The notations which are used in various interest formulae are as follows:
P = principal amount
n = No. of interest periods
i = interest rate (It may be compounded monthly, quarterly, semiannually or
annually)
F = future amount at the end of year n
A = equal amount deposited at the end of every interest period
G = uniform amount which will be added/subtracted period after period to/from
the amount of deposit A1 at the end of period 1
Single-Payment Compound Amount
Here, the objective is to find the single future sum (F) of the initial payment (P)
made at time 0 after n periods at an interest rate i compounded every period. The cash
flow diagram of this situation is shown in Fig. 1.12.

Fig. 1.12 Cash flow diagram of single-payment compound amount

Example 2.1A person deposits a sum of Rs. 20,000 at the interest rate of 18%
compounded annually for 10 years. Find the maturity value after 10 years.

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Single-Payment Present Worth Amount

Here, the objective is to find the present worth amount (P) of a single future
sum (F) which will be received after n periods at an interest rate of i compounded at
the end of every interest period. The corresponding cash flow diagram is shown in Fig.
1.11

Fig. 1.11 Cash flow diagram of single-payment present worth amount

Where (P/F, i, n) is termed as single-payment present worth factor.

Example 2.2
A person wishes to have a future sum of Rs. 1,00,000 for his son‘s education after
10 years from now. What is the single-payment that he should deposit now so that he
gets the desired amount after 10 years? The bank gives 15% interest rate compounded
annually

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Equal-Payment Series Compound Amount

In this type of investment mode, the objective is to find the future worth of n
equal payments which are made at the end of every interest period till the end of the
nth interest period at an interest rate of i compounded at the end of each interest
period. The corresponding cash flow diagram is shown in Fig. 1.13.

Fig. 1.13 Cash flow diagram of equal-payment series compound amount

In Fig. 2.4,
A = equal amount deposited at the end of each interest period
n = No. of interest periods
i = rate of interest
F = single future amount
The formula to get F is

Where (F/A, i, n) is termed as equal-payment series compound amount factor.

Example 2.3
A person who is now 35 years old is planning for his retiredlife. He plans to
invest an equal sum of Rs. 10,000 at the end of every year forthe next 25 years

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starting from the end of the next year. The bank gives 20% interest rate, compounded
annually. Find the maturity value of his account when he is 60 years old.
Solution
A = Rs. 10,000
n = 25 years
i = 20%
F=?
The corresponding cash flow diagram is shown in Fig. 1.14.

Fig. 1.14. Cash flow diagram of equal-payment series compound amount.

Equal-Payment Series Sinking Fund

In this type of investment mode, the objective is to find the equivalent amount
(A) that should be deposited at the end of every interest period for n interest periods to
realize a future sum (F) at the end of the nth interest period at an interest rate of i.
The corresponding cash flow diagram is shown in Fig 1.15.

Fig 1.15 Cash flow diagram of equal-payment series sinking fund

In Fig. 1.15,

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A = equal amount to be deposited at the end of each interest period n = No. of

interest periods
i = rate of interest
F = single future amount at the end of the nth period
The formula to get F is

Example 2.4 A company has to replace a present facility after 15 years at an outlay
of Rs. 5,00,000. It plans to deposit an equal amount at the end of every year for the
next 15 years at an interest rate of 18% compounded annually. Find the equivalent
amount that must be deposited at the end of every year for the next 15 years.
Solution
F = Rs. 5,00,000
n = 15 years
i = 18%
A=?
The corresponding cash flow diagram is shown in Fig. 1.17.

Fig. 1.17 Cash flow diagram of equal-payment series sinking fund

The annual equal amount which must be deposited for 15 years is Rs. 8,200.

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Equal-Payment Series Present Worth Amount

The objective of this mode of investment is to find the present worth of an equal
payment made at the end of every interest period for n interest periods at an interest
rate of i compounded at the end of every interest period. The corresponding cash flow
diagram is shown in Fig. 1.16. Here,
P = present worth
A = annual equivalent payment
i = interest rate
n = No. of interest periods

Where
(P/A, i, n) is called equal-payment series present worth factor.

Fig. 1.16 Cash flow diagram of equal-payment series present worth amount

Example 2.5 A company wants to set up a reserve which will help the company to
have an annual equivalent amount of Rs. 10,00,000 for the next 20 years towards its
employees welfare measures. The reserve is assumed to grow at the rate of 15%
annually. Find the single-payment that must be made now as the reserve amount.
Solution
A = Rs. 10,00,000
i = 15%
n = 20 years
P=?
The corresponding cash flow diagram is illustrated in Fig. 1.18.

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Fig 1.18. Cash flow diagram of equal-payment series present worth amount

Equal-Payment Series Capital Recovery Amount

The objective of this mode of investment is to find the annual equivalent amount (A)
which is to be recovered at the end of every interest period for n interest periods for a
loan (P) which is sanctioned now at an interest rate of i compounded at the end of
every interest period (see Fig. 1.19).

Fig 1.19 Cash flow diagram of equal-payment series capital recovery amount

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Example 2.6 A bank gives a loan to a company to purchase an equipment worth

Rs.10,00,000 at an interest rate of 18% compounded annually. This amount should be
repaid in 15 yearly equal installments. Find the installment amount that the company
has to pay to the bank.
Solution
P = Rs. 10,00,000
i = 18%
n = 15 years
A=?
The corresponding cash flow diagram is shown in Fig. 1.20.

Fig 1.20 Cash flow diagram of equal-payment series capital recovery amount

The annual equivalent installment to be paid by the company to the bank is

Rs.1,96,400.
Uniform Gradient Series Annual Equivalent Amount
The objective of this mode of investment is to find the annual equivalent
amount of a series with an amount A1 at the end of the first year and with an equal
increment (G) at the end of each of the following n – 1 years with an interest rate i
compounded annually.The corresponding cash flow diagram is shown in Fig. 1.21.

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Fig. 1.21 Cash flow diagram of uniform gradient series annual equivalent amount

Example 2.7 A person is planning for his retired life. He has 10 more year of service.
He would like to deposit 20% of his salary, which is Rs. 4,000, at the end of the first
year, and thereafter he wishes to deposit the amount with an annual increase of Rs.
500 for the next 9 years with an interest rate of 15%. Find the total amount at the end
of the 10th year of the above series.
Solution Here,
A1 = Rs. 4,000
G = Rs. 500
i = 15%
n = 10 years
A=?&F=? The cash flow diagram is shown in Fig. 1.22.

Fig. 1.22 Cash flow diagram of uniform gradient series annual equivalent
amount

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This is equivalent to paying an equivalent amount of Rs. 5,691.60 at the end of every
year for the next 10 years. The future worth sum of this revised series at the end of the
10th year is obtained as follows:

At the end of the 10th year, the compound amount of all his payments will be Rs.
1,15,562.25.
Example 2.8 A person is planning for his retired life. He has 10 more years of service.
He would like to deposit Rs. 8,500 at the end of the first year and thereafter he wishes
to deposit the amount with an annual decrease of Rs. 500 for the next 9 years with an
interest rate of 15%. Find the total amount at the end of the 10th year of the above
series.
Solution Here,
A1 = Rs. 8,500
G = –Rs. 500
i = 15%
n = 10 years
A=?&F=?
The cash flow diagram is shown in Fig. 1.23.

Fig. 1.23 Cash flow diagram of uniform gradient series annual equivalent amount

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This is equivalent to paying an equivalent amount of Rs. 6,808.40 at the end of every
year for the next 10 years. The future worth sum of this revised series at the end of the
10th year is obtained as follows:

At the end of the 10th year, the compound amount of all his payments is Rs.
1,38,237.75.
Effective Interest Rate
Let i be the nominal interest rate compounded annually. But, in practice, the
compounding may occur less than a year. For example, compounding may be
monthly, quarterly, or semi-annually. Compounding monthly means that the interest
is computed at the end of every month. There are 12 interest periods ina year if the
interest is compounded monthly. Under such situations, the formula to compute the
effective interest rate, which is compounded annually, is

Example 2.9A person invests a sum of Rs. 5,000 in a bank at a nominalinterest rate
of 12% for 10 years. The compounding is quarterly. Find the maturity amount of the
deposit after 10 years.

Solution
P = Rs. 5,000
n = 10 years
i = 12% (Nominal interest rate)
F=?

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Bases For Comparison Of Alternatives

In most of the practical decision environments, executives will be forced to select
the best alternative from a set of competing alternatives. Let us assume that an
organization has a huge sum of money for potential investment and there are three
different projects whose initial outlay and annual revenues during their lives are
known. The executive has to select the best alternative among these three competing
projects.
There are several bases for comparing the worthiness of the projects. These bases are:
1. Present worth method
2. Future worth method
3. Annual equivalent method
4. Rate of return method

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UNIT - II

METHODS OF COMPARISON OF ALTERNATIVES

Present worth Method
Introduction
In this method of comparison, the cash flows of each alternative will be
reduced to time zero by assuming an interest rate i. Then, depending on the type of
decision, the best alternative will be selected by comparing the present worth
amounts of the alternatives. The sign of various amounts at different points in time
in a cash flow diagram is to be decided based on the type of the decision problem.
In a cost dominated cash flow diagram, the costs (outflows) will be assigned with
positive sign and the profit, revenue, salvages value (all inflows), etc. will be
assigned with negative sign. In a revenue/profit-dominated cash flow diagram, the
profit, revenue, salvage value (all inflows to an organization) will be assigned with
positive sign. The costs (outflows) will be assigned with negative sign. In case the
decision is to select the alternative with the minimum cost, then the alternative
with the least present worth amount will be selected. On the other hand, if the
decision is to select the alternative with the maximum profit, then the alternative
with the maximum present worth will be selected.
Revenue-Dominated Cash Flow Diagram
A generalized revenue-dominated cash flow diagram to demonstrate the present
worth method of comparison is presented in Fig. 3.1.

Fig 2.1 Revenue-dominated cash flow diagram.

In Fig. 3.1, P represents an initial investment and Rj the net revenue at the end of
the jth year. The interest rate is i, compounded annually. S is the salvage value at
the end of the nth year.
To find the present worth of the above cash flow diagram for a given interest rate,
the formula is
PW(i) = – P + R1[1/(1 + i)1] + R2[1/(1 + i)2] + ...
+ Rj[1/(1 + i) j] + Rn[1/(1 + i)n] + S[1/(1 + i)n]
In this formula, expenditure is assigned a negative sign and revenues are assigned
a positive sign. If we have some more alternatives which are to be compared with
this alternative, then the corresponding present worth amounts are to be computed

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and compared. Finally, the alternative with the maximum present worth amount
should be selected as the best alternative.
Cost-Dominated Cash Flow Diagram
A generalized cost-dominated cash flow diagram to demonstrate the present worth
method of comparison is presented in Fig. 3.2.

Fig 2.2 Cost-dominated cash flow diagram

In Fig. 3.2, P represents an initial investment, Cj the net cost of operation and
maintenance at the end of the jth year, and S the salvage value at the end of the
nth year. To compute the present worth amount of the above cash flow diagram for
a given interest rate i, we have the formula

PW(i) = P + C1[1/(1 + i)1] + C2[1/(1 + i)2] + ... + Cj[1/(1 + i) j]

+ Cn[1/(1 + i)n] – S[1/(1 + i)n]

In the above formula, the expenditure is assigned a positive sign and the revenue a
negative sign. If we have some more alternatives which are to be compared with
this alternative, then the corresponding present worth amounts are to be computed
and compared. Finally, the alternative with the minimum present worth amount
should be selected as the best alternative.
Example 1:
In this section, the concept of present worth method of comparison applied to the
selection of the best alternative is demonstrated with several illustrations.
Alpha Industry is planning to expand its production operation. It has
identified three different technologies for meeting the goal. The initial outlay and
annual revenues with respect to each of the technologies are summarized in Table
Suggest the best technology which is to be implemented based on the
present worth method of comparison assuming 20% interest rate,
compounded annually.
Table 2.1

Solution In all the technologies, the initial outlay is assigned a negative sign and
the annual revenues are assigned a positive sign.

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Technology 1
Initial outlay, P = Rs. 12,00,000
Annual revenue, A = Rs. 4,00,000
Interest rate, i = 20%, compounded annually
Life of this technology, n = 10 years

The present worth expression for this technology is

PW(20%)1 = –12,00,000 + 4,00,000 * (P/A, 20%, 10)
= –12,00,000 + 4,00,000 * (4.1925)
= –12,00,000 + 16,77,000
= Rs. 4,77,000

Fig 2.3 Cash flow diagram for technology 1

Technology 2
Initial outlay, P = Rs. 20,00,000
Annual revenue, A = Rs. 6,00,000
Interest rate, i = 20%, compounded annually
Life of this technology, n = 10 years

Fig 2.4 Cash flow diagramfor technology 2

The present worth expression for this technology is
PW(20%)2 = – 20,00,000 + 6,00,000 * (P/A, 20%, 10)
= – 20,00,000 + 6,00,000 * (4.1925)
= – 20,00,000 + 25,15,500
= Rs. 5,15,500

Technology 3
Initial outlay, P = Rs. 18,00,000
Annual revenue, A = Rs. 5,00,000
Interest rate, i = 20%, compounded annually
Life of this technology, n = 10 years

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The cash flow diagram of this technology is shown in Fig. 2.5.

Fig 2.5 Cash flow diagramfor technology 3

The present worth expression for this technology is

PW(20%)3 = –18,00,000 + 5,00,000 * (P/A, 20%, 10)
= –18,00,000 + 5,00,000 *(4.1925)
= –18,00,000 + 20,96,250
= Rs. 2,96,250
From the above calculations, it is clear that the present worth of technology 2 is the
highest among all the technologies. Therefore, technology 2 is suggested for
implementation to expand the production
Example 2: An engineer has two bids for an elevator to be installed in a new
building. The details of the bids for the elevators are as follows

Determine which bid should be accepted, based on the present worth method of
comparison assuming 15% interest rate, compounded annually.
Solution
Bid 1: Alpha Elevator Inc.
Initial cost, P = Rs. 4,50,000
Annual operation and maintenance cost, A = Rs. 27,000
Life = 15 years
Interest rate, i = 15%, compounded annually.

Fig 2.6 Cash flow diagramfor Bid 1

The present worth of the above cash flow diagram is computed as follows:
PW(15%) = 4,50,000 + 27,000(P/A, 15%, 15)

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= 4,50,000 + 27,000 x 5.8474

= 4,50,000 + 1,57,879.80
= Rs. 6,07,879.80
Bid 2: Beta Elevator Inc.
Initial cost, P = Rs. 5,40,000
Annual operation and maintenance cost, A = Rs. 28,500
Life = 15 years
Interest rate, i = 15%, compounded annually.

Fig 2.7 Cash flow diagramfor Bid 2

The present worth of the above cash flow diagram is computed as follows:
PW(15%) = 5,40,000 + 28,500(P/A, 15%, 15)
= 5,40,000 + 28,500 x 5.8474
= 5,40,000 + 1,66,650.90
= Rs. 7,06,650.90

The total present worth cost of bid 1 is less than that of bid 2. Hence, bid 1 is to be
selected for implementation. That is, the elevator from Alpha Elevator Inc. is to be
purchased and installed in the new building.
Example 3:
Investment proposals A and B have the net cash flows as follows:

Compare the present worth of A with that of B at i = 18%. Which proposal should
be selected?
Solution
Present worth of A at i = 18%. The cash flow diagram of proposal A is shown in
Fig

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Fig 2.8 Cash flow diagram for Proposal A

The present worth of the above cash flow diagram is computed as

PWA(18%) = –10,000 + 3,000(P/F, 18%, 1) + 3,000(P/F, 18%, 2)
+ 7,000(P/F, 18%, 3) + 6,000(P/F, 18%, 4)
= –10,000 + 3,000 (0.8475) + 3,000(0.7182)
+ 7,000(0.6086) + 6,000(0.5158)
= Rs. 2,052.10
Present worth of B at i = 18%. The cash flow diagram of the proposal B is shown
in Fig.

Fig 2.9 Cash flow diagramfor Proposal B

The present worth of the above cash flow diagram is calculated as

PWB(18%) = –10,000 + 6,000(P/F, 18%, 1) + 6,000(P/F, 18%, 2)
+ 3,000(P/F, 18%, 3) + 3,000(P/F, 18%, 4)
= –10,000 + 6,000(0.8475) + 6,000(0.7182)
+ 3,000(0.6086) + 3,000(0.5158)
= Rs. 2,767.40
At i = 18%, the present worth of proposal B is higher than that of proposal A.
Therefore, select proposal B.

Example 4:
A granite company is planning to buy a fully automated granite cutting machine. If
it is purchased under down payment, the cost of the machine is Rs. 16,00,000. If it
is purchased under installment basis, the company has to pay 25% of the cost at
the time of purchase and the remaining amount in 10 annual equal installments of
Rs. 2,00,000 each. Suggest the best alternative for the company using the present
worth basis at i = 18%, compounded annually.
Solution There are two alternatives available for the company:
1. Down payment of Rs. 16,00,000
2. Down payment of Rs. 4,00,000 and 10 annual equal installments of Rs.
2,00,000 each

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Present worth calculation of the second alternative. The cash flow diagram of
the second alternative is shown in Fig.

Fig 3.10 Cash flow diagram for Second Alternative

The present worth of the above cash flow diagram is computed as

PW(18%) = 4,00,000 + 2,00,000(P/A, 18%, 10)
= 4,00,000 + 2,00,000 x4.4941
= Rs. 12,98,820
The present worth of this option is Rs. 12,98,820, which is less than the first
option of complete down payment of Rs. 16,00,000. Hence, the company should
select the second alternative to buy the fully automated granite cutting machine.
Example 5:
A finance company advertises two investment plans. In plan 1, the company pays
Rs. 12,000 after 15 years for every Rs. 1,000 invested now. In plan 2, for every Rs.
1,000 invested, the company pays Rs. 4,000 at the end of the 10th year and Rs.
4,000 at the end of 15th year. Select the best investment plan from the investor’s
point of view at i = 12%, compounded annually.
Solution : Plan 1. The cash flow diagram for plan 1 is illustrated in Fig

Fig 2.11 Cash flow diagramfor Plan 1

The present worth of the above cash flow diagram is calculated as

PW(12%) = –1,000 + 12,000(P/F, 12%, 15)
= –1,000 + 12,000(0.1827)
= Rs. 1,192.40
Plan 2. The cash flow diagram for plan 2 is shown in Fig

Fig 2.12 Cash flow diagram for Plan 2

The present worth of the above cash flow diagram is computed as

PW(12%) = –1,000 + 4,000(P/F, 12%, 10) + 4,000(P/F, 12%, 15)

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= –1,000 + 4,000(0.3220) + 4,000(0.1827)

= Rs. 1,018.80

The present worth of plan 1 is more than that of plan 2. Therefore, plan 1 is the
best plan from the investor’s point of view.
Example 6: Novel Investment Ltd. accepts Rs. 10,000 at the end of every year for
20 years and pays the investor Rs. 8,00,000 at the end of the 20th year. Innovative
Investment Ltd. accepts Rs. 10,000 at the end of every year for 20 years and pays
the investor Rs. 15,00,000 at the end of the 25th year. Which is the best
investment alternative? Use present worth base with i = 12%.
Solution: Novel Investment Ltd’s plan. The cash flow diagram of Novel Investment
Ltd’s plan is shown in Fig

Fig 2.13 Cash flow diagramfor novel Investment Ltd

The present worth of the above cash flow diagram is computed as
PW(12%) = –10,000(P/A, 12%, 20) + 8,00,000(P/F, 12%, 20)
= –10,000(7.4694) + 8,00,000(0.1037)
= Rs. 8,266
Innovative Investment Ltd’s plan. The cash flow diagram of the Innovative
Investment Ltd’s plan is illustrated in Fig

Fig 2.14 Cash flow diagramfor Innovative Investment Ltd

The present worth of the above cash flow diagram is calculated as
PW(12%) = –10,000(P/A, 12%, 20) + 15,00,000(P/F, 12%, 25)
= –10,000(7.4694) + 15,00,000(0.0588)
= Rs. 13,506
The present worth of Innovative Investment Ltd’s plan is more than that of Novel
Investment Ltd’s plan. Therefore, Innovative Investment Ltd’s plan is the best from
investor’s point of view.
Example 7:A small business with an initial outlay of Rs. 12,000 yields Rs. 10,000
during the first year of its operation and the yield increases by Rs. 1,000 from its
second year of operation up to its 10th year of operation. At the end of the life of
the business, the salvage value is zero. Find the present worth of the business by
assuming an interest rate of 18%, compounded annually.

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Solution
Initial investment, P = Rs. 12,000
Income during the first year, A = Rs. 10,000
Annual increase in income, G = Rs. 1,000
n = 10 years
i = 18%, compounded annually
The cash flow diagram for the small business is depicted in Fig.

Fig 2.15 Cash flow diagramforSmall Business

The equation for the present worth is
PW(18%) = –12,000 + (10,000 + 1,000 x (A/G, 18%, 10)) x(P/A, 18%, 10)
= –12,000 + (10,000 + 1,000 x3.1936)x 4.4941
= –12,000 + 59,293.36
= Rs. 47,293.36
The present worth of the small business is Rs. 47,293.36.

Future worth Method

Introduction
In the future worth method of comparison of alternatives, the future worth of
various alternatives will be computed. Then, the alternative with the maximum
future worth of net revenue or with the minimum future worth of net cost will be
selected as the best alternative for implementation.
Revenue-Dominated Cash Flow Diagram
A generalized revenue-dominated cash flow diagram to demonstrate the future
worth method of comparison is presented in Fig. 3.6

Fig 2.16 Revenue-dominated cash flow diagram

.
P represents an initial investment, Rj the net-revenue at the end of the jth
year, and S the salvage value at the end of the nth year. The formula for the future
worth of the above cash flow diagram for a given
interest rate, i is
FW(i) = –P(1 + i)n + R1(1 + i)n–1 + R2(1 + i)n–2 + ...

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+ Rj(1 + i)n–j + ... + Rn + S

In the above formula, the expenditure is assigned with negative sign and the
revenues are assigned with positive sign. If we have some more alternatives which
are to be compared with this alternative, then the corresponding future worth
amounts are to be computed and compared. Finally, the alternative with the
maximum future worth amount should be selected as the best alternative.
Cost-Dominated Cash Flow Diagram
A generalized cost-dominated cash flow diagram to demonstrate the future worth
method of comparison is given in Fig. 3.7.

Fig 2.17 Cost-dominated cash flow diagram

P represents an initial investment, Cj the net cost of operation and

maintenance at the end of the jth year, and S the salvage value at the end of the
nth year. The formula for the future worth of the above cash flow diagram for a
giveninterest rate, i is
FW(i) = P(1 + i)n + C1(1 + i )n–1 + C2(1 + i)n–2 + ...
+ Cj(1 + i)n–j + ... + Cn – S
In this formula, the expenditures are assigned with positive sign and revenues with
negative sign. If we have some more alternatives which are to be compared with
this alternative, then the corresponding future worth amounts are to be computed
and compared. Finally, the alternative with the minimum future worth amount
should be selected as the best alternative.
Example
Consider the following two mutually exclusive alternatives:

At i = 18%, select the best alternative based on future worth method of comparison.

Solution Alternative A

Initial investment, P = Rs. 50,00,000

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Annual equivalent revenue, A = Rs. 20,00,000

Interest rate, i = 18%, compounded annually
Life of alternative A = 4 years
The cash flow diagram of alternative A is shown in Fig. 3.8

Fig 2.18 Cash flow diagram for alternative A

The future worth amount of alternative B is computed as

FWA(18%) = –50,00,000(F/P, 18%, 4) + 20,00,000(F/A, 18%, 4)
= –50,00,000(1.939) + 20,00,000(5.215)
= Rs. 7,35,000
Alternative B
Initial investment, P = Rs. 45,00,000
Annual equivalent revenue, A = Rs. 18,00,000
Interest rate, i = 18%, compounded annually
Life of alternative B = 4 years
The cash flow diagram of alternative B is illustrated in Fig. 3.9.

Fig 2.19 Cash flow diagram of alternative B

The future worth amount of alternative B is computed as

FWB(18%) = – 45,00,000(F/P, 18%, 4) + 18,00,000 (F/A, 18%, 4)
= –45,00,000(1.939) + 18,00,000(5.215)
= Rs. 6,61,500
The future worth of alternative A is greater than that of alternative B. Thus,
alternative A should be selected.
Example 2: A man owns a corner plot. He must decide which of the several
alternatives to select in trying to obtain a desirable return on his investment. After
much study and calculation, he decides that the two best alternatives are as given
in the following table:

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Evaluate the alternatives based on the future worth method at i = 12%.

Alternative 1—Build gas station
First cost = Rs. 20,00,000
Net annual income = Annual income – Annual property tax
= Rs. 8,00,000 – Rs. 80,000
= Rs. 7,20,000
Life = 20 years
Interest rate = 12%, compounded annually
The cash flow diagram for this alternative is depicted in Fig

Fig 2.20Cash flow diagram of alternative 1

The future worth of alternative 1 is computed as
FW1(12%) = –20,00,000 (F/P, 12%, 20) + 7,20,000 (F/A, 12%, 20)
= –20,00,000(9.646) + 7,20,000 (72.052)
= Rs. 3,25,85,440
Alternative 2—Build soft ice-cream stand
First cost = Rs. 36,00,000
Net annual income = Annual income – Annual property tax
= Rs. 9,80,000 – Rs. 1,50,000
= Rs. 8,30,000
Life = 20 years
Interest rate = 12%, compounded annually
The cash flow diagram for this alternative is shown in Fig

Fig 2.21Cash flow diagram of alternative 2

The future worth of alternative 2 is calculated as
FW2(12%) = – 36,00,000(F/P, 12%, 20) + 8,30,000 (F/A, 12%, 20)

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= –36,00,000 (9.646) + 8,30,000 (72.052)

= Rs. 2,50,77,560
The future worth of alternative 1 is greater than that of alternative 2. Thus,
building the gas station is the best alternative.

Example 3:The cash flow diagram of two mutually exclusive alternatives are given
in Figs

Fig 2.22Cash flow diagram of alternative 1

Fig 2.23Cash flow diagram of alternative 2

(a) Select the best alternative based on future worth method at i = 8%.
(b) Rework part (a) with i = 9% and 20%

(a) Evaluation at i = 8%
Alternative 1—This comes under equal payment gradient series.
P = Rs. 5,00,000
A1 = Rs. 50,000
G = Rs. 50,000
i = 8%
n = 6 years
The formula for the future worth of alternative 1 is
FW1(8%) = –P(F/P, 8%, 6) + [A1 + G(A/G, 8%, 6)] x(F/A, 8%, 6)
= – 5,00,000(1.587) + [50,000 + 50,000(2.2764)] x7.336
= – 79,35,000 + 1,63,820 x7.336
= –79,35,000 + 12,01,784
= Rs. 4,08,283.52

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Alternative 2—This comes under equal payment gradient series.

P = Rs. 7,00,000
A1 = Rs. 70,000
G = Rs. 70,000
i = 8%
n = 6 years
The formula for the future worth of alternative 2 is
FW2(8%) = –P(F/P, 8%, 6) + [A1 + G(A/G, 8%, 6)] x(F/A, 8%, 6)
FW2(8%) = –7,00,000 x1.587 + [70,000 + 70,000 x2.2764] x 7.336
= –11,10,900 + 16,82,497
= Rs. 5,71,596.93
The future worth of alternative 2 is more than that of alternative 1.
Therefore,alternative 2 must be selected.
(b) (i) Evaluation at i = 9%: Alternative 1
P = Rs. 5,00,000
A1 = Rs. 50,000
G = Rs. 50,000
n = 6 years
The formula for the future worth of alternative 1 is as follows:
FW1(9%) = – P(F/P, 9%, 6) + [A1 + G(A/G, 9%, 6)] x (F/A, 9%, 6)
= – 5,00,000 (1.677) + [50,000 + 50,000 (2.2498)] x7.523
= – 8,38,500 + 12,22,412.27
= Rs. 3,83,912.27
Alternative 2
P = Rs. 7,00,000
A1 = Rs. 70,000
G = Rs. 70,000
n = 6 years

The formula for the future worth of the alternative 2 is

FW2(9%) = –P(F/P, 9%, 6) + [A1 + G(A/G, 9%, 6)] x(F/A, 9%, 6)
= –7,00,000 x1.677 + [70,000 + 70,000 x2.2498] x 7.523
= –11,73,900 + 17,11,377.18
= Rs. 5,37,477.18
The future worth of alternative 2 is more than that of alternative 1. Therefore,
alternative 2 must be selected.
(ii) Evaluation at i = 20%: Alternative 1
P = Rs. 5,00,000
A1 = Rs. 50,000
G = Rs. 50,000
n = 6 years
The formula for the future worth of alternative 1 is
FW1(20%) = –P(F/P, 20%, 6) + [A1 + G(A/G, 20%, 6)] x(F/A, 20%, 6)

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= –5,00,000(2.986) + [50,000 + 50,000 (1.9788)] x9.93

= –14,93,000 + 14,78,974.20
= Rs. –14,025.80
The negative sign of the future worth amount indicates that alternative 1incurs
loss.

Alternative 2
P = Rs. 7,00,000
A1 = Rs. 70,000
G = Rs. 70,000
n = 6 years
The formula for the future worth of alternative 2 is
FW2(20%) = – P(F/P, 20%, 6) + [A1 + G(A/G, 20%, 6)] x(F/A, 20%, 6)
= –7,00,000 _ 2.986 + [70,000 + 70,000 x1.9788] x9.93
= –20,90,200 + 20,70,563.88
= Rs. –19,636.12
The negative sign of the above future worth amount indicates that alternative 2
incurs loss. Thus, none of the two alternatives should be selected.
Example 4: M/S Krishna Castings Ltd. is planning to replace its annealing
furnace. It has received tenders from three different original manufacturers of
annealing furnace. The details are as follows.

Which is the best alternative based on future worth method at i = 20%?

Solution Alternative 1—Manufacturer 1
First cost, P = Rs. 80,00,000
Life, n = 12 years
Annual operating and maintenance cost, A = Rs. 8,00,000
Salvage value at the end of furnace life = Rs. 5,00,000
The cash flow diagram for this alternative is shown in Fig.

Fig 2.24Cash flow diagram of Manufacturer 1

The future worth amount of alternative 1 is computed as

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FW1(20%) = 80,00,000 (F/P, 20%, 12) + 8,00,000 (F/A, 20%, 12) – 5,00,000
= 80,00,000(8.916) + 8,00,000 (39.581) – 5,00,000
= Rs. 10,24,92,800

Alternative 2— Manufacturer 2
First cost, P = Rs. 70,00,000
Life, n = 12 years
Annual operating and maintenance cost, A = Rs. 9,00,000
Salvage value at the end of furnace life = Rs. 4,00,000
The cash flow diagram for this alternative is given in Fig

Fig 2.25 Cash flow diagram of Manufacturer 2

The future worth amount of alternative 2 is computed as

FW2(20%) = 70,00,000(F/P, 20%, 12) + 9,00,000(F/A, 20%, 12) – 4,00,000
= 70,00,000(8.916) + 9,00,000 (39.581) – 4,00,000
= Rs. 9,76,34,900
Alternative 3—Manufacturer 3
First cost, P = Rs. 90,00,000
Life, n = 12 years
Annual operating and maintenance cost, A = Rs. 8,50,000
Salvage value at the end of furnace life = Rs. 7,00,000
The cash flow diagram for this alternative is illustrated in Fig.

Fig 2.26Cash flow diagram of Manufacturer 3

The future worth amount of alternative 3 is calculated as
FW3(20%) = 90,00,000(F/P, 20%, 12) + 8,50,000(F/A, 20%, 12) – 7,00,000
= 90,00,000(8.916) + 8,50,000 (39.581) – 7,00,000
= Rs. 11,31,87,850

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The future worth cost of alternative 2 is less than that of the other two alternatives.
Therefore, M/s. Krishna castings should buy the annealing furnace from
manufacturer 2.

Example 5: A company must decide whether to buy machine A or machine B:

At 12% interest rate, which machine should be selected? (Use future worth method
of comparison).
Solution Machine A
Initial cost of the machine, P = Rs. 4,00,000
Life, n = 4 years
Salvage value at the end of machine life, S = Rs. 2,00,000
Annual maintenance cost, A = Rs. 40,000
Interest rate, i = 12%, compounded annually.

Fig 2.27Cash flow diagram of Machine A

The future worth function of Fig. 5.12 is

FWA(12%) = 4,00,000 x(F/P, 12%, 4) + 40,000 x (F/A, 12%, 4) – 2,00,000
= 4,00,000 x(1.574) + 40,000 x(4.779) – 2,00,000
= Rs. 6,20,760
Machine B
Initial cost of the machine, P = Rs. 8,00,000
Life, n = 4 years
Salvage value at the end of machine life, S = Rs. 5,50,000
Annual maintenance cost, A = zero.
Interest rate, i = 12%, compounded annually.
The cash flow diagram of the machine B is illustrated in Fig

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Fig 2.28Cash flow diagram of Machine B

The future worth function of Fig is
FWB(12%) = 8,00,000 x (F/P, 12%, 4) – 5,50,000
= 8,00,000 x (1.574) – 5,50,000
= Rs. 7,09,200
The future worth cost of machine A is less than that of machine B. Therefore,
machine A should be selected.

Annual Equivalent Method

Introduction
In the annual equivalent method of comparison, first the annual equivalent
cost or the revenue of each alternative will be computed. Then the alternative with
the maximum annual equivalent revenue in the case of revenue-based comparison
or with the minimum annual equivalent cost in the case of cost based comparison
will be selected as the best alternative.
Revenue-Dominated Cash Flow Diagram
A generalized revenue-dominated cash flow diagram to demonstrate the
annual equivalent method of comparison is presented in Fig. 3.10.

Fig 2.29 Revenue-dominated cash flow diagram

P represents an initial investment, Rj the net revenue at the end of the jth
year, and S the salvage value at the end of the nth year. The first step is to find the
net present worth of the cash flow diagram using the following expression for a
given interest rate, i:

PW(i) = –P + R1/(1 + i)1 + R2/(1 + i)2 + ...

+ Rj/(1 + i) j + ... + Rn/(1 + i)n + S/(1 + i)n

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In the above formula, the expenditure is assigned with a negative sign and the
revenues are assigned with a positive sign. In the second step, the annual
equivalent revenue is computed using the following formula:

Where (A/P, i, n) is called equal payment series capital recovery factor.

If we have some more alternatives which are to be compared with this alternative,
then the corresponding annual equivalent revenues are to be computed and
compared. Finally, the alternative with the maximum annual equivalent revenue
should be selected as the best alternative.
Cost-Dominated Cash Flow Diagram
A generalized cost-dominated cash flow diagram to demonstrate the annual
equivalent method of comparison is illustrated in Fig. 3.11.

Fig 2.30 Cost-dominated cash flow diagram.

In Fig. 3.10, P represents an initial investment, Cj the net cost of operation and
maintenance at the end of the jth year, and S the salvage value at the end of the
nth year. The first step is to find the net present worth of the cash flow diagram
using the following relation for a given interest rate, i.

PW(i) = P + C1/(1 + i)1 + C2/(1 + i)2 + ...

+ Cj/(1 + i) j + ... + Cn/(1 + i)n – S/(1 + i)n
In the above formula, each expenditure is assigned with positive sign and the
salvage value with negative sign. Then, in the second step, the annual equivalent
cost is computed using the following equation:

Where (A/P, i, n) is called as equal-payment series capital recovery factor

As in the previous case, if we have some more alternatives which are to be
compared with this alternative, then the corresponding annual equivalent costs are
to be computed and compared. Finally, the alternative with the minimum annual
equivalent cost should be selected as the best alternative. If we have some non-
standard cash flow diagram, then we will have to follow the general procedure for
converting each and every transaction to time zero and then convert the net
present worth into annual equivalent cost revenue depending on the type of the

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cash flow diagram. Such procedure is to be applied to all the alternatives and
finally, the best alternative is to be selected.
Alternate Approach
Instead of first finding the present worth and then figuring out the annual
equivalent cost/revenue, an alternate method which is as explained below can be
used. In each of the cases presented in Sections 6.2 and 6.3, in the first step, one
can find the future worth of the cash flow diagram of each of the alternatives. Then,
in the second step, the annual equivalent cost/revenue can be obtained by using
the equation:

Where (A/F, i, n) is called equal-payment series sinking fund factor.

Example:
A company provides a car to its chief executive. The owner of the company is
concerned about the increasing cost of petrol. The cost per litre of petrol for the
first year of operation is Rs. 21. He feels that the cost of petrol will be increasing by
Re.1 every year. His experience with his company car indicates that it averages 9
km per litre of petrol. The executive expects to drive an average of 20,000 km each
year for the next four years. What is the annual equivalent cost of fuel over this
period of time?. If he is offered similar service with the same quality on rental basis
at Rs. 60,000 per year, should the owner continue to provide company car for his
executive or alternatively provide a rental car to his executive? Assume i = 18%. If
the rental car is preferred, then the company car will find some other use within
the company.

Solution
Average number of km run/year = 20,000 km
Number of km/litre of petrol = 9 km
Therefore,
Petrol consumption/year = 20,000/9 = 2222.2 litre
Cost/litre of petrol for the 1st year = Rs. 21
Cost/litre of petrol for the 2nd year = Rs. 21.00 + Re. 1.00
= Rs. 22.00
Cost/litre of petrol for the 3rd year = Rs. 22.00 + Re. 1.00
= Rs. 23.00
Cost/litre of petrol for the 4th year = Rs. 23.00 + Re. 1.00
= Rs. 24.00
Fuel expenditure for 1st year = 2222.2 *21 = Rs. 46,666.20
Fuel expenditure for 2nd year = 2222.2 *22 = Rs. 48,888.40
Fuel expenditure for 3rd year = 2222.2 *23 = Rs. 51,110.60
Fuel expenditure for 4th year = 2222.2 *24 = Rs. 53,332.80

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The annual equal increment of the above expenditures is Rs. 2,222.20 (G).
The cash flow diagram for this situation is depicted in Fig.3.11.

Fig 2.31 Uniform gradient series cash flow diagram.

In Fig. 3.12, A1 = Rs. 46,666.20 and G = Rs. 2,222.20

A = A1 + G(A/G, 18%, 4)
= 46,666.20 + 2222.2(1.2947)
= Rs. 49,543.28
The proposal of using the company car by spending for petrol by the company will
cost an annual equivalent amount of Rs. 49,543.28 for four years. This amount is
less than the annual rental value of Rs. 60,000. Therefore, the company should
continue to provide its own car to its executive.
Example 2: A company is planning to purchase an advanced machine centre.
Three original manufacturers have responded to its tender whose particulars are
tabulated as follows:

Determine the best alternative based on the annual equivalent method by

assuming i = 20%, compounded annually.
Solution Alternative 1
Down payment, P = Rs. 5,00,000
Yearly equal installment, A = Rs. 2,00,000
n = 15 years
i = 20%, compounded annually
The cash flow diagram for manufacturer 1 is shown in Fig.

Fig 2.32 Cash flow diagram for manufacturer 1.

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The annual equivalent cost expression of the above cash flow diagram is
AE1(20%) = 5,00,000(A/P, 20%, 15) + 2,00,000
= 5,00,000(0.2139) + 2,00,000
= 3,06,950

Alternative 2
Down payment, P = Rs. 4,00,000
Yearly equal installment, A = Rs. 3,00,000
n = 15 years
i = 20%, compounded annually
The cash flow diagram for the manufacturer 2 is shown in Fig

Fig 2.33 Cash flow diagram for manufacturer 2

The annual equivalent cost expression of the above cash flow diagram is
AE2(20%) = 4,00,000(A/P, 20%, 15) + 3,00,000
= 4,00,000(0.2139) + 3,00,000
= Rs. 3,85,560..
Alternative 3
Down payment, P = Rs. 6,00,000
Yearly equal installment, A = Rs. 1,50,000
n = 15 years
i = 20%, compounded annually
The cash flow diagram for manufacturer 3 is shown in Fig.

Fig 2.34 Cash flow diagram for manufacturer 3

The annual equivalent cost expression of the above cash flow diagram is
AE3(20%) = 6,00,000(A/P, 20%, 15) + 1,50,000
= 6,00,000(0.2139) + 1,50,000
= Rs. 2,78,340.

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The annual equivalent cost of manufacturer 3 is less than that of manufacturer 1

and manufacturer 2. Therefore, the company should buy the advanced machine
centre from manufacturer 3
Example 3: A company invests in one of the two mutually exclusive alternatives.
The life of both alternatives is estimated to be 5 years with the following
investments, annual returns and salvage values.

Determine the best alternative based on the annual equivalent method by

assuming i = 25%.
Solution Alternative A
Initial investment, P = Rs. 1,50,000
Annual equal return, A = Rs. 60,000
Salvage value at the end of machine life, S = Rs. 15,000
Life = 5 years
Interest rate, i = 25%, compounded annually
The cash flow diagram for alternative A is shown in Fig

Fig 2.35 Cash flow diagram for Alternative A

The annual equivalent revenue expression of the above cash flow diagram is as
follows:
AEA(25%) = –1,50,000(A/P, 25%, 5) + 60,000 + 15,000(A/F, 25%, 5)
= –1,50,000(0.3718) + 60,000 + 15,000(0.1218)
= Rs. 6,057
Alternative B
Initial investment, P = Rs. 1,75,000
Annual equal return, A = Rs. 70,000
Salvage value at the end of machine life, S = Rs. 35,000
Life = 5 years
Interest rate, i = 25%, compounded annually
The cash flow diagram for alternative B is shown in Fig.

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Fig 2.36 Cash flow diagram for Alternative B

The annual equivalent revenue expression of the above cash flow diagram is
AEB(25%) = –1,75,000(A/P, 25%, 5) + 70,000 + 35,000(A/F, 25%, 5)
= –1,75,000(0.3718) + 70,000 + 35,000(0.1218)
= Rs. 9,198
The annual equivalent net return of alternative B is more than that of alternative A.
Thus, the company should select alternative B.

Example 4: A certain individual firm desires an economic analysis to determine

which of the two machines is attractive in a given interval of time. The minimum
attractive rate of return for the firm is 15%. The following data are to be used in the
analysis:

Which machine would you choose? Base your answer on annual equivalent cost.
Solution Machine X
First cost, P = Rs. 1,50,000
Life, n = 12 years
Estimated salvage value at the end of machine life, S = Rs. 0.
Annual maintenance cost, A = Rs. 0.
Interest rate, i = 15%, compounded annually.
The cash flow diagram of machine X is illustrated in Fig

Fig 2.37 Cash flow diagram for Machine X

The annual equivalent cost expression of the above cash flow diagram is
AEX(15%) = 1,50,000(A/P, 15%, 12)
= 1,50,000(0.1845)
= Rs. 27,675
Machine Y
First cost, P = Rs. 2,40,000
Life, n = 12 years

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Estimated salvage value at the end of machine life, S = Rs. 60,000

Annual maintenance cost, A = Rs. 4,500
Interest rate, i = 15%, compounded annually.
The cash flow diagram of machine Y is depicted in Fig

Fig 2.38 Cash flow diagram for Machine y

The annual equivalent cost expression of the above cash flow diagram is
AEY(15%) = 2,40,000(A/P, 15%, 12) + 4,500 – 6,000(A/F, 15%, 12)
= 2,40,000(0.1845) + 4,500 – 6,000(0.0345)
= Rs. 48,573
The annual equivalent cost of machine X is less than that of machine Y. So,
machine X is the more cost effective machine.

Rate of Return Method

Introduction
The rate of return of a cash flow pattern is the interest rate at which the
present worth of that cash flow pattern reduces to zero. In this method of
comparison, the rate of return for each alternative is computed. Then the
alternative which has the highest rate of return is selected as the best alternative.
In this type of analysis, the expenditures are always assigned with a negative sign
and the revenues/inflows are assigned with a positive sign. A generalized cash flow
diagram to demonstrate the rate of return method of comparison is presented in
Fig. 2.13.

Fig 2.39 Generalized cash flow diagram

In the above cash flow diagram, P represents an initial investment, Rj the net
revenue at the end of the jth year, and S the salvage value at the end of the nth
year. The first step is to find the net present worth of the cash flow diagram using
the following expression at a given interest rate, i.

PW(i) = – P + R1/(1 + i)1 + R2/(1 + i)2 + ...

+ Rj/(1 + i) j + ... + Rn/(1 + i)n + S/(1 + i)n

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Now, the above function is to be evaluated for different values of i until the present
worth function reduces to zero, as shown in Fig. 2.14.
In the figure, the present worth goes on decreasing when the interest rate is
increased. The value of i at which the present worth curve cuts the X-axis is the
rate of return of the given proposal/project. It will be very difficult to find the exact
value of i at which the present worth function reduces to zero.

Fig 2.40 Present worth function graph

So, one has to start with an intuitive value of i and check whether the present
worth function is positive. If so, increase the value of i until PW(i) becomes negative.
Then, the rate of return is determined by interpolation method in the range of
values of i for which the sign of the present worth function changes from positive to
negative.
Example 1
A person is planning a new business. The initial outlay and cash flow pattern for
the new business are as listed below. The expected life of the business is five years.
Find the rate of return for the new business.

Solution
Initial investment = Rs. 1,00,000
Annual equal revenue = Rs. 30,000
Life = 5 years
The cash flow diagram for this situation is illustrated in Fig. 3.15.

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Fig 2.41 Cash flow diagram

The present worth function for the business is

PW(i) = –1,00,000 + 30,000(P/A, i, 5)

When i = 10%,
PW(10%) = –1,00,000 + 30,000(P/A, 10%, 5)
= –1,00,000 + 30,000(3.7908)
= Rs. 13,724.
When i = 15%,
PW(15%) = –1,00,000 + 30,000(P/A, 15%, 5)
= –1,00,000 + 30,000(3.3522)
= Rs. 566.
When i = 18%,
PW(18%) = –1,00,000 + 30,000(P/A, 18%, 5)
= –1,00,000 + 30,000(3.1272)
= Rs. – 6,184

Therefore, the rate of return for the new business is 15.252%.

Example 2: A company is trying to diversify its business in a new product line. The
life of the project is 10 years with no salvage value at the end of its life. The initial
outlay of the project is Rs. 20,00,000. The annual net profit is Rs. 3,50,000. Find
the rate of return for the new business.
Solution
Life of the product line (n) = 10 years
Initial outlay = Rs. 20,00,000
Annual net profit = Rs. 3,50,000
Scrap value after 10 years = 0
The cash flow diagram for this situation is shown in Fig.

Fig 2.42 Cash flow diagram

The formula for the net present worth function of the situation is

PW(i) = –20,00,000 + 3,50,000(P/A, i, 10)

When i = 10%,
PW(10%) = –20,00,000 + 3,50,000(P/A, 10%, 10)

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= –20,00,000 + 3,50,000(6.1446)
= Rs. 1,50,610.

When i = 12%,
PW(12%) = –20,00,000 + 3,50,000(P/A, 12%, 10)
= –20,00,000 + 3,50,000(5.6502)
= Rs. –22,430.

= 11.74 %
Therefore, the rate of return of the new product line is 11.74%

Example 3: A firm has identified three mutually exclusive investment proposals

whose details are given below. The life of all the three alternatives is estimated to be
five years with negligible salvage value. The minimum attractive rate of return for
the firm is 12%.

Find the best alternative based on the rate of return method of comparison.
Solution Calculation of rate of return for alternative A1
Initial outlay = Rs. 1,50,000
Annual profit = Rs. 45,570
Life = 5 years
The cash flow diagram for alternative A1 is shown in Fig.

Fig 2.43 Cash flow diagram for Alternative A1

The formula for the net present worth of alternative A1 is given as
PW(i) = –1,50,000 + 45,570(P/A, i, 5)
When i = 10%,
PW(10%) = –1,50,000 + 45,570(P/A, 10%, 5)
= –1,50,000 + 45,570(3.7908)
= Rs. 22,746.76
When i = 12%,
PW(12%) = –1,50,000 + 45,570(P/A, 12%, 5)

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= –1,50,000 + 45,570(3.6048)
= Rs. 14,270.74
When i = 15%,
PW(15%) = –1,50,000 + 45,570(P/A, 15%, 5)
= –1,50,000 + 45,570(3.3522)
= Rs. 2,759.75
When i = 18%,
PW(18%) = –1,50,000 + 45,570(P/A, 18%, 5)
= –1,50,000 + 45,570(3.1272)
= Rs. –7,493.50
Therefore, the rate of return of the alternative A1 is

= 15% + 0.81%
= 15.81%
Calculation of rate of return for alternative A2
Initial outlay = Rs. 2,10,000
Annual profit = Rs. 58,260
Life of alternative A2 = 5 years
The cash flow diagram for alternative A2 is shown in Fig.

Fig 2.44 Cash flow diagram for Alternative A2

The formula for the net present worth of this alternative is
PW(i) = –2,10,000 + 58,260 (P/A, i, 5)
When i = 12%,
PW(12%) = –2,10,000 + 58,260(P/A, 12%, 5)
= –2,10,000 + 58,260(3.6048)
= Rs. 15.65
When i = 13%,
PW(13%) = –2,10,000 + 58,260(P/A, 13%, 5)
= –2,10,000 + 58,260 (3.5172)
= Rs. –5,087.93
Therefore, the rate of return of alternative A2 is

= 12 % + 0%

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= 12%

Calculation of rate of return for alternative A3

Initial outlay = Rs. 2,55,000
Annual profit = Rs. 69,000
Life of alternative A3 = 5 years
The cash flow diagram for alternative A3 is depicted in Fig.

Fig 2.45 Cash flow diagram for Alternative A3

The formula for the net present worth of this alternative A3 is

PW(i) = –2,55,000 + 69,000(P/A, i, 5)
When i = 11%,
PW(11%) = – 2,55,000 + 69,000(P/A, 11%, 5)
= –2,55,000 + 69,000 (3.6959)
Rs. 17.1
When i = 12%,
PW(12%) = – 2,55,000 + 69,000(P/A, 12%, 5)
= –2,55,000 + 69,000 (3.6048)
= Rs. – 6,268.80
Therefore, the rate of return for alternative A3 is

= 11%
The rates of return for the three alternatives are now tabulated.

From the above data, it is clear that the rate of return for alternative A3 is less than
the minimum attractive rate of return of 12%. So, it should not be considered for
comparison. The remaining two alternatives are qualified for consideration. Among
the alternatives A1 and A2, the rate of return of alternative A1 is greater than that
of alternative A2. Hence, alternative A1 should be selected.

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Example 4: For the cash flow diagram shown in Fig. compute the rate of return.
The amounts are in rupees.

Fig 2.46 Cash flow diagram

Solution For the positive cash flows of the problem,
A1 = Rs. 150, G = Rs. 150
The annual equivalent of the positive cash flows of the uniform gradient series is
given by
A = A1 + G(A/G, i, n)
= 150 + 150(A/G, i, 5)
The formula for the present worth of the whole diagram
= –1,275 + [150 + 150(A/G, i, 5)] x(P/A, i, 5)
PW(10%) = –1,275 + [150 + 150(A/G, 10%, 5)] x(P/A, 10%, 5)
= –1,275 + [150 + 150(1.8101)] x(3.7908)
= Rs. 322.88
PW(12%) = –1,275 + [150 + 150(A/G, 12%, 5)] x (P/A, 12%, 5)
= –1,275 + [150 + 150(1.7746)] x(3.6048)
= Rs. 225.28
PW(15%) = –1,275 + [150 + 150(A/G, 15%, 5)] x(P/A, 15%, 5)
= –1,275 + [150 + 150(1.7228)] _ (3.3522)
= Rs. 94.11
PW(18%) = –1,275 + [150 + 150(A/G, 18%, 5)] x(P/A, 18%, 5)
= –1,275 + [150 + 150(1.6728)] _ (3.1272)
= Rs. –21.24
Therefore, the rate of return for the cash flow diagram is

= 15% + 2.45% = 17.45%

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UNIT-III

DEPRECIATION

Introduction
Any equipment which is purchased today will not work for ever. This may be
due to wear and tear of the equipment or obsolescence of technology. Hence, it is to
be replaced at the proper time for continuance of any business. The replacement of
the equipment at the end of its life involves money. This must be internally
generated from the earnings of the equipment. The recovery of money from the
earnings of equipment for its replacement purpose is called depreciation fund since
we make an assumption that the value of the equipment decreases with the
passage of time. Thus, the word ―depreciation‖ means decrease in value of any
physical asset with the passage of time.

Methods of Depreciation
There are several methods of accounting depreciation fund. These are as
follows:
1. Straight line method of depreciation
2. Declining balance method of depreciation
3. Sum of the years—digits method of depreciation
4. Sinking-fund method of depreciation
3. Service output method of depreciation

Straight Line Method Of Depreciation

In this method of depreciation, a fixed sum is charged as the depreciation
amount throughout the lifetime of an asset such that the accumulated sum at the
end of the life of the asset is exactly equal to the purchase value of the asset.
Here, we make an important assumption that inflation is absent.
Let,
P = first cost of the asset,
F = salvage value of the asset,
n = life of the asset,
Bt= book value of the asset at the end of the period t,
Dt= depreciation amount for the period t.
The formulae for depreciation and book value are as follows:
Dt= (P – F)/n
Bt= Bt–1 – Dt= P – t *[(P – F)/n]

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3.3.1 Example1
A company has purchased an equipment whose first cost is Rs. 1,00,000 with an
estimated life of eight years. The estimated salvage value of the equipment at the
end of its lifetime is Rs. 20,000. Determine the
depreciation charge and book value at the end of various years using the straight
line method of depreciation.
Solution
P = Rs. 1,00,000
F = Rs. 20,000
n = 8 years
Dt= (P – F)/n
= (1,00,000 – 20,000)/8
= Rs. 10,000
In this method of depreciation, the value of Dt is the same for all the years. The
calculations pertaining to Bt for different values of t are summarized in Table3.1.

Table 3.1 Dt and Bt Values under Straight line Method of Depreciation

If we are interested in computing Dt and Bt for a specific period (t), the formulae
can be used. In this approach, it should be noted that the depreciation is the same
for all the periods.
EXAMPLE 2 Consider Example 1 and compute the depreciation and the book value
for period 3.
P = Rs. 1,00,000
F = Rs. 20,000
n = 8 years
D5 = (P – F)/n
= (1,00,000 – 20,000)/8
= Rs. 10,000 (This is independent of the time period.)
Bt= P – t x (P – F)/n
B5 = 1,00,000 – 5 x(1,00,000 – 20,000)/8
= Rs. 50,000

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3.4.1 Declining Balance Method Of Depreciation

In this method of depreciation, a constant percentage of the book value of
the previous period of the asset will be charged as the depreciation amount for the
current period. This approach is a more realistic approach, since the depreciation
charge decreases with the life of the asset which matches with the earning potential
of the asset. The book value at the end of the life of the asset may not be exactly
equal to the salvage value of the asset. This is a major limitation of this approach.
Let,
P = first cost of the asset,
F = salvage value of the asset,
n = life of the asset,
Bt= book value of the asset at the end of the period t,
K = a fixed percentage, and
Dt= depreciation amount at the end of the period t.

The formulae for depreciation and book value are as follows:

Dt= K *Bt-1
Bt= Bt–1 – Dt= Bt–1 – K *Bt–1
= (1 – K) *Bt–1
The formulae for depreciation and book value in terms of P are as follows:
Dt= K(1 – K)t–1 *P
Bt= (1 – K)t*P
While availing income-tax exception for the depreciation amount paid in each year,
the rate K is limited to at the most 2/n. If this rate is used, then the corresponding
approach is called the double declining balance method of depreciation.
3.4.1 Example 2
Consider Example 1 and demonstrate the calculations of the declining balance
method of depreciation by assuming 0.2 for K.
Solution
P = Rs. 1,00,000
F = Rs. 20,000
n = 8 years
K = 0.2
The calculations pertaining to Dtand Btfor different values of t are summarized in
Table using the following formulae:
Dt= K *Bt–1
Bt= Bt–1 – Dt

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Table 3.2Dt and Bt according to Declining Balance Method of Depreciation

If we are interested in computing Dtand Btfor a specific period t, the respective

formulae can be used.
EXAMPLE 3 Consider Example 1 and calculate the depreciation and the book
value for period 5 using the declining balance method of depreciation by assuming
0.2 for K.
Solution
P = Rs. 1,00,000
F = Rs. 20,000
n = 8 years
K = 0.2
Dt= K(1 – K)t –1 xP
D5 = 0.2(1 – 0.2)4 x1,00,000
= Rs. 8,192
Bt= (1 – K)txP
B5 = (1 – 0.2)5 x1,00,000
= Rs. 32,768

Sum-Of-The-Years-Digits Method Of Depreciation

In this method of depreciation also, it is assumed that the book value of the
asset decreases at a decreasing rate. If the asset has a life of eight years, first the
sum of the years is computed as
Sum of the years = 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8
= 36 = n(n + 1)/2
The rate of depreciation charge for the first year is assumed as the highest
and then it decreases. The rates of depreciation for the years 1–8, respectively are
as follows: 8/36, 7/36, 6/36, 5/36, 4/36, 3/36, 2/36, and 1/36. For any year, the
depreciation is calculated by multiplying the corresponding rate of depreciation
with (P – F).

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Dt= Rate *(P – F)

Bt= Bt–1 – Dt

The formulae for Dtand Btfor a specific year t are as follows:

Dt = n-t+1 (P-F)
n(n+1)/2

3.3.1 Example 4
Consider Example 1 and demonstrate the calculations of the sum-of-the-years-
digits method of depreciation.
Solution
P = Rs. 1,00,000
F = Rs. 20,000
n = 8 years
Sum = n(n + 1)/2 = 8 *9/2 = 36

The rates for years 1–8, are respectively 8/36, 7/36, 6/36, 5/36, 4/36, 3/36, 2/36
and 1/36.

The calculations of Dtand Btfor different values of t are summarized in Table using
the following formulae:
Dt= Rate _ (P – F)
Bt= Bt–1 – Dt

Table 3.3 Dt and Bt under Sum-of-the-years-digits Method of Depreciation

If we are interested in calculating Dtand Btfor a specific t, then the usage of the
formulae would be better.

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EXAMPLE 5 Consider Example 1 and find the depreciation and book value for the
5th year using the sum-of-the-years-digits method of depreciation.
Solution
P = Rs. 1,00,000
F = Rs. 20,000
n = 8 years

Sinking Fund Method of Depreciation

In this method of depreciation, the book value decreases at increasing rates
with respect to the life of the asset.
Let
P = first cost of the asset,
F = salvage value of the asset,
n = life of the asset,
i = rate of return compounded annually,
A = the annual equivalent amount,
Bt= the book value of the asset at the end of the period t, and
Dt= the depreciation amount at the end of the period t.
The loss in value of the asset (P – F) is made available an the form of cumulative
depreciation amount at the end of the life of the asset by setting up an equal
depreciation amount (A) at the end of each period during the lifetime of the asset.
A = (P – F) * [A/F, i, n]
The fixed sum depreciated at the end of every time period earns an interest at the
rate of i% compounded annually, and hence the actual depreciation amount will be
in the increasing manner with respect to the time period. A generalized formula for
Dtis
Dt= (P – F) *(A/F, i, n) * (F/P, i, t – 1)
The formula to calculate the book value at the end of period t is

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Bt= P – (P – F) (A/F, i, n) (F/A, i, t)

The above two formulae are very useful if we have to calculate Dtand Btfor any
specific period. If we calculate Dtand Btfor all the periods, then the tabular
approach would be better.

Example 6 Consider Example 1 and give the calculations regarding the sinking
fund method of depreciation with an interest rate of 12%, compounded annually.
Solution
P = Rs. 1,00,000
F = Rs. 20,000
n = 8 years
i = 12%
A = (P – F) _ [A/F, 12%, 8]
= (1,00,000 – 20,000) _ 0.0813
= Rs. 6,504
In this method of depreciation, a fixed amount of Rs. 6,504 will be depreciated at
the end of every year from the earning of the asset. The depreciated amount will
earn interest for the remaining period of life of the asset
at an interest rate of 12%, compounded annually. For example, the calculations of
net depreciation for some periods are as follows:
Depreciation at the end of year 1 (D1) = Rs. 6,504.
Depreciation at the end of year 2 (D2) = 6,504 + 6,504 _ 0.12
= Rs. 7,284.48
Depreciation at the end of the year 3 (D3)
= 6,504 + (6,504 + 7,284.48) x12
= Rs. 8,158.62
Depreciation at the end of year 4 (D4)
= 6,504 + (6,504 + 7,284.48 + 8,158.62) x0.12
= Rs. 9,137.65
These calculations along with book values are summarized in Table 3.1
Table 3.1 Dtand Btaccording to Sinking Fund Method of Depreciation

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Example 7 Consider Example 1 and compute D5 and B7 using the sinking fund
method of depreciation with an interest rate of 12%, compounded annually.
Solution
P = Rs. 1,00,000
F = Rs. 20,000
n = 8 years
i = 12%
Dt= (P – F) (A/F, i, n) (F/P, i, t – 1)
D5 = (P – F) (A/F, 12%, 8) (F/P, 12%, 4)
= (1,00,000 – 20,000) x0.0813 x1.574
= Rs. 10,237.30
This is almost the same as the corresponding value given in the table. The minor
difference is due to truncation error.
Bt= P – (P – F) (A/F, i, n) (F/A, i, t)
B7 = P – (P – F) (A/F, 12%, 8) (F/A, 12%, 7)
= 1,00,000 – (1,00,000 – 20,000) x0.0813 x10.089
= 34,381.10

Service Output Method of Depreciation

In some situations, it may not be realistic to compute depreciation based on
time period. In such cases, the depreciation is computed based on service rendered
by an asset.
Let
P = first cost of the asset
F = salvage value of the asset
X = maximum capacity of service of the asset during its lifetime
x = quantity of service rendered in a period.

Then, the depreciation is defined per unit of service rendered:

Example
The first coat of a road laying machine is Rs. 80,00,000. Its salvage value
after five years is Rs. 50,000. The length of road that can be laid by the machine
during its lifetime is 75,000 km. In its third year of operation, the length of road
laid is 2,000 km. Find the depreciation of the equipment for that year.
Solution
P = Rs. 80,00,000
F = Rs. 50,000
X = 75,000 km
x = 2,000 km

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Evaluation of Public Alternatives

Introduction
In evaluating alternatives of private organizations, the criterion is to select
the alternative with the maximum profit. The profit maximization is the main goal
of private organizations while providing goods/services as per specifications to their
customers. But the same criterion cannot be used while evaluating public
alternatives. Examples of some public alternatives are constructing bridges, roads,
dams, establishing public utilities, etc. The main objective of any public alternative
is to provide goods/services to the public at the minimum cost. In this process, one
should see whether the benefits of the public activity are at least equal to its costs.
If yes, then the public activity can be undertaken for implementation. Otherwise, it
can be cancelled. This is nothing but taking a decision based on Benefit-Cost ratio
(BC) given by

BC ratio =Equivalent benefits

Equivalent costs
The benefits may occur at different time periods of the public activity. For
the purpose of comparison, these are to be converted into a common time base
(present worth or future worth or annual equivalent). Similarly, the costs consist of
initial investment and yearly operation and maintenance cost. These are to be
converted to a common time base as done in the equivalent benefits. Now the ratio
between the equivalent benefits and equivalent costs is known as the ―Benefit-Cost
ratio‖. If this ratio is at least one, the public activity is justified; otherwise, it is not
justified.
Let
BP = present worth of the total benefits
BF = future worth of the total benefits
BA = annual equivalent of the total benefits
P = initial investment
PF = future worth of the initial investment
PA = annual equivalent of the initial investment
C = yearly cost of operation and maintenance
CP = present worth of yearly cost of operation and maintenance

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Example 1
In a particular locality of a state, the vehicle users take a roundabout route to
reach certain places because of the presence of a river. This results in excessive
travel time and increased fuel cost. So, the state government is planning to
construct a bridge across the river. The estimated initial investment for
constructing the bridge is Rs. 40,00,000. The estimated life of the bridge is 15
years. The annual operation and maintenance cost is Rs. 1,50,000. The value of
fuel savings due to the construction of the bridge is Rs. 6,00,000 in the first year
and it increases by Rs. 50,000 every year thereafter till the end of the life of the
bridge. Check whether the project is justified based on BC ratio by assuming an
interest rate of 12%, compounded annually.
Solution

Initial investment = Rs. 40,00,000

Annual operation and maintenance = Rs. 1,50,000
Annual fuel savings during the first year = Rs. 6,00,000
Equal increment in fuel savings in the following years = Rs. 50,000
Life of the project = 15 years
Interest rate = 12%

Fig 3.1 Cash flow diagram for constructing bridge

Total present worth of costs = Initial investment (P)
+ Present worth of annual operating and
maintenance cost (CP) = P + CP
= Rs. 40,00,000 + 1,50,000 *(P/A, 12%, 15)
= Rs. 40,00,000 + 1,50,000 * 6.8109
= Rs. 50,21,635
Total present worth of fuel savings (BP):
A1 = Rs. 6,00,000
G = Rs. 50,000
n = 15 years
i = 12%
Annual equivalent fuel savings (A) = A1 + G (A/G, 12%, 15)
= 6,00,000 + 50,000 (4.9803)
= Rs. 8,49,015
Present worth of the fuel savings (BP) = A(P/A, 12%, 15)

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= 8,49,015 (6.8109)
= Rs. 57,82,556

= 1.1515
Since the BC ratio is more than 1, the construction of the bridge across the river is
justified.

Example 2: Two mutually exclusive projects are being considered for investment.
Project A1 requires an initial outlay of Rs. 30,00,000 with net receipts estimated as
Rs. 9,00,000 per year for the next 5 years. The initial outlay for the project A2 is
Rs. 60,00,000, and net receipts have been estimated at Rs. 15,00,000 per year for
the next seven years. There is no salvage value associated with either of the
projects. Using the benefit cost ratio, which project would you select? Assume an
interest rate of 10%.
Solution
Alternative A1
Initial cost (P) = Rs. 30,00,000
Net benefits/year (B) = Rs. 9,00,000
Life (n) = 5 years
Annual equivalent of initial cost = P x(A/P, 10%, 5)
= 30,00,000 x0.2638
= Rs. 7,91,400

= 9,00,000/7,91,400
= 1.137
Alternative A2
Initial cost (P) = Rs. 60,00,000
Net benefits/year (B) = Rs. 15,00,000
Life (n) = 7 years
Annual equivalent of initial cost = PX (A/P, 10%, 7)
= 60,00,000 X0.2054
= Rs. 12,32,400

= 15,00,000/12,32,400 = 1.217
The benefit-cost ratio of alternative A2 is more than that of alternative A1. Hence,
alternative A2 is to be selected. The comparison is made on a 35-year period which
is the minimum common multiple of the lives of
alternatives 1 and 2.

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Example 2: A government is planning a hydroelectric project for a river basin. In

addition to the production of electric power, this project will provide flood control,
irrigation and recreation benefits. The estimated benefits and costs that are
expected from the three alternatives under consideration are given in the following
table.

If the interest rate is 9% and the life of projects is estimated to be 50 years, by

comparing the BC ratios, determine which project should be selected.
Solution
Benefits/year = Flood control savings + irrigation benefits
+ Recreation benefits.
Costs/year = Annual equivalent cost of the initial cost
+ Operating and maintenance cost/year
– Power sales/year
Based on these guidelines, the computation of benefits, costs and BC ratio for each
of the projects are summarized in Table 3.2

Table 3.2 Illustration of Example 2 (Interest rate = 9%, n = 50 years)

From the last row of Table 3.2, it is clear that alternative A is the only eligible
alternative because the BC ratio of each of the other two alternatives is less than
one. Since A is the only eligible alternative, it is selected as the best alternative for
implementation.

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Inflation Adjusted Decisions

Introduction
A general inflationary trend in the cost of goods is common everywhere due
to various interacting factors. If the rate of inflation is very high, it will produce
extremely serious consequences for both individuals and institutions. Inflation is
the rate of increase in the prices of goods per period. So, it has a compounding
effect. Thus, prices that are inflated at a rate of 7% per year will increase 7% in the
first year, and for the next year the expected increase will be 7%
of these new prices. The same is true for succeeding years and hence the rate of
inflation is compounded in the same manner that an interest rate is compounded.
If the average inflation over six years period is 7%, then the prices at the beginning
of the seventh year would be 150% that of the first year by assuming 100% for the
prices at the beginning of the first year of the six-year period. If economic decisions
are taken without considering the effect of inflation into account, most of them
would become meaningless and as a result the organizations would end up with
unpredictable return. But there is always difficulty in determining the rate of
inflation. The worldwide trend/wish is to curtail inflation. But due to various
reasons, it is very difficult to have zero inflation. For practical decision making, an
average estimate may be assumed depending on the period of the proposals under
consideration. Hence, we need a procedure which will combine the effects of
inflation rate and interest rate to take realistic economic decision.

Procedure to Adjust Inflation:

A procedure to deal with this situation is summarized now.
1. Estimate all the costs/returns associated with an investment proposal in terms
of today’s rupees.
2. Modify the costs/returns estimated in step 1 using an assumed inflation rate so
that at each future date they represent the costs/returns at that date in terms of
the rupees that must be expended/received at that time, respectively.
3. As per our requirement, calculate either the annual equivalent amount or future
amount or present amount of the cash flow resulting from step 2 by considering
the time value of money.

Examples
Comparison of alternatives and Determination of Economics Life of asset.
Suppose a 40-year old man is planning for his retirement. He plans to retire
at the age of 60 and estimates that he can live comfortably on Rs. 24,000 per year
in terms of today’s rupee value. He can invest his savings at 15% compounded
annually. Assume an average inflation rate of 9% for the next 30 years. What equal
amount should he save each year until he retires so that he can make withdrawals

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at the end of each year commencing from the end of the 21st year from now that
will allow him to live as comfortably as he desires for 10
years beyond his retirement?
Solution
Step 1. The estimated future requirement per year in terms of today’s rupees from
his age 61 through 70 is Rs. 24,000.
Step 2. Modification of the costs estimated in step 1 is summarized in Table 11.1.
The formula which is given below is used to get future equivalent of Rs. 24,000
with the inflation of 9% per year (IR-inflation rate).
F = P (1 + IR)n
Table 3.4 Inflated Future Requirements

Step 3. Now, the calculation of the equivalent amount of cash flow as per the
requirement is presented in the above table.

Fig 3.2 Overall cash flow diagrams

The sum of the present equivalents of the year end withdrawals from the year 21 to
30 is computed by assuming the end of the year 20 as the base (time zero) and it is
shown at the end of the year 20 in Fig. 3.3 . The method of computing the present
equivalent of the withdrawals is as follows:

PW(i = 15%) = 1,46,611/(1 + 0.15)1 + 1,59,806/(1 + 0.15)2

+ 1,74,189/(1 + 0.15)3 + 1,89,866/(1 + 0.15)4
+ 2,06,954/(1 + 0.15)5 + 2,25,580/(1 + 0.15)6
+ 2,45,882/(1 + 0.15)7 + 2,68,011/(1 + 0.15)8
+ 2,92,132/(1 + 0.15)9 + 3,18,424/(1 + 0.15)10
= Rs. 10,13,631.

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Fig 3.3 Equivalent cash flow diagram

The annual equivalent amount (A), which should be invested from the end of year 1
(age 41) to year 20 (age 60), is computed using the following formula.
A = F(A/F, 15%, 20)
= 10,13,631 *(0.0098)
= Rs. 9,934
Recommendation: The person has to invest an amount of Rs. 9,934 at the end of
every year starting from his age 41 (year 1) through 60 (year 20) which will enable
him to make withdrawals at the end of every year starting from his age 61 (year 21)
through 70 (year 30)

Inflation Adjusted Economic Life Of Machine

In any industrial/service organization, equipment/machinery forms an
important element. The productivity of any organization is a function of many
factors. It is largely affected by efficient and effective use of machinery and
equipment. So, operations and maintenance of these equipment are very important
to the organization.
A machine which is purchased today cannot be used forever. It has a definite
economic lifetime. After the economic life, the machine should be replaced with a
substitute machine with similar operational capabilities. This kind of analysis is
called replacement analysis.
The elements of costs involved in the replacement analysis are as follows:
1. Purchase cost (initial cost)
2. Annual operation and maintenance cost
3. Salvage value at the end of every year, if it is significant
The trade-off between different cost elements is shown in Fig.

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Fig 3.4 Chart showing economic life.

From Fig. it is clear that the sum of operation and maintenance cost increases with
the life of the machine. But the capital recovery with return decreases with the life
of the machine. The total cost of the machine goes on
decreasing initially but it starts increasing after some years. The year with the
minimum total cost is called as the economic life of the machine.

Limitation of Existing Model

In the case where the machine is replaced due to wear and tear, the following costs
are considered
1. Initial cost
2. Operation and maintenance cost
3. Salvage value
In the existing model to deal with this type of replacement analysis, the
different cost elements are estimated without taking the effect of inflation into
account.
The annual cost of operation and maintenance of the machine will increase
with the age of the machine due to decline in efficiency of the machine. In the
existing model, this in the operation and maintenance cost is taken into account.
But the increase in the operation and maintenance cost due to inflation is not
considered. Similarly, in the existing model, the salvage value is estimated without
taking into account the effect of inflation.
To highlight this particular fact on salvage value, an example is now given.
The internal combustion engines (R.A. Lister) which were made in England during pre-
independence of India are still functioning well. Their resale value is going upyear
after year. This may be partly due to inflation and partly due to good quality of the
engine parts. So, consideration of the effect of the inflation on the economic life of
the machine is a realistic approach.
In replacement analysis, a discount rate is usually assumed to reflect the
time value of money. First the concept of replacement analysis is demonstrated
without taking the inflation into account. Then, the same is demonstrated by

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taking the effect of inflation into account. At the end, a comparison between the
two models is presented.
Economic Life Determination without Inflationary Effect
The determination of economic life of a machine without considering the
effect of inflation is demonstrated using the following example.
Example 1: A machine costs Rs. 5,00,000. Its annual operation cost during the
first year is Rs. 40,000 and it increases by Rs. 5,000 every year thereafter. The
maintenance cost during the first year is Rs. 60,000 and it increases by Rs. 6,000
every year thereafter. The resale value of the machine is Rs. 4,00,000 at the end of
the first year and it decreases by Rs. 50,000 every year thereafter. Assume an
interest rate (discounting factor) of 20%. The method of finding the economic life of
the machine with a discounting factor of 20% at zero inflation rate is summarized
in Table 11.2. From the table it is clear that the total annual equivalent cost is
minimum if the machine is used for 14 years. Hence, the economic life of the
machine is 14 years.

Economic Life Determination with Inflationary Effect

The illustration in Section 11.3.2 is reconsidered for analyzing the effect of inflation
on the economic life of the machine. An average annual inflation rate of 6% is
assumed for discussion. The corresponding steps are explained in Table 3.3. From
the Table 11.3, it is clear that the total annual equivalent cost is minimum if the
machine is used for three years. Thus, the economic life of the machine is three
years.

Table 3.5 Determination of Economic Life of the Machine without Inflation

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Table 3.6 Determination of Economic Life of the Machine with Inflationary

Effect

Comparison of results The results of the two approaches are summarized in

Table. From thetable, it is clear that the inflation has an effect on the economic life
of the machine. Since it is meaningful and realistic to analyze this type of problem
byconsidering the effect of inflation, the second approach should be used for such
analysis.
Table 3.7 Results of the Two Approaches

EXAMPLE 1 A company has received quotes for its recent advertisement for the
purchase of a sophisticated milling machine. The data are as per the estimate in
today’s rupee value.

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Assuming an average annual inflation of 5% for the next five years, determine the
best machine based on the present worth method. Interest rate is 15%,
compounded annually.
Solution
Average annual inflation rate = 5%
Interest rate = 15% compounded annually
Machine X
Purchase price = Rs.15,00,000
Machine life = 7 years
Salvage value at the end of machine life = Rs. 2,00,000
Annual operating & maintenance cost = Rs. 3,00,000
The computation of the present worth of the annual operating and
maintenance costs of the machine X is summarized in following Table

Table 3.7 Computation of the Present Worth of the Annual Operating and
Maintenance Costs of Machine x

The equation for the present worth of the machine X is

PWX(15%) = Purchase price
+ Present worth of inflated annual and operating cost
– Present worth of the salvage value
= 15,00,000 + 14,83,680 – 2,00,000 x (inflation factor)
x(P/F, 15%, 7)

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= 15,00,000 + 14,83,680 – 2,00,000(F/P, 5%, 7) (P/F, 15%, 7)

= 15,00,000 + 14,83,680 – 2,00,000 x 1.407 x 0.3759
= Rs. 28,77,901.74

Machine Y
Purchase price = Rs. 20,00,000
Machine life = 7 years
Salvage value at the end of machine life = Rs. 3,00,000
Annual operating & maintenance cost = Rs. 2,50,000
The computation of the present worth of the annual operating and maintenance
costs of the machine Y is summarized in Table

Table 3.8 Computation of the Present Worth of the Annual Operating and
Maintenance Costs of Machine Y

The expression for the present worth of machine Y is

PWY(15%) = Purchase price
+ present worth of inflated annual and operating cost
– present worth of the salvage value
= 20,00,000 + 12,36,400 – 3,00,000 x(inflation factor) x(P/F, 15%, 7)
= 20,00,000 + 12,36,400 – 3,00,000 (F/P, 5%, 7) (P/F, 15%, 7)
= 20,00,000 + 12,36,400 – 3,00,000 x1.407 x 0.3759
= Rs. 30,77,732.61
Remark.Since the present worth cost of machine X is less than that of machine Y,
select machine X.

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UNIT - IV

GENERAL MANAGEMENT

Introduction of Management
According to American Marketing Association,
"Management is guiding human and physical resources into dynamic
organizational units which attain their objectives to the satisfaction of those served
within a high degree of moral and sense of attainment on the part of those
rendering services"

Various definitions of Management

1. Josef Massie
“Management is the process by which co-operation group directs action
towards common goal.”
4.Harold Koontz
Management is the art of getting things done through and with people in
formally organized groups.
3. George R. Terry
Management is a disconnect process consisting of planning organizing
activating and controlling performed to determine and accomplish the objectives
by the use of people and resources.
4. Donald J. Cough
Management is the art and science of decision making and leadership.
5. Mary Cushing Nile
Good Management, or scientific management, achieves a social objective
with the best use of human and material energy and time, and with satisfaction
for the participants and the public.
6. Henry Fayol
To manage is to forecast, to plan, to organize, to command, to coordinate,
and to control.

Importance of Management
1. Determination of objectives
2. Human Development
3. Efficient and smooth running of business
4. Accomplishments of objectives
5. Higher Profits
6. Fulfillments of social obligation
7. Efficient use of resources
8. Sound organization Structure
9. Co-ordinate Human Efforts
10. Meets the Change of Change
11. Meeting Challenges
12. Stability
13. Role in National Economic development
14. Useful for developing countries

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Management Vs Administration

Table 4.1 Management vs Administration

No Administration Management
1 Legislative and Determinative Executive Function
Function
2 Determination of objectives and Implementation of policies
Policies
3 Provides the sketch of the Provides the entire body
Enterprise
4 Influences mainly by public Influenced mainly by
opinion and other outside forces administrative decisions
5 Mainly a top level function Mainly a lower level functions
6 Involves thinking and planning Involves doing and acting

Basic Concepts of Management

1. Scientific Management is the key to productivity
2. Decentralization for quicker decisions and better control
3. Personnel management as a means of selecting people into organization
4. Manager‟s development program to train managers how to meet the
needs of tomorrow
5. Management Accounting - a foundation for managerial decisions
6. Marketing
7. Long range Planning
8. Role of operational research in management decision making
Integration Concept :
“Management is the total task of welding into a single working force men,
money, machinery, materials and methods” – MrityunjoyBannerjee
Leadership and Decision Making Concept :
“Management is simply the process of decision making and control over the
action of the human beings for the express purpose of attaining predetermined
goals” – Stanley Vance
Human Relation Concept:
“Management is getting things done through the efforts of other people” –
Lawrence AAppley
Productivity Concept:
“Management is the art of knowing what you want to do in the best
cheapest way” – F.W. Taylor
Functional Concept :
“To manage is to forecast and plan to organize, to command, to co-ordinate
and to control” – Henry Fayol

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Scientific Management :
Frederick Winslow Taylor (1856 - 1915) is considered to be the “Father of Scientific
Management”. He exerted agreat influence on the development of management
thoughts through his experiments and writings.
 During his career spanning a period of 26 years he conducted a series of
experiments at Midvale Steel Company.
 Made a study on the movements on a series of job called “Time and Motion
Study”
1. Time Study
a. It is a technique which enables the manager to ascertain standard time
taken for performing a specified job.
b. Every job or every part of it is studied in detail.
c. This technique is based on the study of an average worker having reasonable
skill and ability.
d. Average worker is selected and assigned the job and then with the help of a
stop watch, time is ascertained for performing that particular job.
e. Taylor maintained that Fair day‟s work should be determined through
observations, experiment and analysis by keeping in view an average worker.
Standard Time × Working Hours = Fair Day‟s Work
2. Motion Study
a. In this study, movement of body and limbs required to perform a job are
closely observed.
b. In other words, it refers to the study of movement of an operator on machine
involved in a particular task.
c. The purpose of motion study is to eliminate useless motions and determine
the bet way of doing the job.
d. By undertaking motion study an attempt is made to know whether some
elements of a job can be eliminated combined or their sequence can be
changed to achieve necessary rhythm.
 Motion study increases the efficiency and productivity of workers by cutting
down all wasteful motions.
 Tried to find answers for
 Could some elements of the work be eliminated or some parts of the
operation be combined
 Could the sequence of the task be improved
 Was there any best way of doing the job
 Established how much workers should be able to do with the equipment and
materials at hand
This led to the systematic way of doing work as determined by the management.
This led to dramatic increase in productivity. Hostile members of American
Congress called Taylor to explain his ideas and techniques.

Principles of Scientific Management:

(a) Scientific Study and Planning of Work :
Taylor has suggested that the work to be assigned to and performed by workers
should be studied, analyzed and planned as to determine the day‟s fair work

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(Standard of work) for each worker. Various studies on this distinct aspect like
time, speed, fatigue work and motion study to give precise ideas to the workers on
what to be done and how it can be done efficiently.
(b) Scientific Selection, Placement, and Training :
Selection Should be made by using scientific methods by tallying job requirements
with abilities and skills. Workers should be given placements on the basis of
capability and Aptitude. And, for developing the existing level of knowledge and
potential scientific training should be imparted to workers on regular basis.
(c) Standardization :
Standardization is a means of achieving Economics of Production. By minutely
studying metal cutting operations Taylor suggested that the scheme of
standardization should be adopted in respect of trade tools and equipments, raw
materials used by the workers and physical working conditions provided to them.
Any difference in quality may directly affect the level of efficiency of workers.
(d) Division of Responsibilities Between Management and workers:
It can be classified into Planning and Implementation
Planning of various aspects should be done by the managers after undergoing
studies on various aspects of performing a job.
Implementation of works should be confined to the workers
Benefits:
 Division of Labor
 Specialization

a. Functional Foremanship :
According to this concept, instead of having one foreman as an in charge for
production department all activities should be grouped into two groups namely
Planning in charge and production in charge. Each forum should have 4
supervisors to command over the activities of workers.
In doing so dual command emerges, because each worker will get orders and
instructions from 8 supervisors dealing with different aspect of his job.
The fig. below represents the concept clearly

Fig 4.1 Functional Foremanship

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b. Mental Revolution:
In order to get desired results of scientific management there should be
complete mental revolution on the part of workers as well as management.
Mental Revolution is a process or bringing drastic change in their attitude, outlook
and behavioural pattern in respect of their duties towards work, towards their
fellow workers and employees.
Outcome:
 Workers participation in the management
 Sharing Surplus as Bonus

c. Wage Incentives :
Taylor suggested that, incentives should be directly linked with productivity.
The worker producing more should be given higher wages. He devised differential
piece rate plan which implies different rates o wages for different levels of efficiency
of workers.
Ex for differential Piece Rate System :
Two piece rates are Rs.1 and Rs. 1.50
Standard daily output laid down through time and motion is 10 units
A=8 units
B=12 units
Therefore, A‟s wage = 8 units * Rs.1 = Rs. 8
B‟s wage = 12 units * Rs.1.50 = Rs. 18
Criticisms :
a. Mechanistic Approach :
The main criticism is that it treats workers as factors of production and not as
human beings. Too much emphasis is placed on technical aspects of work
ignoring the human side.

b. Unrealistic Assumptions :
Scientific management is based on the assumption that people are rational and
they are motivated by material gains. Failed to emphasis on job satisfaction,
participation, and recognition.
c. Narrow View :
Scientific management is quite limited in scope. It has been described as a
theory of industrial engineering. It does not deal with management of the total
organization
d. Impractical :
Functional foremanship is likely to create problems because it violates the
principle of unity of command
e. Exploitation of Labor :
In the name of increasing efficiency, workers were forced to speed up affecting
their physical and mental health. Specialization make the job dull and
monotonous.

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Henry Fayol’s Principles of Management (1841-1925)

1. Division of Labor
a. Henry Fayol has stressed on the specialization of jobs.
b. He recommended that work of all kinds must be divided & subdivided
and allotted to various persons according to their expertise in a
particular area.
c. Subdivision of work makes it simpler and results in efficiency.
d. It also helps the individual in acquiring speed, accuracy in his
performance.
e. Specialization leads to efficiency & economy in spheres of business.
2. Authority & Responsibility
a. Authority & responsibility are co-existing.
b. If authority is given to a person, he should also be made responsible.
c. In a same way, if anyone is made responsible for any job, he should
also have concerned authority.
d. Authority refers to the right of superiors to get exactness from their sub-
ordinates whereas responsibility means obligation for the performance of
the job assigned.
e. There should be a balance between the two i.e. they must go hand in
hand.
f. Authority without responsibility leads to irresponsible behavior whereas
responsibility without authority makes the person ineffective.
3. Unity of command:
a. A sub-ordinate should receive orders and be accountable to one and
only one boss at a time.
b. In other words, a sub-ordinate should not receive instructions from
more than one person because -
- It undermines authority
- Weakens discipline
- Divides loyalty
- Creates confusion
- Delays and chaos
- Escaping responsibilities
- Duplication of work
- Overlapping of efforts
c. Therefore, dual sub-ordination should be avoided unless and until it is
absolutely essential.
d. Unity of command provides the enterprise a disciplined, stable &
orderly existence.
e. It creates harmonious relationship between superiors and sub-
ordinates.
4. Unity of Direction
a. Fayol advocates one head one plan which means that there should be
one plan for a group of activities having similar objectives.

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b. Related activities should be grouped together. There should be one

plan of action for them and they should be under the charge of a
particular manager.
c. According to this principle, efforts of all the members of the
organization should be directed towards common goal.
d. Without unity of direction, unity of action cannot be achieved.
e. In fact, unity of command is not possible without unity of direction.
Table 4.2 Unity of Command and Direction

Basis Unity of command Unity of direction

Meaning It implies that a sub-ordinate It means one head, one plan for
should receive orders & a group of activities having
instructions from only one boss. similar objectives.

Nature It is related to the functioning of It is related to the functioning

personnel‟s. of departments, or organization
as a whole.

Necessity It is necessary for fixing It is necessary for sound

responsibility of each subordinate. organization.

Advantage It avoids conflicts, confusion & It avoids duplication of efforts

chaos. and wastage of resources.

Result It leads to better superior sub- It leads to smooth running of

ordinate relationship. the enterprise.

Therefore it is obvious that they are different from each other but they are
dependent on each other i.e. unity of direction is a pre-requisite for unity of
command. But it does not automatically comes from the unity of direction.
5. Equity
a. Equity means combination of fairness, kindness & justice.
b. The employees should be treated with kindness & equity if devotion is
expected of them.
c. It implies that managers should be fair and impartial while dealing
with the subordinates.
d. They should give similar treatment to people of similar position.
e. They should not discriminate with respect to age, caste, sex, religion,
relation etc.
f. Equity is essential to create and maintain cordial relations between
the managers and sub-ordinate.
g. But equity does not mean total absence of harshness.
h. Fayol was of opinion that, “at times force and harshness might
become necessary for the sake of equity”.
6. Order

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a. This principle is concerned with proper & systematic arrangement of

things and people.
b. Arrangement of things is called material order and placement of
people is called social order.
c. Material order- There should be safe, appropriate and specific place
for every article and every place to be effectively used for specific
activity and commodity.
d. Social order- Selection and appointment of most suitable person on
the suitable job. There should be a specific place for everyone and
everyone should have a specific place so that they can easily be
contacted whenever need arises.
7. Discipline
a. According to Fayol, “Discipline means sincerity, obedience, respect of
authority & observance of rules and regulations of the enterprise”.
b. This principle applies that subordinate should respect their superiors
and obey their order.
c. It is an important requisite for smooth running of the enterprise.
d. Discipline is not only required on path of subordinates but also on the
part of management.
e. Discipline can be enforced if -
- There are good superiors at all levels.
- There are clear & fair agreements with workers.
- Sanctions (punishments) are judiciously applied.

8. Initiative
a. Workers should be encouraged to take initiative in the work assigned
to them.
b. It means eagerness to initiate actions without being asked to do so.
c. Fayol advised that management should provide opportunity to its
employees to suggest ideas, experiences& new method of work.
d. It helps in developing an atmosphere of trust and understanding.
e. People then enjoy working in the organization because it adds to their
zeal and energy.
f. To suggest improvement in formulation & implementation of place.
g. They can be encouraged with the help of monetary & non-monetary
incentives.
9. Fair Remuneration
a. The quantum and method of remuneration to be paid to the workers
should be fair, reasonable, satisfactory & rewarding of the efforts.
b. As far as possible it should accord satisfaction to both employer and
the employees.
c. Wages should be determined on the basis of cost of living, work
assigned, financial position of the business, wage rate prevailing etc.

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d. Logical & appropriate wage rates and methods of their payment

reduce tension & differences between workers & management creates
harmonious relationship and pleasing atmosphere of work.
e. Fayol also recommended provision of other benefits such as free
education, medical & residential facilities to workers.
10. Stability of Tenure
a. Fayol emphasized that employees should not be moved frequently
from one job position to another i.e. the period of service in a job
should be fixed.
b. Therefore employees should be appointed after keeping in view
principles of recruitment & selection but once they are appointed their
services should be served.
c. According to Fayol. “Time is required for an employee to get used to a
new work & succeed to doing it well but if he is removed before that
he will not be able to render worthwhile services”.
d. As a result, the time, effort and money spent on training the worker
will go waste.
e. Stability of job creates team spirit and a sense of belongingness
among workers which ultimately increase the quality as well as
quantity of work.
11. Scalar Chain
a. Fayol defines scalar chain as ‟The chain of superiors ranging from the
ultimate authority to the lowest”.
b. Every orders, instructions, messages, requests, explanation etc. has
to pass through Scalar chain.
c. But, for the sake of convenience & urgency, this path can be cut shirt
and this short cut is known as Gang Plank.
d. A Gang Plank is a temporary arrangement between two different
points to facilitate quick & easy communication as explained below:

In the figure given, if D has to communicate with G he will first send

the communication upwards with the help of C, B to A and then
downwards with the help of E and F to G which will take quite some
time and by that time, it may not be worth therefore a gang plank has
been developed between the two.
e. Gang Plank clarifies that management principles are not rigid rather
they are very flexible. They can be molded and modified as per the
requirements of situations
12. Sub-Ordination of Individual Interest to General Interest

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a. An organization is much bigger than the individual it constitutes

therefore interest of the undertaking should prevail in all
circumstances.
b. As far as possible, reconciliation should be achieved between
individual and group interests.
c. But in case of conflict, individual must sacrifice for bigger interests.
d. In order to achieve this attitude, it is essential that -
- Employees should be honest & sincere.
- Proper & regular supervision of work.
- Reconciliation of mutual differences and clashes by mutual
agreement. For example, for change of location of plant, for
change of profit sharing ratio, etc.
13. Espirit De’ Corps (can be achieved through unity of command)
a. It refers to team spirit i.e. harmony in the work groups and mutual
understanding among the members.
b. Spirit De‟ Corps inspires workers to work harder.
c. Fayol cautioned the managers against dividing the employees into
competing groups because it might damage the moral of the workers
and interest of the undertaking in the long run.
d. To inculcate Espirit De‟ Corps following steps should be undertaken -
 There should be proper co-ordination of work at all levels
 Subordinates should be encouraged to develop informal
relations among themselves.
 Efforts should be made to create enthusiasm and keenness
among subordinates so that they can work to the maximum
ability.
 Efficient employees should be rewarded and those who are not
up to the mark should be given a chance to improve their
performance.
 Subordinates should be made conscious of that whatever they
are doing is of great importance to the business & society.
e. He also cautioned against the more use of Britain communication to
the subordinates i.e. face to face communication should be developed.
The managers should infuse team spirit & belongingness. There
should be no place for misunderstanding. People then enjoy working
in the organization & offer their best towards the organization.
14. Centralization & De-Centralization
a. Centralization means concentration of authority at the top level. In
other words, centralization is a situation in which top management
retains most of the decision making authority.
b. Decentralization means disposal of decision making authority to all
the levels of the organization. In other words, sharing authority
downwards is decentralization.
c. According to Fayol, “Degree of centralization or decentralization
depends on no. of factors like size of business, experience of
superiors, dependability & ability of subordinates etc.

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d. Anything which increases the role of subordinate is decentralization &

anything which decreases it is centralization.
e. Fayol suggested that absolute centralization or decentralization is not
feasible. An organization should strike to achieve a lot between the
two.
Types of Management

1. Development Management:
It includes research into materials, machines, processes etc
2. Distribution Management:
It can be defined as the arm or wind of Management which serves aa link between
procurement, manufacturing, marketing/sales, and finance proper functioning of
which synergizes the effect of all activities, and absence of which cannot only
reduce efficiency but can lead chaos to the org.
Distribution Mission
The distribution mission can be described as a set of goals to be achieved by
the system within a specific product/market context will get shaped by
 The product
 Production method
 Nature of the product
 The channel
 Outlets
 Customer service levels Introduction to Logistics

Development Management

Distribution Management

Financial Management

Maintenance Management

Purchase Management

Manag Production Management

ement
Transport Management

Human Resource

Office Management

Fig 4.2 Distributed Mission

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Fig 4.3 Distributed Management

3. Financial Management:
Meaning of Financial Management
Financial Management means planning, organizing, directing and controlling
the financial activities such as procurement and utilization of funds of the
enterprise. It means applying general management principles to financial resources
of the enterprise.
Objectives of Financial Management
The financial management is generally concerned with procurement, allocation and
control of financial resources of a concern. The objectives can be-
1. To ensure regular and adequate supply of funds to the concern.
2. To ensure adequate returns to the shareholders which will depend upon the
earning capacity, market price of the share, expectations of the
shareholders?
3. To ensure optimum funds utilization. Once the funds are procured, they
should be utilized in maximum possible way at least cost.
4. To ensure safety on investment, i.e., funds should be invested in safe
ventures so that adequate rate of return can be achieved.
5. To plan a sound capital structure-There should be sound and fair
composition of capital so that a balance is maintained between debt and
equity capital.
Functions of Financial Management
1. Estimation of capital requirements: A finance manager has to make estimation
with regards to capital requirements of the company. This will depend upon
expected costs and profits and future programmers and policies of a
concern. Estimations have to be made in an adequate manner which
increases earning capacity of enterprise.
2. Determination of capital composition: Once the estimation has been made, the
capital structure have to be decided. This involves short- term and long-
term debt equity analysis. This will depend upon the proportion of equity

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capital a company is possessing and additional funds which have to be

raised from outside parties.
3. Choiceof sources of funds: For additional funds to be procured, a company has
many choices like-
a. Issue of shares and debentures
b. Loans to be taken from banks and financial institutions
c. Public deposits to be drawn like in form of bonds.
Choice of factor will depend on relative merits and demerits of each source
and period of financing.
4. Investment of funds: The finance manager has to decide to allocate funds into
profitable ventures so that there is safety on investment and regular returns
is possible.
5. Disposal of surplus: The net profits decision have to be made by the finance
manager. This can be done in two ways:
a. Dividend declaration - It includes identifying the rate of dividends and
other benefits like bonus.
b. Retained profits - The volume has to be decided which will depend
upon expansional, innovational, diversification plans of the company.
6. Management of cash: Finance manager has to make decisions with regards to
cash management. Cash is required for many purposes like payment of
wages and salaries, payment of electricity and water bills, payment to
creditors, meeting current liabilities, maintenance of enough stock, purchase
of raw materials, etc.
7. Financial controls: The finance manager has not only to plan, procure and
utilize the funds but he also has to exercise control over finances. This can
be done through many techniques like ratio analysis, financial forecasting,
cost and profit control, etc.
4. Maintenance Management:
The term „maintenance‟ means to keep the equipment in operational condition or
repair it to its operational mode. Main objective of the maintenance is to have
increased availability of production systems, with increased safety and optimized
cost. Maintenance management involves managing the functions of maintenance.
Maintaining equipment in the field has been a challenging task since the beginning
of industrial revolution. Since then, a significant of progress has been made to
maintain equipment effectively in the field. As the engineering equipment becomes
sophisticated and expensive to produce and maintain, maintenance management
has to face even more challenging situations to maintain effectively such
equipments in industrial environment.
Funtions of A Maintenance Department
Following are the major functions of a maintenance department:

 Maintenance of installed equipment and facilities
In st al l at i o n s of n e w e q u i p m e nt a n d f a ci l i t i e s 

 Inspection and lubrication of existing equipment

 monitoring of faults and failures using appropriate techniques
 Modifications of already installed equipment and facilities
 Management of inventory
 Supervision of manpower
 Keeping records

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Elements Of Effective Maintenance Management

An effective maintenance system includes the following elements:
 Maintenance Policy
 Control of materials
 Preventive Maintenance
 Condition Monitoring
 Work Order
 Job planning
 Priority and backlog control
 Data recording system
5. Purchasing management
Purchasing management is the management of purchasing process, and
related aspects in an organization. Because of production companies purchase
nowadays about 70% of their turnover, and service companies purchase
approximately 40% of their turnover, purchasing management is one of the most
critical areas in the entire organization and needs intensive management.
Purchasing Process
Purchasing Process includes as usual 8 main stages as follows:
1. Approving
2. Studying Market
3. Making Purchase Decision
4. Placing Orders
5. Receipting Goods and Services Received
6. Accounting Goods and Services
7. Receiving Invoices and Making Payment
8. Debit note in case of material defect
Purchasing Management Process
Purchasing Management Process consists usually of 3 stages:
1. Purchasing Planning
2. Purchasing Tracking
3. Purchasing Reporting
Purchasing Planning
Purchasing Planning may include steps as follows:
 creating purchasing projects and tasks
 providing related information (files, links, notes etc.) 
 assigning purchasing tasks to the concern person
 setting task priorities, start/finish dates etc. 
 assigning supervisors
 setting reminders
 control and evaluation
Purchasing Reporting
Purchasing Reporting includes:
 comparing actual and estimated values
 calculating purchasing task and project statistics
 sorting, grouping or filtering tasks by attributes
 creating charts to visualize key statistics

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6. Production Management:
The performance of the management activities with regards to selecting, designing,
operating,
Controlling and updating production system.. Production management is a
function of Management, related to planning, coordinating and controlling the
resources required for production to produce specified product by specified
methods, by optimal utilization of resources.
Objective Of Production Management
The objective of Production Management is to produce the desired product or
specified product byspecified methods so that the optimal utilization of available
resources is met with. Hence theproduction management is responsible to produce
the desired product, which has marketability at the cheapest price by proper
planning, the manpower, material and processes.

Functions of Production Management:

Fig 4.4 Functions of HRM

7. Human Resource Management:

The HRM process consists of planning, attracting, developing, and retaining the
human resources (employees) of an organization.
Functions of HRM:

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Fig 4.5 Functions of HRM

8. Transport Management:
It includes transportation by rail, road, air and water, packingw, warehousing etc.

9. Office Management:
People that hold office management positions conduct special studies and based on
the results of these special studies, they develop reports. Apart from developing
reports, they also provide input to management on the development of policies and
procedures. Office management may also provide paralegal support, and may draft
correspondence for management, schedule appointments, etc.
Main functions
Positions allocated to usual classification perform a combination of the following
office management functions:
 Budget development and implementation
 Purchasing
 Book Keeping
 Human resources
 Accounting
 Printing
 Records management
 Forms management
 Payroll
 Facilities management
 Space management.

Different Types (Styles) of Management)

 Democratic management
In a democratic style, management will make decisions which are
agreed upon by the majority of employees, therefore the workers feel involved
and important to the organization. By involving the employees, management
will be better informed to make the right decisions and harvest new ideas
from the people who are involved in the day to day business of the company.
 Autocratic Management:
An autocratic manager cuts an imposing and knowledgeable figure;
decisions are made quickly and forcefully without involvement from anyone
else. Other people‟s judgements and suggestions are usually neither
listened to nor considered. A truly „my way or the highway‟ attitude towards
the employees.
 Laissez-faire management:
The Laissez-faire management will take a back seat role in the
company, providing guidance when needed, the employees are allowed to let

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their own ideas and creativity flourish in their specific areas. The manager
is looked upon as more of a mentor than a leader.
 Paternalistic Management:
A paternalistic type of management encourages feedback from the
workers to the leaders, essentially to maintain good morale and loyalty. It is
the manager who will make the final decision, but the leader will listen to
ideas and suggestions from the workers. Decisions are usually made in the
best interest of the employees and business.

Functions of Management:

Fig 4.6 Functions of Management

1. Planning
It is the basic function of management. It deals with chalking out a
future course of action & deciding in advance the most appropriate course of
actions for achievement of pre-determined goals. According to KOONTZ,
“Planning is deciding in advance - what to do, when to do & how to do. It
bridges the gap from where we are & where we want to be”. A plan is a
future course of actions. It is an exercise in problem solving & decision
making. Planning is determination of courses of action to achieve desired
goals. Thus, planning is a systematic thinking about ways & means for
accomplishment of pre-determined goals. Planning is necessary to ensure
proper utilization of human & non-human resources. It is all pervasive, it is
an intellectual activity and it also helps in avoiding confusion, uncertainties,
risks, wastages etc.
2. Organizing
It is the process of bringing together physical, financial and human
resources and developing productive relationship amongst them for
achievement of organizational goals. According to Henry Fayol, “To organize
a business is to provide it with everything useful or its functioning i.e. raw
material, tools, capital and personnel‟s”. To organize a business involves
determining & providing human and non-human resources to the
organizational structure. Organizing as a process involves:
 Identification of activities. 
 Classification of grouping of activities. 
 Assignment of duties. 

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 Delegation of authority and creation of responsibility. 

 Coordinating authority and responsibility relationships. 
3. Staffing
It is the function of manning the organization structure and keeping it
manned. Staffing has assumed greater importance in the recent years due to
advancement of technology, increase in size of business, complexity of
human behavior etc. The main purpose o staffing is to put right man on
right job i.e. square pegs in square holes and round pegs in round holes.
According to Kootz&O‟Donell, “Managerial function of staffing involves
manning the organization structure through proper and effective selection,
appraisal & development of personnel to fill the roles designed un the
structure”. Staffing involves:
 Manpower Planning (estimating man power in terms of searching,
choose the person and giving the right place).
 Recruitment, selection & placement.
 Training & development.
 Remuneration.
 Performance appraisal.
 Promotions & transfer.
4. Directing
It is that part of managerial function which actuates the organizational
methods to work efficiently for achievement of organizational purposes. It is
considered life-spark of the enterprise which sets it in motion the action of
people because planning, organizing and staffing are the mere preparations
for doing the work. Direction is that inert-personnel aspect of management
which deals directly with influencing, guiding, supervising, motivating sub-
ordinate for the achievement of organizational goals. Direction has following
elements:
 Supervision
 Motivation
 Leadership
 Communication
Supervision- implies overseeing the work of subordinates by their superiors.
It is the act of watching & directing work & workers.
Motivation- means inspiring, stimulating or encouraging the sub-ordinates
with zeal to work. Positive, negative, monetary, non-monetary incentives may
be used for this purpose.
Leadership- may be defined as a process by which manager guides and
influences the work of subordinates in desired direction.
Communications- is the process of passing information, experience, opinion
etc from one person to another. It is a bridge of understanding.

5. Controlling
It implies measurement of accomplishment against the standards and
correction of deviation if any to ensure achievement of organizational goals.
The purpose of controlling is to ensure that everything occurs in
conformities with the standards. An efficient system of control helps to
predict deviations before they actually occur. According to Theo Haimann,
“Controlling is the process of checking whether or not proper progress is
being made towards the objectives and goals and acting if necessary, to
correct any deviation”. According to Koontz &O‟Donell “Controlling is the
measurement & correction of performance activities of subordinates in order
to make sure that the enterprise objectives and plans desired to obtain them
as being accomplished”. Therefore controlling has following steps:

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a. Establishment of standard performance.

b. Measurement of actual performance.
c. Comparison of actual performance with the standards and finding out
deviation if any.
d. Corrective action.

Establishment of standard performance.

Measurement of actual performance.

Comparison of actual performance with the standards and finding out deviation if any

Corrective Actions
Fig 4.7 Controlling

Types of Organization:

Organization

Formal Organization Informal Organization

1. Line Organization Free form Organization

2. Functional
Organization
3. Line and Staff
Organization
4. Project Organization
5. Matrix Organization
6. Committee
Organization
7. Task Force

Fig4.8 Types of Organitsation

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Formal Organization:
Characteristics
 Organization structure is predetermined by the top management
 It is based on division of labor and specialization
 The organization does not take consideration of emotional aspect
 The authority and responsibility relationship created by the organization
structure are to be honored by everyone.
 The principle of unity of command is observed
 It is deliberately impersonal.
 It is based on delegated authority.
1) Line Organization:
Characteristics:
 Under this system authority flows from top to bottom
 A subordinate will receive all his instructions from his immediate
superior and will directly be responsible to him
 No subordinate can approach any higher authority except through his
superior boss.
Structure:

MD

Production Manager

Plant Superintendent

Foreman Shop A Foreman Shop B Foreman Shop C

Fig 4.9Structure of Line of Organization

Merits:
 Simple
 Discipline
 Quick Decisions
 Flexibility
Demerits:
 Top Manager will be overloaded
 Lack of Specialization
 Lack of Communication
 Nepotism and Favoritism

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2) Functional Organization:
Characteristics:
 The organization will be divided into number of functional areas.
 Each function is managed by an expert in that area
 Every functional area serves all areas in the organization
 An individual receives instructions from functional heads.
 Follows functional foremanship followed by Taylor.

Fig 4.10Structure of Functional Organization

Merits:
 Specialization
 Reduction of Workload
 Better Control
 Easier Staffing
 Higher Efficiency
 Scope of expansion
Demerits:
 Uneconomic
 Confusing
 Diluted Responsibility
 Loose Discipline

3) Line and Staff Organization:

Characteristics:
 It is a combination of line and functional structures
 Under it, line authority flows in a vertical line in the same manner as in
the line organization
 In addition, staff specialists are attached to line positions to achieve them
on important matters but they do not have power of command over the
subordinates.

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Fig 4.11Structure of Line and Staff Organization

Merits:
 Expert Advice
 Relief to top executives
 Quality Decisions
 Training of personal
 Flexibility
Demerits:
 Staff advice is not always practiced
 Conflict between line and staff
 Centralization
 Expensive
4) Project Organization:
Characteristics:
 Project and matrix are of recent origin developed after World War II.
 When an organization has to execute large projects of long duration it
may adopt a project organization
 Under this each project is organized as a semi autonomous project
division.
 Activities are coordinated by the Project Manager

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Fig 4.12 Structure of Project Organization

Merits:
 Focuses on specific Project
 Unity of command
 Flexibility of Operations
 Fixation of individuals responsibility for results
 Maximum use of specialized knowledge of skills
Demits:
 Difficulty in Decision Making
 Lack of Motivation
 Difficulty in co-ordination
 Pressure and uncertainty due to several specialists.
5) Matrix Organization:
 It is a hybrid grid structure wherein pure project organization is
superimposed on a functional structure.
 It is a 2 dimensional pattern developed to meet the roles of growing size and
complexity of undertakings.
 It is characterized by an overlapping of command, control and behavior
patterns.
Merits

 Helps the organization in the optimum development and utilization of

specialized functional services
 High degree of flexibility and adaptable in the organizational structure
Demerits:
 Violates unity of command
 Organizational relationship become more complex and there is great
confusion among personnel

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Fig 4.13 Structure of Matrix Organization

6) Committee Organization:
 A committee is a group of persons formed to discuss and deliberate on
problems and to recommend or decide solutions
 Its area of operations is determined by its constitutions
 Members of the committee have authority to go into details of the problems
Types:
 Standing or adhoc Committee
 Executive or Advisory Committee
 Line or Staff Committee
 Formal or Informal Committee
Merits:
 Group adjustments
 Effective Co-ordination
 Motivation through participation
 Representation of diverse interest groups
Demerits:
 Expensive
 Slow Decisions
 Compromise Decisions
 Misuse of committees
Advantages of formal Organizations:
 Sense of belongingness
 Value of emotional problems
 Check on Authority
 Important Channel of communication
Disadvantages of Formal Organization:
 No one has overall responsibility on a project
 Employees have their time split between projects (thus no dedication to a
certain project)
7) Informal Organization:

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Characteristics:
 Informal Relations are unplanned, they arise spontaneously
 Formation of information organization is a natural process
 It reflects human relationships
 It is based upon common taste, problem, language, religion, culture etc.
Merits:
1. To employees:
 Sense of belonging
 Value of emotional problems
 Aid of job
 Social Control
 Innovation & Originality
2. To Management:
 Less Supervision
 An Aid to Management
Demerits:
 Resistance to Change
 Role conflict and sub-optimization
 Rumor
 Group think Philosophy
Types of Ownership:
Ownership:
The ultimate and exclusive right conferred by a lawfulclaim or title, and
subject to certain restrictions to enjoy, occupy, possess, rent, sell, use, give away,
or even destroy an item of property.
Types
1. Single Ownership
2. Partnership
3. Joint Stock Companies
4. Cooperative Organizations
5. State and central Government owned.

1. Single Ownership:
 Business owned by one man is called single ownership
 In Single ownership, one person contributes the original assets to start the
business, maintains and controls business operations, reaps full benefits in
terms of profit and fully liable for all debts associated with the business.
Merits:
 Simplicity of the organization
 Expenses in starting the business are minimal
 Owner is free to make all decisions
 Owner enjoys all the profit
 Minimum legal restrictions are associated
Demerits:
 The owner is liable for all the obligations and the debts of the business

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 The business may not be successful if the owner has limited money lacks
ability and necessary experience
 There is limited opportunities for employees as regards monetary rewards
and promotions
Applications:
Suitable for:
 Business which do not involve high risks of failure
 Retail trades, service concerns and small engineering firms which require
relatively small capital to start with and to run
2. Partnership:
 Combination of individual traders is called as partnership
 Partnership may be defined as the relation between persons who have
agreed to share the profits of a business carried on the all or any of them
acting for all.
Kinds of Partners:
(i) Active Partners:
Who take part in the management of the business enterprise.
(ii) Sleeping Partners:
Who do not take any active part in the conduct of the business. Both active and
sleeping partners are responsible for the debts of the partnership
Duties of Partners:
 Be just and faithful to one another
 Respect the views of one another
 Render true accounts and full information about everything that affects any
partner 
Types of Partnership:
1. General Partnership:
 Same as the duties of the partner
 As the partnership grows or a personnel change occurs additional
partners can be had with the consent of the other partners.
Merits:
 Large capital is available to the firm
 Incentive for success is high
 Partnership firms can borrow money quite easily form the banks
 The firm possesses much talents, judgments and skills
 There is a definite legal status of the firm
Demerits:
 Each Partner will have unlimited liability for the debts of the firm
 All partners will suffer because of the wrong steps taken by one partner
 Authority will br divided among the partners.

2. LimitedPartnership:
 Limited partnership is an association of one or more general partners
who manage the business and one or more limited partners whose
liability is limited to the capital they have invested in the business.

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Merit:
Investors and vendors who used to hesitate investing in the venture can do
without much risk.
Demerit:
Limited partner though he invests in the business has no voice in the
management.

Joint Stock Company:

 A Joint stock company is an association of individuals called
shareholders, who join together for carrying a specific business
 The managing body of a joint company is BOD elected by the share
holders.
BOD
(i) Makes Policies
(ii) Take Decisions
(iii) Runs the company Efficiently
Types
 Private Limited Company
 Public Limited Company
1. Private Limited Company:
 The capital is collected from the private partners, some of them may be
active and others be sleeping.
 The number of members is between 2 and 50.
 Need not file documents such as consent of directors, list of directors, etc.
with the registrar of joint stock companies.
 It must be get its accounts audited
 The company need not circulate the balance sheet, Profit and Loss Account
etc. among its members but it should hold its members but it should hold
its annual general meeting and place such financial statement in the
meeting.
 The company restricts the right to transfer shares, avoids public to take up
shares or debentures.
2. Public Limited Company:
 In this, the capital is collected from the public by issuing the shares having
small face value (Rs.50,20,30)
 The number of shareholders should not be less than 7 but there is no limit
to the maximum numbers
 A public limited company has to file with the registrar of the joint stock
companies documents such as consent of the directors, director‟s contract
etc.
 A public limited company has to release prospectus to the public
 It has to allot shares within 180 days from the date of prospectus
 There is no restriction on the transfer of shares
 Directors of the company are subject to rotation
 Needs to hold a general meeting every year

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Merits of Joint Stock Companies:

 A huge sum of money can be raised
 Shares are transferable
 Risk of loss is divided among many shareholders
 It associates limited liability with it.
 The company is associated with its stability, efficiency and flexibility of
management
Demerits of Joint Stock Companies:
 A great deal of legal formalities are required
 Company is managed by big shareholders only
 Divided responsibility
 People can commit frauds with the company
 Board of directors and managers who remain familiar with the financial
positions of the company may sell or purchase shares for their personal
benefits.
Applications:
 Steel Mills
 Fertilizers factories
 Engg. Concerns

3. Cooperative Organizations:
 It is a form of private ownership which contains features of large
partnership as well as some features of the corporations
 It aims to eliminate profit and provide goods and services to the members of
the cooperative at cost
 Members pay fees or buy shares of the cooperative and profits are
periodically redistributed to them
 In cooperatives there are shareholders, BOD, and the elected officers similar
to the corporations
 There are periodic meetings of shareholders
 Special laws deals with the formation and taxation of cooperatives
 The principle behind the cooperatives is that cooperation and self help.
Forms of cooperative Enterprises:
(i) Consumers Cooperatives:
In retail trade and services.
(ii) Producer cooperatives:
For group buying and selling such items as dairy products, grain, fruits etc.
(iii) Cooperative Farming:
More and quality products from farms.
(iv) Cooperative Housing:
For constructing and providing houses to the members of the association at
relatively lesser rates.
(v) Cooperative Credit Society:
To provide loans to the needy individuals.

Merits:

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 Democratic form of ownership

 Monetary help can be secured from government
 Daily necessities of life can be made available at lower rates
 Goods required can be purchased directly from the manufactures and
therefore can be sold at less rates
 Common man is benefited by cooperatives
Demerits:
 Since the members of the cooperative manage the whole show, they may not
be competent enough to make it a good success
 Finance being limited specialist‟s services cannot be taken
 Members who are in position may try to take personal advantage
 Conflict may arise among the members on the issue of sharing responsibility
and enjoying authorities.
4. Public Sector:
 A public sector is one that is
i. Owned by the state
ii. Managed by the state
iii. Owned and managed by the state
 The sector of the public enterprise is popularly known as the public sector
 It prevents concentration and unbalanced growth of industries.
Evolution:
The industrial revolution gave rise to many bitter social evils. It also gave
birth to private capitalism. consumers and workers were exploited and
therefore the need of state intervention in industrial field. The intervention
led to evolution of public sectors.
Objectives:
 To promote rapid economic development
 To look after well being and welfare of public
 To create employment opportunities on an increasing scale
 To provide basic infrastructure facilities for the growth of economy
 To earn foreign exchange in order to export commodities not available in the
country Eg: Petroleum Oil, Sophisticated weapon systems etc.
Merits:
 Capital, raw materials, fuels, power and transport are easily made available
 Profits earned by the public sector may be used for the general welfare of the
community
 Public sector offers equitable employment opportunities to all, there is no
discrimination as may be in the private sector
Demerits:
 Delay in decision making
 Incompetent persons may occupy high levels workers shirk work
 There is too much interference by the government and politicians in the
internal affairs of the public enterprises. As a result efficiently decreases.

5. Private Sector:

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 It serves personal interests and is a non government sector.

 Profit is the main objective
 Private sector constitutes mainly consumers goods industries where profit
possibilities are high
 Private enterprises are run by businesses capital is collected from the private
partners.
Merits:
 Magnitude of profits incurred is high
 Wastage of materials and labour is minimum
 Decision making is very prompt
 No interferences of the politicians
Demerits:
 There is dearth of capital to expand the business
 Leads to unbalanced growth of industry
Leads to concentration of wealth in the hands of a few

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CHAPTER - V

FINANCIAL MANAGEMENT

Fixed and Variable Cost:

Variable Cost:
Variable cost is an expense that changes in relation to a company‟s business
activity. As opposed to fixed costs, which remain constant, these costs arise in
direct proportion to a business‟s output, increasing and decreasing along with the
volume of production. Most often, variable rates are associated with production and
packaging materials, as well as some hourly wage labor expenses.
Good examples include:
 Raw materials
 Bought-in stocks and components
 Wages based on hours worked or amount produced
 Marketing costs based on sales (e.g. % discounts offered on a sales price)
 Agent and other commissions
The formula for calculating total variable cost is:
Total Variable Cost = Total Quantity of Output x Variable Cost per Unit of Output
The term variable cost is not to be confused with variable costing, which is an
accounting method related to reporting variable costs.
Example:
Let's assume XYZ Company has received an order for 5,000 widgets for a total sales
price of $5,000 and wants to determine the gross profit that will be generated by
completing the order. First, the variable costs per widget must be determined.

Let's assume the following:

Annual Widgets Produced: 100,000
Raw Materials Costs: $10,000
Direct Labor Costs: $50,000
From this information, we can conclude that each widget costs 10 cents
($10,000 / 100,000 widgets) in raw materials and 50 cents ($50,000 / 100,000
widgets) in direct labor costs. Using the formula above, we can calculate that XYZ
Company's total variable cost on the order is:
5,000 x ($0.10 + $0.50) = $3,000
Therefore, the company can reasonably expect to earn a $2,000 gross profit ($5,000
- $3,000) from the order.

Fixed Cost
A cost that does not change with an increase or decrease in the amount of
goods or services produced. Fixed costs are expenses that have to be paid by a
company, independent of any business activity. It is one of the two components of
the total cost of a good or service, along with variable cost.
Some examples of fixed costs include

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 rent,
 Insurance Premiums or loan payments.
Fixed costs can create economies of scale, which are reductions in per-unit
costs through an increase in production volume. This idea is also referred to as
diminishing marginal cost.
Example
Let's assume it costs Company XYZ $1,000,000 to produce 1,000,000
widgets per year ($1 per widget). This $1,000,000 cost includes $500,000 of
administrative, insurance, and marketing expenses, which are generally fixed. If
Company XYZ decides to produce 2,000,000 widgets next year, its total production
costs may only rise to $1,500,000 ($0.75 per widget) because it can spread its fixed
costs over more units.
Although Company XYZ's total costs increase from $1,000,000 to
$1,500,000, each widget becomes less expensive to produce and therefore more
profitable.

Break Even Analysis:

CVP Analysis:
The analytical technique employed to study the inter-relationship of cost, volume
and price and its impact on the behaviour of profit is known as „Cost-Volume Profit
Analysis:
Break-even analysis establishes the relationship between revenues and costs
with respect to volume. It indicates the level of sales at which total costs are equal
to total revenues. Breakeven analysis is a specific way of presenting information to
management in a precise manner. Many a time, CVP analysis is popularly
designated as break-even analysis. But, there is a narrow difference between the
two.
CVP analysis is concerned with the entire profit planning, while the break
even analysis is one of the techniques used in that process. Break-even point:
Break-even point is the point at which the firm makes no profit or loss.
At the break-even point, the firm is in the stage of equilibrium. The
equilibrium point is commonly known as break-even point. Break-even point is
that point, where the revenue is just equal to total costs. It is the point where
the firm makes neither profit nor loss. This is a zero position. After this level, if the
firm makes production and sells above the variable cost, it earns profit. If the sales
fall below this level, firm sustains loss. There are two approaches to calculate the
break-even point. They are:
(A) Break-even Formulae Approach and
(B) Break-even Chart or Graphic Method Break-even Analysis

(A) Break-even Formulae Approach:

The break-even point can be calculated in terms of units, in terms of money
value of sales volume or as a percentage of estimated capacity.
Contribution
When the selling price per unit is more than its variable cost, the excess is called
contribution.

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Total contribution is calculated by multiplying the unit contribution with the

number of units sold. Total contribution is the excess amount, after covering total
fixed costs that is incurred by the firm. After covering fixed costs, the amount left
out from total sales in the firm is gross margin. So, contribution covers total fixed
costs and profit. If the contribution does not cover fixed costs, the difference is loss,
sustained by the firm. Every firm looks to achieve break-even point, at the earliest.
After the break-even level, whatever is sold that can leave in the form of
contribution to the firm is a welcome decision. While making production and sales
decisions, the firm chooses that product that gives the highest contribution.
Contribution is vital in profit planning decision-making. Firm is always concerned
to choose that product, where it can sell and achieve the highest amount of
contribution. Contribution is important to the finance manager and, equally, to
marketing manager to show impressive performance of the firm, in terms of
profitability.

The formulae for their calculation are

Contribution per unit = Selling price per unit – Variable cost per unit

Contribution per unit × Number of units sold = Total Contribution

Total Contribution = Total fixed costs + Profit

Profit = Total Contribution – Total fixed costs

Loss = Total fixed costs – Total contribution

BEP in Terms of Units:

The break-even point, in terms of units, can be computed by dividing fixed
costs by contribution per unit. The formula for break-even point (BEP), in terms of
units, is as follows:

BEP (units) = Total fixed cost / (Selling price per unit – Variable cost per unit)
Or
BEP (units) = Total fixed cost / Contribution per unit

The above formula is useful to find out break-even point, in terms of number of
units of sales. From the above formula, it is evident that the selling price per unit
should be higher than the variable cost per unit to have positive break-even point.
Suppose, if the variable cost is higher than the selling price, a negative sales
volume can be calculated, mathematically, to arrive at break-even point, but is of
no help in the real life situation.
Example:
A firm produces a single product and its selling price is Rs.40. Its variable
cost per unit is Rs. 32. Its fixed costs are Rs. 2, 40,000. What is its break-even
point?
Solution:

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Selling price per unit = Rs. 40

Variable cost per unit = Rs. 32
Contribution per unit = 8
BEP (units) = Fixed costs / Contribution per unit

= 2, 40,000 / 8
= 30,000 units
Proof:
Total Sales 30,000 × 40 = 12,00,000
Total Variable cost 30,000 × 32 = 9,60,000

Contribution 30,000 × 8 = 2,40,000

Fixed costs 2,40,000

Profit 0

BEP in terms of Rupees:

The break-even point can be calculated with the following formula:

BEP (in rupees) = BEP (in terms of units) × Selling price per unit (or)
BEP (in rupees) = Total fixed cost / (1 – (Variable cost per unit/Selling price per unit))

When we apply the same formula to the illustration No. 1, we can find out
the BEP in terms of rupees:
BEP (in rupees) = Total fixed cost / (1– (Variable cost per unit/Selling price per
unit))
BEP (in rupees) = 2, 40,000 /(1– (32/40))
= 2, 40,000/ (8/40)

= 2,40,000 × 40/8 = 12,00,000

PV Ratio or Contribution ratio:

PV Ratio is important for studying the profitability of operations of a
business. This ratio establishes the relationship between contribution and sales
value. PV ratio is useful to calculate the BEP, in terms of rupees. The term P
represents Profit that is equivalent to contribution, when calculating BEP, in terms
of rupees. The term V refers to Volume of sales.

Contribution ratio = Contribution per unit / Selling price per unit

or
PV Ratio

Alternatively,
P/V Ratio = (Change in profit or Contribution / Change in sales) × 100

PV Ratio can be used to calculate BEP and ascertain required sales to

achieve a desired level of profit.

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BEP (in terms of Rupees) = Fixed cost / P/V Ratio

BEP to Achieve a Desired Amount of Profit: The above formula requires a small change.
In the numerator, the desired amount of profit is to be added. The formula is

BEP (to achieve required amount of profit) = (Total fixed cost + Desired Profit) / PV Ratio

(B) Break-even Chart or Graphic Method of Break-even Analysis

The break-even point can be presented graphically. The pictorial presentation
gives a better view of the relationship of cost, volume and profit. Graphical
presentation gives immediate and clear understanding of the picture. This type of
presentation always impresses the management as it gives instantaneous
understanding of the situation.
Following are the steps involved in preparing break-even chart:
1. Sales volume is plotted on the horizontal line i.e. X-axis. Sales volume may be
expressed in terms of units, rupees or as a percentage of capacity.
2. Vertical line i.e. Y-axis is used to represent revenue, fixed costs and variable
costs.
3. Both horizontal and vertical lines are spaced, equally, with the same distance.
5. Break-even point is the point of intersection between total cost line and sales
line.
5. Sales revenue at the break-even point can be determined by drawing a
perpendicular line to the X-axis from the point of above intersection.
6. Total sales line and Total cost line intersect forming an angle known as „Angle
of Incidence‟.
Angle of Incidence
The break-even point is indicated where the Total cost line and Total
sales line intersect each other. The angle that is formed with their
intersection is called „Angle of incidence‟. Larger the angle of incidence, lower is
the break-even point and vice versa. A lower breakeven point is an indication
that the firm can withstand, even if the sales fall. Firm does not go into loss
immediately and remains, at least, with a small amount of profit.

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Fig 5.1 Break Even Chart

Assumptions Of Break-Even Analysis

The break-even analysis is based on the following assumptions:
1. Costs segregation: It is based on the assumption that all costs can be segregated
into fixed costs and variable costs.
2. Constant Selling Price: The selling price remains constant. That is, selling price
does not change with volume or other factors.
3. Constant Fixed costs:Fixed costs are constant, at all levels of activity. They do not
change, with change in sales.
5. Constant Variable costs:Variable cost per unit is constant. So, variable costs
fluctuate, directly, in proportion to changes in volume of output. In other words,
they change in direct proportion to sales volume.
5. Synchronized production and sales:It is assumed production and sales are
synchronized. That is, inventories remain the same in the opening stock and
closing stock.
6. Constant sales mix:Only one product is manufactured. In case, more than one
product is manufactured, sales mix of products sold does not change.
7. No Change in operating efficiency:There is no change in operating efficiency.
8. No other factors:The volume of output or production is the only factor that
influences the cost. No other factors have any influence on break-even analysis.

Limitations Of Break-Even Analysis And Break-Even Chart

1. Number of Assumptions: Break-even analysis is based on several assumptions
and they may not hold well, under all circumstances. Fixed costs are presumed to
be constant, irrespective of the level of output. It does not happen. When the
production increases, above the installed capacity, fixed costs change as new plant
and machinery has to be installed for increased production. Variable costs do not

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vary in direct proportion to the change in volume of output, due to the laws of
diminishing returns. Selling price that is supposed to be constant also changes due
to increased competition.
2. Application in Short Run: Break-even analysis is a short run analysis. In long
run, the cost analysis may not hold good as the assumptions may vary and
situation may be, totally, different.
3. Applicable in Single Product line: This analysis is applicable for a single
product only. If break-even point for each product is to be calculated, fixed costs
have to be allocated to different products, which is a practical problem in the real
life. Otherwise, BEP for the overall firm only is possible to calculate.
5. No Remedial Action: It does not suggest any remedy or action to the
management for solving the problem.
5. Other Factors Ignored: Other important factors such as amount of investment,
problems of marketing and policies of Government influence the problem. Break-
even analysis does not consider them. This analysis focuses only on cost volume
profit relationship.
6. Limited Information: Break-even charts provide limited information. If we want
to study the effects of changes in fixed costs, variable costs and selling prices on
profitability, a number of charts have to be drawn. It becomes rather more
complicated and difficult to understand.
7. Static View: More often, a break-even chart presents a static view of the
problem under consideration.
Margin Of Safety
The excess of actual or budgeted sales over the break-even sales are called
„Margin of safety‟. It is the difference between actual sales minus break-even sales.
Margin of safety = Estimated sales – Sales at Break-even point

Margin of safety ratio can be calculated as under:

Example:

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Example:

Types of Capital:
There are 2 types of capital. They are
1. Fixed Capital
2. Working Capital.

1. Fixed Capital:
Definition:
“Fixed capital is a compulsory initial investment made by the entrepreneur to
start up the activities of his business.”
Fixed capital is a mandatory one-time investment made at the introductory phase
of a business establishment.Fixed capital is not alike working capital, which is

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required on a continuous basis to operate (run) the ordinary course of production

and distribution of goods and services.Fixed capital is a permanent investment
made to meet the longer-term needs (requirements) of the business activities.Thus,
fixed capital has a permanent existence in the business. It is usually present in the
form of fixed assets like land, building, plant, machinery, etc.
Meaning:
The meaning of fixed capital can be easily grasped from these points:
 Fixed capital is a compulsory initial investment made in the business.
 It helps to lay down the basic infrastructure on which business is
supposed to stand and flourish in a long run.
 It is a part of total capital invested in the business.
 It has a permanent existence in the business to meet its long-term needs.
 It is used for purchasing fixed assets like land, building, plant,
machinery, etc.
 It is also used for purchasing intangible assets like patents, copyrights,
goodwill, etc.
 It is required for promoting the business.
 It is also required for expansion, modernization and diversification of
business.
 Fixed capital gets depreciated as an asset is used over time with few
exceptions like in case of land.
 Fixed capital requirement is estimated by the promoters of business. This
estimation must be made as accurately as possible. To achieve this, the
promoters seek professional help and take advice from experts such as
engineers, architects, etc.

Fig 5.2 Fixed Capital

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Fig 5.3 Features of Fixed Capital

Role or Importance of Fixed Capital:

The main role or importance of fixed capital is listed in following eight points:
 Fixed capital is required to buy fixed assets for the company.
 It is needed to meet various promotional expenses of a company.
 It aids a company to modernize by easing the process of purchasing modern
machines and implementation of latest technologies.
 It is necessary to replace out of date and scrapped assets.
 It helps in expansion and diversification of a company.
 It also helps in automation of a company.
 It is essential if a company decides to widen its scope of activities.
 It increases the capital requirements of a company.
Factors Influencing or Affecting Fixed Capital Requirement
The factors determining, affecting or influencing fixed capital requirements of a
business are briefly given in the following nine points:
 Nature of business is the most crucial factor of all that significantly affects
its fixed capital requirement.
 Size of business has a direct relationship with its fixed capital need.
 The availability of fixed capital impacts the scale of operation.
 Modern technologies demand more fixed capital than traditional ones.
 Manufacturing of complex products need more fixed capital than what
amount is required for making simple products.
 The scope of activities determines fixed capital needs of a business.
 The method of acquiring assets for business use influences it.
 The allocation of subsidy by government also has an influence on it.
 Along with above eight main factors, other minute considerations like the
lifetime of assets, annual maintenance costs (AMC), sustainability of

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sensitive projects, stages in development of a business, etc., also influence

the fixed capital requirements to some extent.

Fig 5.4 Sources of Fixed Capital

Fig 5.5Examples of FC
2. Working Capital:
Working capital management is the part of financial management. In working
capital management, management of cash, management of inventory, management
of debtor and creditor will include. Following are its main notes. By studying these
working capital management notes, you will become perfect in managing your
company's working capital. To study these notes are very necessary for any student
who is studying business because without management of working capital, we can
not operate our business with profitability.
Definition:
" Working capital is an excess of current assets over current liabilities. In other
words, The amount of current assets which is more than current liabilities is
known as Working Capital. If current liabilities are nil then, working capital will
equal to current assets. Working capital shows strength of business in short period
of time . If a company have some amount in the form of working capital , it means

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Company have liquid assets, with this money company can face every crises
position in market. "
Formula:
Working Capital = Current Assets - Current LiabilitiesCurrent Assets

Current assets are those assets which can be converted into cash within One
year or less than one year. In current assets, we includes cash, bank, debtors, bill
receivables, prepaid expenses, outstanding incomes.

Current Liabilities
Current Liabilities are those liabilities which can be paid to respective
parties within one year or less than one year at their maturity. In current liabilities,
we includes creditors, outstanding bills, bank overdraft, bills payable and short
term loans, outstanding expenses, advance incomes .

Other names of Working Capital: operating capital, operating liquidity, positive working
capital.
Concept of Working Capital:
Concept of working capital includes meaning of working capital and its
nature. Working capital is the investment in current assets. Without this
investment, we can not operate our fixed assets properly. For getting good profits
from fixed assets, we need to buy some current assets or pay some expenses or
invest our money in current assets. For example, we keep some of cash which is
the one of major part of working capital. At any time, our machines may need
repair. Repair is revenue expense but without cash, we can not repair our
machines and without machines, our production may delay. Like this, we need
inventory or to invest in debtors and other short term securities.
On the basis of Concept, we can divide our working capital into two parts:

Fig 5.6 Working Capital

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1. Gross Working Capital

In this concept of working capital, we study gross working capital. We do not

deduct current liabilities in this concept but we use current liabilities as source of
fund. Suppose, if we buy goods on credit, it means our save our cash and we can
use this as working capital for paying other expenses.

2. Net Working Capital

Under this concept we use net working capital. For this, we first deduct all
our current liabilities from our current assets. Excess of current assets over
current liabilities will be current assets. We have to maintain minimum level of
working capital in our business for operation of business activities. This concept is
also used for preparation of balance sheet. In the vertical form of balance sheet, we
show excess of current assets over current liabilities.
Optimal Level of Working Capital:
Optimal level of working capital is that level where company is capable to
pay day to day expenses and company has enough cash to buy the stocks in case if
it does not receive money from debtors on the time. This level is achieved by
thinking and using the techniques of working capital management. We all know
that both low level or over level of working capital is harmful for development of
business. If company has not enough cash to repay its liability, it will create the
risk of solvency and liquidity and company may go for liquidation. In case,
company has over working capital, it will be misuse of money because that money
is not gaining any earning and its opportunity cost will suffer by shareholders and
ultimately it will decrease the value of share in share market. So, as finance
manager, you should try to create equilibrium or optimal or optimum level of
working capital.
Working Capital Forecasts:
Working capital forecasts means to estimate the value of working capital in
one year. Following are main items which are estimated in working capital
forecasts.
1. Future Operating Costs
We estimated our future operating cost, more future operating cost means
more need of cash and cash is the part of working capital. It means, we need more
working capital in that situation. For estimating this, w analyze past income
statements of company.
2. Forecast Revenue Growth
By sales and other revenue's trend analysis, we can forecast revenue growth.
This will tell us, how working capital will manage from revenue in future.
3. Changes of Working Capital
To analyze the past working capital changes is useful for working capital
future forecast. Working capital is difference between current assets and current
liabilities. If we check two years' working capital changes, we can estimate what
changes in working capital in next year.
Determinants of Working Capital:
1. Small or Large Business

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It is the first determinant of working capital that it is affected with the

nature of business. Business may be small or large. In small business, company
need high working capital because, small business is relating to trading of
goods, for starting small business, you need very small fixed capital but need
high working capital for paying day to day expenses. But in large business, we
require more fixed capital than working capital for purchasing fixed asset.
2. Small or Large Demand
Nature of demand also absolutely affects the working capital need. Some
product can be easily sold by businessman, in that business; you need small
amount of working capital because your earned money from sale can easy fulfill
the shortage of working capital. But, if demand is very less, it is required that
you have to invest large amount of working capital because your all fixed
expenses must be paid by you.
For paying fixed capital you need working capital.
3. Production Policy
Production policy is also main determinant of working capital requirement.
Different company may different production policy. Some companies stop or
decrease the production level in off seasons, in that time, company may also
reduce the number of employees or decrease the purchasing of new raw
material, so, it will certainly decrease the amount of working capital but on the
side, some company may continue their productions in off season, in that case,
they need definitely large amount of working capital.
5. Credit Policy
Credit policy is relating to purchasing and selling of goods on credit basis. If
company purchases all goods on credit and sells on cash basis or advance
basis, then it is certainly company need very low amount of working capital. But
if in company, goods are purchased on cash basis, and sold on credit basis, it
means, our earned money will receive after sometime and we require large
amount of working capital for continuing our business.
5. Dividend Policy
Dividend policy also effect working capital requirement. Company can distribute
major part of net profit. But, if there is no reserve, we have to invest large
amount in working capital because, lacking of reserve will affect on adversely on
fulfill our liabilities. In that case, we have to yield working capital by taking
short term loan for paying uncertain liability.
6. Working Capital Cycle
Working capital cycle shows all steps which starts from cash purchasing of
raw material and then this converted into finished product, after this it is
converted into sale, if it is credit sale, debtors will also the part of working
capital cycle and when we gets money from our debtors, it is the final part of
working capital cycle. If we receive fastly from our debtors, we need small
amount working capital. Otherwise, for purchasing new raw material, we need
more amount of workingcapital.
7. Manufacturing Cycle
Manufacturing cycle means the process of converting raw material
into finished product. Long manufacturing cycle will create the situation in
which we require large amount of working capital. Suppose, we have to

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construct the building, for constructing colony of buildings, it may consume

the time more than 5 years, so according to this we need working capital.
8. Business Cycle
There are two main part of business cycle, one is boom and other is
recession. In boom, we need high money or working capital for development
of business but in recession, we need only low amount of working capital.
9. Price Level Changes
If there is increasing trend of products prices, we need to store high
amount of working capital, because next time, it is precisely that we have to
pay more for purchasing raw material or other service expenses. Inflation
and deflation are two major factors which decide the next level of working
capital in business.
10. Effect of External Business Environmental Factors
There are many external business environmental factors which affect
the need of working capital like fiscal policy, monetary policy and bank
policies and facilities.

Sources of Finance:
Sources of finance can be classified into:
• Internal sources (raised from within the organisation)
• External (raised from an outside source)

External Sources
There are five internal sources of finance:
• Owner‟s investment (start up or additional capital)
• Retained profits
• Sale of stock
• Sale of fixed assets
• Debt collection

Owner’s investment
• This is money which comes from the owner/s own savings
• It may be in the form of start up capital - used when the business is setting
up
• It may be in the form of additional capital – perhaps used for expansion
• This is a long-term source of finance
Advantages
• Doesn‟t have to be repaid
• No interest is payable
Disadvantages
• There is a limit to the amount an owner can invest
Retained Profits
• This source of finance is only available for a business which has been
trading for more than one year
• It is when the profits made are ploughed back into the business
• This is a medium or long-term source of finance
Advantages

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• Doesn‟t have to be repaid

• No interest is payable
Disadvantages
• Not available to a new business
• Business may not make enough profit to plough back
Sale of Stock
• This money comes in from selling off unsold stock
• This is what happens in the January sales
• It is when the profits made are ploughed back into the business
• This is a short-term source of finance
Advantages
• Quick way of raising finance
• By selling off stock it reduces the costs associated with holding them
Disadvantages
• Business will have to take a reduced price for the stock
Sale of Fixed Assets
• This money comes in from selling off fixed assets, such as:
– a piece of machinery that is no longer needed
• Businesses do not always have surplus fixed assets which they can sell off
• There is also a limit to the number of fixed assets a firm can sell off
• This is a medium-term source of finance
Advantages
• Good way to raise finance from an asset that is no longer needed

Disadvantages
• Some businesses are unlikely to have surplus assets to sell
• Can be a slow method of raising finance
Debt Collection
• A debtor is someone who owes a business money
• A business can raise finance by collecting the money owed to them (debts)
from their debtors
• Not all businesses have debtors ie those who deal only in cash
• This is a short-term source of finance
Advantages
• No additional cost in getting this finance, it is part of the businesses‟ normal
operations
Disadvantages
• There is a risk that debts owed can go bad and not be repaid

External Sources
There are five internal sources of finance:
• Bank Loan or Overdraft
• Additional Partners
• Share Issue
• Leasing
• Hire Purchase

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• Mortgage
• Trade Credit
• Government Grants
Bank Loan
• This is money borrowed at an agreed rate of interest over a set period of time
• This is a medium or long-term source of finance
Advantages
• Set repayments are spread over a period of time which is good for budgeting
Disadvantages
• Can be expensive due to interest payments
• Bank may require security on the loan
Bank Overdraft
• This is where the business is allowed to be overdrawn on its account
• This means they can still write cheques, even if they do not have enough
money in the account
• This is a short-term source of finance
Advantages
• This is a good way to cover the period between money going out of and
coming into a business
• If used in the short-term it is usually cheaper than a bank loan
Disadvantages
• Interest is repayable on the amount overdrawn
• Can be expensive if used over a longer period of time
Additional Partners
• This is sources of finance suitable for a partnership business
• The new partner/s can contribute extra capital
Advantages
• Doesn‟t have to be repaid
• No interest is payable
Disadvantages
• Diluting control of the partnership
• Profits will be split more ways
Share Issue
• This is sources of finance suitable for a limited company
• Involves issuing more shares
• This is a long-term source of finance
Advantages
• Doesn‟t have to be repaid
• No interest is payable
Disadvantages
• Profits will be paid out as dividends to more shareholders
• Ownership of the company could change hands
Leasing
• This method allows a business to obtain assets without the need to pay a
large lump sum up front
• It is arranged through a finance company
• Leasing is like renting an asset

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• It involves making set repayments

• This is a medium-term source of finance
Advantages
• Businesses can have the use of up to date equipment immediately
• Payments are spread over a period of time which is good for budgeting
Disadvantages
• Can be expensive
• The asset belongs to the finance company
Hire Purchase
• This method allows a business to obtain assets without the need to pay a
large lump sum up front
• Involves paying an initial deposit and regular payments for a set period of
time
• The main difference between hire purchase and leasing is that with hire
purchase after all repayments have been made the business owns the asset
• This is a medium-term source of finance
Advantages
• Businesses can have the use of up to date equipment immediately
• Payments are spread over a period of time which is good for budgeting
• Once all repayments are made the business will own the asset
Disadvantages
• This is an expensive method compared to buying with cash
Mortgage
• This is a loan secured on property
• Repaid in instalments over a period of time typically 25 years
• The business will own the property once the final payment has been made
• This is a long-term source of finance
Advantages
• Business has the use of the property
• Payments are spread over a period of time which is good for budgeting
• Once all repayments are made the business will own the asset
Disadvantages
• This is an expensive method compared to buying with cash
• If business does not keep up with repayments the property could be
repossessed
Trade Credit
• Trade credit is summed up by the phrase:
Buy now pay later
• Typical trade credit period is 30 days
• This is a short-term source of finance
Advantages
• Business can sell the goods first and pay for them later
• Good for cash flow
• No interest charged if money is paid within agreed time
Disadvantages
• Discount given for cash payment would be lost

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• Businesses need to carefully manage their cash flow to ensure they will have
money available when the debt is due to be paid
Government Grants
• Government organisations such as Invest NI offer grants to businesses, both
established and new
• Usually certain conditions apply, such as where the business has to locate
Advantages
• Don‟t have to be repaid
Disadvantages
• Certain conditions may apply e.g. location
• Not all businesses may be eligible for a grant

Factors Affecting Choice of Source of Finance:

The source of finance chosen will depend on a number of factors:
– Purpose – what the finance is to be used for
– Time Period – how long the finance will be needed for
– Amount – how much money the business needs
– Ownership and Size of the business

Evaluation of Investments:

Present Worth Method:

Introduction

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1. Revenue Dominated Cash Flow:

2. Cost Dominated Cash Flow Diagram:

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