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ith their focused portfolio of products and services, these Non Banking Financial I The popularity of these banks can be gauged by the fact that in a short span of time, these banks have gained considerable customer confidence and consequently have shown impressive growth rates. Today, the private banks corner almost four per cent share of the total share of deposits. Most of the banks in this category are concentrated in the high-growth urban areas in metros (that account for approximately 70% of the total banking business with efficiency being the major focus,ay now & pay later in parts!
Dial-A-Draft:
One can use your bank card to pay for your personal expense at places where credit cardas are not acceptable yet. Like paying for investments, telephone & electricity bills, school fees & much more. Just call to your bank phone & the draft you need, will be delivered to you!
Credit limit increase:
Just call & ask for a credit limit increase in the event that you have to make a large purchase on your card urgently. It is especially handy for paying off vehicles repairs, telephone bills & electricity bills, And for anniversaries, weddings, birthdays, or business trips or when a holiday goes beyond budget.
24 Hours ATMs:
One can withdraw emergency cash up to 60% of your credit limit from 24 hours ATMs in Ahmedabad, Bangalore, Calcutta, Chennai, Delhi, Hyderabad, Mumbai & Pune. While traveling overseas you can draw cash from MasterCard ATMs spread across the globe. The same is applicable for any bank branch. What is more the cash withdraw is ensured against theft for a period of 12 hours after withdrawal. A never before facility brought to you with the Bank card. At a transaction fee of 2.5% or Rs. 50 whichever is higher. All cash advances also carry a service charge from the date of the transaction fee of 2.5 % or Rs. 50 whichever is higher. All cash advances also carry a service charge from the date of the transaction. The cash withdrawal limit for the first year is Rs. 5,000.
Photo card:
One may choose to have your photograph & signature digitally imprinted on the front of your card in color. So that you get the extra recognition & security you expect as a Bank card member.
Concession on Personal Remittance:
Do you often need to remit funds to other cities using facilities such as Drafts/ Telegraphic transfers, etc.? Here’s a benefit you would most appreciate. A 25% rebate on standard commission is offered on personal remittance bank branches.
Overdraft Facility:
Your bank card provides you with an overdraft facility to the extent of 75% of the value of your holding of Demat shares & units! Moreover, you get the waiver of 0.5% on interest rate chargeable under scheme. All you need to avail yourself of these benefit is a Demat A/c with every bank.
Free ATM card:
The bank offers you a free ATM card, which can be used at Bank ATM centers allover India. All you have to do is open a saving bank/ current account with such bank.
Other Features:
The bank card has the widest possible reach – welcome by 1,10,000 Merchant partners across India & Nepal & yet another 160lakh merchant Establishment worldwide. Spend in a foreign currency & pay in Indian rupees. The card can be used for both major occasions, & also for everyday purchase like groceries, cosmetics & petrol & auto accessories. To buy high value items like consumer durable (refrigerators, washing machines, microwave ovens, etc.) And even paying customs duty & hospitals bills become so convenient with your cards.
Product Width & Depth:
Width:
Width of the product mix is no. Of product lines a company is offering. The product width could be a narrow one or a wide one depending from bank to bank. A wide mix encourages more sales since the bank is able to diversify & provide more to the customers & they also appeal to a larger target market.
Depth:
Depth of the product mix is the number of product items in each product line. Banks with more schemes & service have more depths than those offering only a few.
Here is table given an example of a bank width & depth in a product mix.
WIDTH
Thus similarly different bank plan out their product portfolios & bases on that the depth & width of their product mix can be determined.
In today’s scenario when there is so much competition & there are new foreign banks entering the Indian market it has became more or less like a law to have very wide product lines with more & more number of products in each line.
Product Levels:
Core Benefits:
It is the main or core reason why the customer will buy the service of the bank. More like the basic purpose or necessity.
Basic Product:
The core benefit is converted into a basic product. That is the service that can use by the customer in order to fulfill his / her needs.
Expected Product:
It refers to the set of attributes & conditions expect by the customers when they purchase the service.
Augmented Product:
It is the additional features that the bank provides which exceeds the customer’s expectations.
Potential Product:
Innovations & product differentiation is the bases of a potential product. If the bank alters its services according to the requirements of the individual customers it reaches this level.
Thus, it can be seen in the chart how that how particular product passes through different levels. In today’s competitive scenario most bank try offerings services at augmented & potential level. In below chart: -
The Price Mix
The price mix in the banking sector is nothing but the interest rates charged by the different banks. In today’s competitive scenario where the customer is the king the banks have to charge them interest at the rate in force on accordance with the RBI directives.
Banks also compete in terms of annual fees for services lie credit cards, DMAT etc. another important part of the banks pricing policy today is the interest charged on the Home Loans and Car Loans but at a very competitive interest rate.
Let’s understand this with an example: - A particular buyer approaches for a car loan say for a period of 3 years. He is charged Rs.20000 as interest. However if sales representative of another bank come to know of this deal he will try to attract the customer by giving him a better deal that is loan at a lower rate of interest. In this way due to the high level of competition the customer benefits.
Transaction:
Pricing Strategy:
This model shows a pricing strategy, which should be adopted in order to ensure maximum satisfaction to both the bank as well as the customers.
The price should be set in such a manner that the customer is assured that he is not being cheated or overcharged by the bank and at the same time the bank is able to reap maximum profits. Such a pricing stand help the bank get maximum sales as well as profits since the customer feels that by entering such a transaction he is winning.
The Place Mix
Place mix is the location analysis for bank branches. There are number of factors affecting the determination of the location of the branch of a bank. It is very necessary for a bank to be situated at a location where most of its target population is located.
Some of the important factors affecting the location analysis of a bank are:
The Trade Area:
The trade area is a very important factor determining the place where a bank branch should be set up. For example a particular location may be a huge trading place for textiles, diamonds or for that case even the stock market. Such location is ideal for setting up of bank branches.
Population Characteristics:
The demography of a place is very important factor. This includes:
The income level of the population
The age level
The average male female population
The caste, religion, culture and customs
The average spending and saving habit of the people.
These factors are very important for a bank as it may help to know the kind of business the branch will get.
Commercial Structure:
The commercial structure refers to the level of commercial i.e. business activities taking place at a particular location. The higher the level of business activities taking place in a particular location the more preferable it is for setting up a bank branch.
Industrial Structure:
This is nothing but a combination of the trade area analysis and the commercial structure. However the industrial structure focuses more on thekind of industries operating in a particular location. For example an area like SEEPZ is marked with a lot of electronic manufacturing units. Thus the industrial structure determines the kind of financial transaction that could take place in a particular location.
Banking Structure:
The banking Structure refers to the existence of other banks in the area. Whether there is already an efficient network of other bank branches operating at that particular area. Thus the overall infrastructure needed for the working of a bank.
Proximity of other convenient outlets:
This refers to the other branches of the same bank as well other commercial, entertainment and industrial outlets.
Real Estate Rates:
This is mainly dealing with the cost factor involved in opening up a bank branch at a particular location. The real estate rate is very strong factor influencing the location decision for a bank branch.
Proximity to public transportation:
The location should be proximate to public transportation facilities. This means it should have bus stops close by as well as it should be proximate to railway stations so to make it convenient for the common man.
Drawing Time:
Drawing time refers to the time period in which a bank can draw a huge amount either from other banks or from the RBI in case of any kind of emergency requirement. No bank has more than a certain amount with them and in case a customer wants to withdraw an amount more than that available with the bank, the bank needs to draw that amount from other banks.
Hence a location must be such that it facilitates minimum drawing time.
Location of Competition:
The existence of other banks also means competition. If the level of competition is very high in a particular location it is necessary that a bank do a lot of market research before opening a branch so as to estimate the kind of business it would get.
Visibility:
The location of a branch should be such that it is visible and easily noticed by the customers as well as the other people.
Access:
The bank branch should be very easily accessible to the customers. If this is not the case the customer might switch to some other bank, which is more convenient to him and very easily accessible. The location should be such that it is very convenient for the customers to reach.
The Promotion Mix
Promotion is nothing but making the customers more and more aware of the services and benefits provided by the bank. The banks today can use a lot of new technology to communicate to their customers. Two of the fastest growing modern tools of communicating with the customers are:
1. Internet Banking
2. Mobile Banking
Let’s understand this with an example of services provided by banks to promote its modern services.
SMS functions through simple text message sent from cellular phone. These messages are recognized by bank to provide you with the required information.
ICICI was the first organization in India to provide Wireless Application Protocol (WAP) based services. Mobile commerce using WAP technology, allow secure online access of the web using mobile devices. With WAP one can directly access the ICICI WAP server, check one’s account details and use other value added services.
What is ICICI Bank Internet Banking?
ICICI Bank Internet Banking is convenient banking! Almost all the banking transactions for which you need to visit the branch can be done on their Internet banking site.
From checking your account balance to transaction history to transferring funds to paying bills, you can do everything here. Its convenience banking – anytime, anywhere! To avail of this convenience, you have to get registered.
You can make the following requests online:
Apply for a Credit Card
Apply for a Debit Card
Order a new cheque book
Stop cheque request
Cheque status inquiry
Intimation for loss of ATM Card
Open Fixed Deposit
Open a Recurring Deposit
Apply for a Value Added Savings Account
Apply for Phone Banking
Given below is a small list of transactions that you can do online:
Banking
Balance enquiry
Transaction history
Use Bank Funds Transfer (eCheques) to:
Transfer funds between your own Bank A/cs
Transfer funds to any Bank a/c
Transfer funds to any non Bank a/c (in 15 cities)
Make Service requests like open a Fixed Deposit, duplicate pin etc.
Credit card
View current and past statement
Service requests like auto debit, dial a draft etc.
Demat
View your transaction and holding statement
Bill Payment
Use your Bank Account or Credit Card to pay your bills from the comfort of your home.
Thus different banks to promote its services use different methods.
A bank may have very attractive schemes and services to offer to their customers but they are of no use if they are not communicated properly to the customers. Promotion is to inform and remind the individuals and persuades them to accept, recommend or use of product, service or idea. However there are some very important points that are to be considered before the promotion strategy is made. These points are:
Finalizing the Budget:
Before the bank decides the kind of promotion that should be done it is very important to finalize the budget for it. The formulation of a sound budget is essential to remove the financial constraints in the process. The budget is determined on the volume of business of the bank. In addition to this intensity of competition also plays a decisive role.
Selecting a suitable vehicle:
Another very important task is to select a suitable vehicle for driving the message. There are a number of devices to advertise such as broadcast media, telecast media and the print media. The selecting of the mode of advertising is strongly influenced by the kind of budget decided. Usually for promoting banks the most effective and economical form of advertising has been the print media.
Making possible creativity:
Making possible creativity is nothing but the kind slogans, punch lines etc. that are supporting the message. They should be very creative but yet simple to be understood by the common man. It should appeal to the customers. It should be distinct from that of the competitors and should be successful in informing and sensing the customers.
Testing the Effectiveness:
It should be bear in mind that the advertisement is first tested for its effectiveness. This should be done with the help of various techniques like testing effectiveness on a sample group. This helps determine the success of the advertisement and in case of any problem the advertisement can be altered and remade.
Instrumentality of Branch Managers:
At a micro level it is the responsibility of the branch managers to promote and drive the message to the people in the local area. They should organize small programs in order to attract people and create awareness in the local area about the new schemes of the bank.
Different Ways of Promotion:
Public Relations:
In today’s competitive scenario developing strong public relations is very important for any bank to be successful. Most banks today have a separate Public Relations department. However primarily it is considered as a responsibility of the various bank managers to develop a steady and strong relationship with their present customers as well as potential customers. This can be done by a constant follow- up and also some small programmers etc.
Personal Selling:
Personal selling is found to be one of the most effective and popular form of promoting bank business. The main reasons for this are that banking is a service in which trust plays a very important role. In personal selling a bank representative goes to the customers and explains the scheme to the customers. Also he gives the customers any kind consultation he might need. He provides the customers all the information seeked by him. Representative tries to persuade the customers to go for the scheme provided by the bank by telling him all the benefits. Here are some of the important features of personal selling.
It is a direct relation between the buyers and seller
It is oral presentation in conversation
It is personal and social behavior
It is found to be more effective in service oriented organizations.
It is based on the professional excellence or expertise of an individual.
Sales Promotion:
Sales promotions are basically giving the customers some additional benefits maybe at times just some small gifts in order to promote the schemes. The more innovative the sales promotions the more positive are the results. Some of the most popular sales promotions techniques are gifts, contests, fairs and shows, discounts and commission, entertainment and traveling plans for bankers, additional allowances, low interest financing etc. it is very important that the sales promotion benefits are designed in such a manner that they are better than those of the competitors.
Word – of – Mouth Promotion:
This form of promotions is not only very effective in banking services but in any kind of service. However it is more important in banking for the only reason that this is a service where trust plays a very important role. If one’s friends, relatives, or other well recommends a particular bank’s services – wishers the person is more influences and inclined towards that bank. It is very important to note that the internal employees of the bank play a very important role in word –of – mouth promotion technique. This is because they can start the process by recommending the bank to their friends and relatives and after that it is like chain which spreads like wild fire.
Telemarketing:
In recent times telemarketing has gained increasing importance as an effective tool for promotion. This telemarketing is a process of making use of sophisticated communication network for promoting the banks. This includes promoting through television, telephone, radio and nowadays largely through cell phones. This is most popular form of promotion. Banks today have started using ‘SMS’ and many other services supported by cell phones to provide benefits to their customers and thus have tried to increase their sales. In today’s competitive and modern scenario it very important that banks makes use of telemarketing techniques very efficiently to have desirable results.
Internet:
The use of internet as a promotion tool is increasing very fast today. More and more banks are using internet to promote their services. The online banking has made it even easier for the customers to avail the bank’s services. No longer do people have to go to their bank branches for small petty matters like checking their balance etc. all this can be done with the help of a few clicks.
The People Mix
People are the employees that are the service providers. In a banking sector the service provider plays a very important and determinant role in rendering the customers a satisfactory and a good service. It is extremely essential that the service provider understand what his customers expect from him. In a banking sector the customer needs to be guided in a lot of matters, which is possible only with the help of the service provider.
The position in the eyes of the customer will be perceived by appearance, attitude and behavior of the customer contact employees. Not only has the customers contact employee influenced the customer base of the organization done so.
ICICI Bank, India's second largest bank, with total assets of about Rs.112, 024 crore, wanted to provide an enriched customer experience that would encourage loyalty among existing users and help it gain new business. ICICI, by training their employees, delight their customers.
The Process Mix
The process mix constitutes the overall procedure involved in using the services offered by the bank. It is very necessary that the process is very customer friendly. In other words a process should be such that the customer is easily able to understand and easy to follow. Today if particular banks formalities are long and the procedure very complicated the overall process fails and the customer may not inclined towards using that banks services.
Let’s take for example the process for application for a car loan.
Now this mainly involves 3 things.
1. Producing of proper documents
2. Filling up of application form
3. Paying for the initial down payment
Here the process may fail in the following cases:
If the customer is asked to produce a number of forms out of which some may not be necessary at all. Thus it is very necessary that the customer be asked for minimum but most necessary document and not other unnecessary documents.
In case of application form, the application form must in a language best understood by the customers and it should not be very lengthy one demanding a lot on unnecessary information.
Finally the payment of initial amount. The customer should be given options as to how he would like to pay by cheques or by credit card. Once again the amount should be very competitive not very high above the regular rates prevailing in the markets.
The smaller and simpler the procedures the better the process and the customer will be more satisfied.
The 4I’s of Bank Marketing
There are four distinctive characteristics of service, which create challenges and opportunities. They are commonly known as the four I’s namely:
It is that characteristics of a service indicating that it is not a physical attribute, which a person may feel, hear, taste before they buy it.
For example if a person wants to open an account in a bank and wants to have transactions through a particular bank then he/she is not able to decide unless and until he/she experiences the banking services all by himself/herself. This is because the core service of a bank is maintaining and carrying out the money transactions of a person. Thus it becomes very important for a person to experience the core service in order to make a perception about a particular bank.
2. Inconsistency
This refers to variability that a company or an organization may depend on Inconsistency. For a bank, a new customer or a rare going customer may not get the same type of service as much as a regular customer may get. This may be case because the staff members know the person well as he comes often but they don’t know that person does not come in again and again.
Also another point for inconsistency is that different types of people deliver the service delivery by different people that is service differently. Like in case of a bank, different staff members would provide different services. In the bank a person may have a lot of work and may not attend a customer as may be a person with the same work may attend him with great enthusiasm.
I heard this statement that “Punjab National Bank” promotes itself as “crown of quality for customers who is the king” and is an ISO 9002 certified bank. Thus it has to have consistency and quality to serve its customers.
3. Inseparability
Inseparability is that characteristics of a product that cannot be separated from creator-seller of the products. This means that whenever a product is sold a service is also attached with it. Like for e.g. If you buy a room in a hotel to stay for 2 days then the receptionist, the waiters all have their service attached with it. But this only possible when the hotels have customers to stay in and the hotel owner has managers, waiters etc. to provide them services. Thus, services when provided should have both the accepter as well as the seller. This is known as inseparable.
There are basically 3 types of services
Co- production: Where the service provider and the customer work together to produce services. Bank service where if a customer wants to withdraw cash then both need to be present.
Isolated production: The part of the service that is done outside to an organization.
Self-service production: Uses the equipments of the service provider and self-server it. Services of an ATM.
4. Inventory
By this it means that the perishable characteristics of the service marketing. In a bank if a customer starts with his day in the morning eight and ending in the day at four where as in bank is open in morning at 9:00 am and closes at 1:00 pm in the afternoon, then one might not be able to attend it but nothing can be done in this case because for such a person the bank cannot be on tall end. Also there may be less work in the middle of the month whereas in end and starting of the month there could be more work like people come in put money as they get their salary, there would be withdrawals, pass book checking etc. which cannot be transferred in the between of the month as it depend on the people when they come as well one would come to put his money of salary only when he gets it and that’s the end of month. So service faces a lot of problems from inventory and cannot be stored, saved and then used later.
Rater Analysis in Banking Service
Quality means improving customer satisfaction by creating better service processes and outcomes. It means providing better value and maintaining a long-term relationship with the customers.
There are many reasons why a customer should be given a Quality Service. Few of them are listed as follows:
1. As the competition in service sector is increasing day by day, marketers have realized the importance of the customer. They know that if a single customer is lost, then it is very difficult to win him back. Hence, they attempt to provide quality service to their customers better than their competitors.
2. Companies have realized that the cost of making new customers is more than the cost of retaining them. Hence they want to be right at the first time and do not want to lose any customer.
3. The lost customers may spread bad word of mouth about the company. This will create a bad image for the company.
Quality of a service can be improved with the help of ten dimensions of quality. These dimensions are summarized into a RATER model since many of them were over lapping. These five quality dimensions are:
RATER MODEL
1. R – Reliability
2. A – Assurance
3. T – Tangibility
4. E – Empathy
5. R - Responsiveness.
This model is explained as follows with the example of SBI & ICICI.
1. Reliability:
Reliability is the ability to perform the promised service dependably and accurately. Here the organization does what it is suppose to do. They do it right the first time. It also called as “no excuse” service delivery.
The SBI tries its level best to provide reliable service to their customers. They made every attempt to keep their promise and provide a better service different than its competitors. For being more reliable the bank has come up with following services that enables their customer more comfort.
7 Days Banking:
SBI provides seven days banking so that to reduce any inconvenience from bank toward the customers.
SBI has been successful in creating a brand name. It is known for fast and best service. Customers have the perception that they will not be cheated and feel secured. This is the reason why SBI is financially one of the largest banks in India.
Home banking:
Bank has introduced home banking facility for their customers, whereby they can withdraw or deposit any amount simply by operating from their homes. Here customer needs to place their order of payment or deposit in call center on the assigned number of bank. This lead to more safe service for both the parties in this transaction. This service really differentiates this bank from those of other financial institute.
Thus we can say that SBI realize that satisfied customer is one who keep returning to them, thus they have provided them with an reliable service. And customers are also very much satisfied that they believe shopping or using the services of same people over a year. Thus they are also sure about banks reliability & this is what that bank builds from their reliability.
2. Assurance:
Assurance deals with knowledge and accuracy of the employees & their ability to convey trust & confidence. This dimension is of great significance where customer perceives high risk & is not sure of outcomes. In case of banking sector, the risk involved is high. Thus when a person approach’s to the bank in all this circumstances then its banks responsibility to make him assured that he would be completely comfortable & profitable in this deal.
In the advertisement of ICICI bank features a young employee with good personality speaking three words through his gesture i.e. “Hum Hay Naa” -We are always there to help you. This advertisement strategy creates a kind of assurance in the minds of people that ICICI is always there to help them in their financial matters.
Thus the knowledge genuineness, honest & ability to provide the service of front office staff creates trust in the minds of customer. Bank also trained its employees who have high customer contact that can build trust & confidence between employee& customer.
3. Tangibility:
Tangibility is the appearance of physical facilities, equipment, personnel & communication material. The customer actually evaluates the quality of service by above tangible things. Tangibility refers to those items that a person can touch or see. In short how a customer chooses a service? Often customer evaluates the services on the tangible clues or physical evidence, before experiencing it.
ICICI Bank is fully equipped with decent interior. It has all the latest technical instruments such as printer, scanner, fax machines, computers, etc. All the equipments are well maintained to avoid any blockage in the service. There were signboards indicating which department lies where, different counter number etc.
All the employees were in their formal uniforms, which gave a decent look and differentiated them from the customers. All this facility probably helps new customer to reduce his confusion for banking transaction & importantly they get involved in banking environment quickly.
4. Empathy:
Empathy is the ability to provide caring individualized attention that bank provides to its customers. It also means treating the customer as an individual. For bank each customer is unique & they provide them with an personalize attention. Here bank makes efforts to know their customer fully & make them fill that they are important for bank.
The employees of SBI are very polite, humble and helpful. They treat their customers as if they are some one special. All the employees were trained to behave in this kind of attitude. This politeness has helped them to retain their customers with Bank.
In today’s competitive world, banks need to understand what their customer expects from them. At the same time, the company should be able to delight its customers to differentiate their service. For this it is necessary to anticipate their needs, to solve problems before they start and to provide service that wows. To deliver that kind of service, bank needs to hire the right people and train them. Employees should understand what delights their customers. At the same time, it's important for employees to use their own personality and their own ideas - to make the customers happy. They have to know that banking service is a relationship with the customers, and not a transaction.
5. Responsiveness:
Responsiveness is the willingness to help the customers & provide prompt services. The bank should be responsive to their customers in handling complaints and requests.
The customer relates responsiveness to the length of time taken to wait for assistance and to answer the queries & handling the problems.
A successful bank should consider following points to set up speed for their service delivery:
All the staff members have been instructed to be present in the counter fifteen minutes before the commencement of business hours.
Almost all the branches have been provided with a 'May I Help You' counter, whose services can be used by the citizens to complete their transactions in a speedy manner.
Instructions have been issued to the branches to accept local clearing and outstation cheques even after the business hours, till one hour before the closure of working hours of the branch.
Different time limits have been prescribed for specific transactions like encashment of cheques, issuance of demand drafts, deposit of cash, etc.
Teller counters have been functioning in most of ICICI branches for speedy encashment of cheques/withdrawals and also acceptance of cash remittances up to a sum of Rs. 1,000/-.
Staff Committees have been formed in all the branches that look after the improvement of the customer service, maintenance and cleanliness of the branch.
Regional Managers and officials of the Regional Office also visit the branches once in a quarter and guide the branch staff to help serve our customers better.
Blue Printing in Banking Service
A service blueprint is a visual portrayal of a service plan. It is a key tool in service designing. It is a detailed flow chart of different stages in the process. It displays the service by depicting the process of service delivery, points of customer contact, the roles of customers and employees. Blueprints are useful in designing and redesigning the service process.
A key characteristic of service blueprinting is that it distinguishes between what the customers experience “front-stage” and the activities of employees and support processes “backstage”, where customers can’t see them. The line, which distinguishes front stage from back stage, is known as ‘Line of Visibility’.
Service blueprints clarify the interactions between customers and employees and support it from backstage activities. In the blue print, ‘Line of Interaction’ provides the service encounter of customers with the front line staff. The interaction, which supports the service from backstage, is called ‘Line of Internal Interaction’. This line divides the front line staff employees and the operational support staff.
In banks, the blueprint comprises a long-term development strategy and a sector development plan. The long-term strategy is based on key lessons drawn from the experiences of financial sector development and reform in other countries, and it guides the sector development plan.
In banking service, the Blue print:
Sets out a long-term vision and development strategy for the financial sectors.
Aims to develop a sound market-based financial system to support sustainable economic growth
Anticipates that the financial sector whether it will double in terms of the ratio.
To understand the role blueprint in banking service, let us see the two examples of opening an account in ICICI Bank and State Bank of India.
Blueprint of ICICI Bank:
ICICI Bank prepares a ‘blueprint' to lay out its strategy for consolidating its operations and increasing its customer base. Their blueprints have a ‘focus objective' of adding more clients and increasing the branch network, besides introducing new products and value-added services in the coming years.
The process of opening an account in ICICI Bank is given as follows:
Firstly, the customer has to collect the form from the counter.
He has to fill in the details such as name, address, and type of account, name of nominee and so on.
He has to attach certain documents to give a proof for his identity and residential address. These documents include Passport copy, Ration card copy, Telephone bill, etc and his photograph.
Along with the documents, he is required to give a self signed cheque of Rs.5, 100/-
The attached form is then submitted at the counter. Here the form is physically checked.
After checking the form, the information is feed in the computer. The account number and ATM pin card is given to the customer on the spot. But his account activates only after three days.
The branch then sends the attached form to the Regional Processing Center (RPC), where the documents are physically checked and scrutinized.
After the verification is complete, and if they are satisfied with the documents, they activate the account else the form the application is rejected. The control of activating the account is under only RPC. The branch cannot do this activity.
RPC informs the respected branch about the activation of the account.
Finally, the branch employee gives a call to the customer informing him that his account is activated.
Blueprint of State Bank Of India:
This bank prepares blueprint as it helps them to find out the faults in their service and take proactive measures to rectify the same. They use this technique to provide a better quality service to their customers.
The process of opening an account at State Bank Of India is as follows:
The account officer regarding the type of account consults the customer. He explains the complete procedure of opening an account.
The customer has to first attest the photocopies of the documents. At this stage, the originals are verified and the officer stamps the Xerox copies.
Then the three processes remain the same i.e. collection of form, fill the form and submit it with the documents.
In this bank the minimum amount to open account is Rs. 500/-
The officer collecting the form thoroughly and feeds the information in the computer.
The form is again counter checked by the Manager. If all the information is correct then he approves the form by signing it.
With the approval, the account is activated on the spot. All the details regarding the account are provided to the customer.
The last stage in this process is that the bank sends a call letter thanking the customer. The main purpose of this letter is to verify the address of the customer. If the address is not confirmed, a Payorder is released and the account is closed.
Thus by comparing the procedures of both the banks it can be seen that the process of ICICI Bank is longer and takes three days to activate an account. Whereas, it is simpler in SBI, and the account is also activated on the spot.
At the same time, the minimum amount to open an account also differs. In ICICI Bank it is Rs.5100/- and in SBI it is Rs.2, 500/-. This is so because ICICI aims the upper middle class and the rich class as their customers. Whereas, SBI targets the all class of people like lower, middle and upper class people as their customers.
Fish Bone Analysis
The fish bone analysis is the cause- effect analysis of the service failure. There are eight main aspects that lead to delay in service delivery or service failure.
They are as follows:
Customers:
They are important in services sector because they are directly involved in the process of service making and service delivery. So any delay on the part of the customers may lead to the eventual delay in service delivery.
Facilities & equipments:
Facilities and equipments play an important role when it comes to service delay or service failure. This is because if the arises a problem in the facilities provided or the equipments used then that will lead to delay in service delivery.
In case of the banking sector facilities like ATMs, online banking etc and equipments like computers, printers, money counting machines etc play an important role. If there is a breakdown in any of these equipments or there is some basic formulation problem with the facilities provided then it may lead to delay in service delivery.
Material Supply:
Materials and supplies are also playing an important role during the delivery of the service because they act as the supportive goods for the services provided by the service provider.
In the banking sector materials like pass book, chequebook etc play an important role in service delivery. For example if the cheque book is received by the account holder before he/she uses the last cheque it will lead to enhancement of the service experience but a delay in the issue of the cheque book may lead to service failure.
Front stage personal:
Again a very important aspect with regards to service delivery because it the frontline personnel who come in direct contact of the customers. Any misbehavior on their part or lack of knowledge may lead to service failure or at least delay in service delivery.
In case of a bank a person at the information desk, at the passbook update desk etc are the people that come under this category. As a result of this they have to be well informed about the various policies, procedures as well as the various services provided by the bank and that they must be well behaved. Lack of any of these aspects may lead to service failure.
Back stage personal:
They are the people who support the front line staff and thus play an important role in the process of service delivery.
In the banking sector the backline staff includes the people who are involved with providing loans, accepting deposits, maintaining accounts of the customers etc. if these people are not efficient in their work then it will affect the efficiency of the frontline staff which will in turn lead to delay in service delivery.
Procedures:
Procedures play an equally important role in service delivery. The shorter the process, the faster the service delivery and vice versa.
In most of the banks the procedures are very lengthy which leads to delay in service delivery.
Information:
Proper giving of information is also important or else it may lead to service failure.
Other causes:
There may be other reasons apart from this, which may lead to delay in service delivery or service failure.
FLOWER OF SERVICE
The Case Study
Ashok was a regular customer of Bank of India Borivali branch. He had to make a Demand Draft of Rs.5000/- for the admission process in the college. He was supposed to reach Andheri before 12 noon to submit the DD. Therefore; he reached the bank sharp at 8:30 because he knew that it would take time, as it was a nationalized bank.
On entering the bank Ashok noticed that there was too much crowd. The customers were waiting in a queue and the staff was roaming around which made the place further crowded. He inquired about the procedure for making a DD at the inquiry counter. The officer at the counter was polite and friendly, and guided him. Ashok collected the form from Counter 2, filled in all details and went to submit it on Counter 3. It was 9:00 a.m. when he was standing in the queue. His number came after 20 minutes. When he went to submit the form, with smiles he was told he had to submit an additional form along with it. Ashok was shocked to hear that. He quickly collected the other form and filled the details and again stood for submission. By the time he reached the counter it was 9:45. The person operating at the counter was so slow that it took him 10 min to feed the information in the computer. At 10 he was told that he would be called to collect the DD. Ashok took a sigh of relief and sat patiently.
He waited till 10:30 and went to inquire. The employee said their printer is not working. He was shocked to see that the whole staff was sharing only one printer. He explained his problem to the Manager and made a request to issue the DD as soon as possible. At 11a.m., the Manager handed over a handwritten DD. Ashok rushed quickly and was worried whether he will reach college before 12 or not. He decided to close his account in this bank.
Questions:
1) Which is the deformed pattern of flower of service in this case?
2) List the encounters and the critical encounters?
Flower of Service
It is very important for a firm to provide a variety of service related activities along with the core product. Of the potentially dozens of supplementary services, almost all of them can be classified into one of the following eight clusters. They are classified into two types: facilitating services and enhancing services. They are listed as follows:
FACILITATING SERVICES
Information
Order Taking
Billing
Payment
ENHANCING SERVICES
Consultation
Hospitality
Safekeeping
Exceptions
These eight clusters are displayed as petals surrounding the center of a flower, which is known as ‘Flower of Service.’
In a well-designed and well-managed service organization, the petals and core are fresh and well formed. A badly designed service is like a flower with missing petals. Even if the core is perfect, the overall impression of the flower is unattractive.
All eight supplementary clusters do not surround every core product. It depends upon the type of service. Also the size of the petals varies in different organizations. All the eight clusters are explained below with the example of ICICI Bank:
Information:
Organizations like banks need to provide complete information to the customer as well as the employees. Many a time’s new customers and the existing customers need a direction to the process of service. The bank officers have all the information regarding the banking service.
In the case of Ashok, it can be seen that there was lack of information amongst the employees. The information officer asked him to fill only one form when two forms were required. Thus the employees could not provide suitable direction to the customer. Companies should also take into consideration the time of the process. They should make the customer waited for a long time.
Consultation:
Consultation involves finding out customer’s requirements and develop solution. Customers often seek for consultation in the type of account to be opened. Bank consulters need to understand each customer’s current situation, before suggesting suitable course of action. At this stage, bank employees should have ample of knowledge about the types of account and different situations in which a particular account is opened.
The consultation petal does not apply in the case of Ashok. He did not require any consultation.
Order Taking:
Order taking refers to accepting applications, orders and reservations. In home banking, bankers take orders of money transaction. They see to it that the order taking is easily accessible to the customers. The front line staff is trained in such a manner so that the process is carried politely, fast and accurately.
This petal is not applicable in Ashok’s case.
Hospitality:
Hospitality deals with nurturing the customers and providing all the facilities and makes them feel that they are special to the organization. Most of the banks ensure that their employees treat their customers as guests.
In Ashok’s case, the employees made him stand in the queue for long time. The bank did not comfort their customers while providing the service to them.
Safekeeping:
Customers often want assistance with their personal possessions, while visiting a service site. Unless certain safekeeping services are provided some may not come at all. Responsible businesses also worry about the safety of their customers. Many Bankers pay close attention to safety and security issues of the customers who are visiting their service facilities. Bank educates its customers about how to protect Passbooks, Chequebooks, ATM cards, etc. from theft. They even provide safety measures to operate the ATM machine to avoid personal injuries.
As Ashok was intending to close the account, this petal is not applicable to the case.
Exceptions:
Exceptions involve supplementary services that fall outside the routine of normal service delivery. Banks anticipates exceptions and develops contingency plans and guidelines in advance. They train their employees so that they don’t appear helpless and surprised when customers ask for special assistance. There are several types of exceptions. Few of them are special request, problem solving, handling complaints and restitution.
A special request was made by Ashok to handover the DD as soon as possible. But his request was not granted immediately. In fact, they delayed it. At the same time the problem of printer was not solved quickly. They made him wait for a long time. The bank should have kept more printers to avoid such incidences. This has created a bad image about the bank in Ashok’s mind.
Billing:
Inaccurate and incomplete billing disappoints the customers. Billing should be done timely because it serves to stimulate faster payment. In case of banking, customers expect their passbooks and other documents to be clear, informative and itemized in ways that make it clear how the total was computed. Now a day every bank has computerized billing facility, which makes the billing process easier and faster.
In Ashok’s case, there was problem in providing DD. The billing process of the bank was too lengthy and tiring.
Payment:
In most cases, a bill requires the customers to take action on payment and such action may be very slow in coming. The best example is bank statements. It details the charges that are already been deducted from the customer’s account. Customers expect ease and convenience in payment, thus bank makes all attempts to make their payment process simple and easy. The other examples of payment in banks would be handling of cash, cheques, tokens, vouchers, coupons, etc.
The payment process is negligible in case of Ashok.
Service Encounters
Service encounter is the moment of truth whereby the customer comes in contact with service. There are three types of encounters:
Remote encounter
Encounter on the telephone
Face-to-face encounter
The first few interactions with the customers are most important. These interactions lead the customer to high satisfaction or high dissatisfaction.
In the case study, Ashok had interactions with the following front line staff:
Inquiry counter officer:
The first encounter of the Ashok in the bank was at the inquiry counter. Here the officer in-charge guides him regarding the process and whom shall he meet. The duty of the officer at inquiry counter is to solve small doubts of the customer.
Clerk at the Counter no. 2:
His next interaction was with the clerk at counter no.2. Ashok collected the form from this counter. The role of the clerk is to issue these requirements to the customers and scroll it after the customer fills them.
Clerk at the Submission Counter:
After filling the form, the next encounter of Ashok is with the clerk at Counter no. 3 (i.e. the submission counter). This incidence was critical as it disappointed Ashok very much. This is because he was informed to fill another form along with the one he had.
Manager:
Lastly, Ashok meets the Manager who in turn gives him a handwritten DD. This incidence was also critical because the manager further delayed. He was highly disappointed to meet him. But in the end he is the one who helps Ashok.
Interaction with the employee making the draft:
The most critical encounter here in this case is Ashok’s interaction with employee who was making the draft for Ashok. As the system was computerized, a printer was used to print the draft. But at the last minute the printer got spoiled and stopped working. This made Ashok very restless.
Pest Analysis
Meaning
PEST analysis is very important that an organization considers its environment before beginning the marketing process. In fact, environmental analysis should be continuous and feed all aspects of planning. The organization's marketing environment is made up from:
1. The internal environment e.g. staff (or internal customers), office technology, wages and finance, etc.
2. The micro-environment e.g. our external customers, agents and distributors, suppliers, our competitors, etc.
3. The macro-environment e.g. Political (and legal) forces, Economic forces, Sociocultural forces, and Technological forces.
These are known as PEST factors.
Political:
Political factors can have a direct impact on the way business operates. Decisions made by government affect our every day lives and can come in the form of policy or legislation. Government and RBI policies affects the banking sector at times looking into the political advantage in a particular party the govt. declares some measures to their benefits like a waver of the short term agricultural loans, to attract the farmers votes. By doing so, the profits of the bank go down. Various banks in the co-operative sector are open and run by politicians. They exploit these banks for their benefits. The government appoints various chairmen’s of the banks.
Economical:
All businesses are affected by economical factors nationally and globally. Interest rate policy and fiscal policy will have to be set accordingly. Whether an economy is in a boom, recession or recovery will also affect consumer confidence and behavior. Banking is as old as authentic history and the modern commercial banking are traceable to the ancient times. The present era in the banking may be taken to have commenced with the establishment of the BANK OF BENGAL, Punjab national bank and so on.
Every year RBI declares its 6 monthly policy and accordingly the various measures and rates are implemented. Also union budget affects the sector to boost the economy by giving certain concessions and facilities. If in the budget savings are encouraged more deposits will attract the banks and they in turn can lend more money to the rural sectors, industrial sectors, therefore booming the economy. If the FDI limits are relaxed then more FDI can be brought in INDIA through banking channels.
Social:
Within society forces such as family, friends, and media affect our attitude, interest and opinions. These forces shape that we are as people and the way we behave and what we ultimately purchase. As society changes, as behaviors change organizations must be able to offer products and services that aim to complement and benefit peoples lifestyle and behavior. Before nationalization of the banks the control of banks were in the hands of the private parties and only big business houses and effluent sections of the society were getting benefits of banking in India. In 1969 govt., nationalized 14 banks. The banks helped the weaker sections of the society and provided need-based finance to all the sectors with flexible and liberal attitude. Now even they provide various types of loans to farmers, working women, professionals and traders. Big companies have to provide personalized baking also.
Technological:
Changes in technology are changing the way business operates. The Internet is having a profound impact on the marketing mix strategy of organizations. Consumers can now shop 24 hours a day comfortably from their homes. The challenge these organization faces is to ensure that they can deliver on their promise. Those businesses, which are slow to react, will fall at the first few hurdles. This technological revolution means a faster exchange of information beneficial for businesses as they can react quickly to changes within their operating environment.
There is renewed interest by many governments to encourage investment in research and development and develop technology that will give their country the competitive edge. The latest development in the technology in computer and telecommunication has encouraged banking from everywhere. The use of ATM and Internet banking are helpful. Voice recorders answer simple queries, currency accounting machines self-service counters are now encouraged. Credit card facility is another example of the cashless society now debit cards are also in. these are called as an electronic purse. Some of the banks have also started home banking through telecommunication facilities and computer technology by using terminals installed at customers home and they can make a balance enquiry, get the statement of accounts, give instructions for fund transfers etc through ECS we can receive the dividends and interest directly to our account avoiding the delay of chance of loosing the post. Banks also have started using the SMS systems and interest as a major tool of promotion giving great utility to the customers.
All these technological changes have forced the bakers to adopt the customer-based approach instead of product-based approach.
THE STATE BANK STORY
The demand for funds by the SBI is even more acute than even the Corporation Bank since the SBI Act provides for a minimum 55 per cent RBI holding in SBI, and the bank is already close to breaching this threshold. The immediate beneficiary of this move would be Corporation Bank where government equity is down to 66 per cent. The bank would be able to access funds from the market without being hampered by the 51 per cent minimum government holding threshold, which currently limits the ability of banks to expand beyond a certain level. Since a decision on the new threshold has been taken in the case of the nationalised banks, the government is expected to follow suit by moving an ordinance to reduce the RBI stake in the SBI to 33%.
The issue of reducing government stake in the nationalised banks has come about on account of demand from the SBI which had demanded that either RBI as the stakeholder pump in funds for the SBI’s massive expansion plans or permit it to issue shares to the public to raise the necessary funds.
Both the Banking Regulation Act and the SBI Act provide that government shares cannot be divested and since the government has decided that it would no longer support banks through budgetary support, they have no option but to go to the market to meet their fund requirements.
Though there is no special significance attached to the 33 per cent threshold in the Company Law — which recognized only 26 per cent and 74 per cent as two major thresholds for management and ownership control — the government has opted for 33 per cent on the basis of the recommendations of the Narasimham Committee. The committee had felt that this threshold would provide comfort to the employees. The banks, like insurance companies, have strong unions and, hence, a phased reduction in government equity was recommended.
The State would continue to be the single largest shareholder in banks even after its stake had been brought down to 33%.
The government is also proposing to move an ordinance for demerger of four subsidiaries of GIC. The law ministry has already cleared both proposals of the finance ministry. In the case of GIC, the ordinance would amend the GIC Act, 1972, and demerge its four subsidiaries - National Insurance Corp, Oriental Insurance, United Insurance and New India Assurance.
Subsidiary of State Bank of India
State Bank of Bikaner & Jaipur
State Bank of Hyderabad
State Bank of Indore
State Bank of Mysore
State Bank of Saurastra
State Bank of Travancore
The services of SBI Bank
Personal Banking
Gold Banking
NRI Banking
International Banking
Corporate Banking
Small Scale Industries
Small Business Finance
Rural Banking
Government Business
Home Loans
SBI Credit Card
The SBI Credit Card offers a Classic VISA card duly acceptable in India and Nepal. It transfers all the advantages provided by the VISA Card. The present eligibility for applying for the SBI Credit Card is Rs. 75,000 for salaried and Rs. 60,000 p.a. for businessmen (kindly verify the rate with SBI before applying).
SBI Credit Card is acceptable over 1,05,000 merchants in India and Nepal. The SBI Credit Card is accepted to 117 cashpoint locations in 57 cities from Leh to Port Blair. The daily withdrawal limit is Rs. 10,000.
SBI Credit Card comes with an insurance of Rs. 2 lakhs on road and Rs. 4 lakhs by air.
Worldwide network of SBI Bank
SBI Bank India has 52 Foreign Offices in 34 countries. SBI India serves the international needs of its foreign customers, in addition to conducting retail operations. The focus of the offices of SBI is India-related business. Few of the countries where SBI Bank has branches are as under:
Australia
Bahamas
Bahrain
Bangladesh
Belgium
Bhutan
Canada
France
Germany
Hong Kong
Japan
Maldives
Mauritious
Muscat
Nepal
Nigeria
Oman
Russia
Singapore
Sri Lanka
South Africa
UK
USA
SBI Central Office
State Bank of India,
State Bank Bhawan,
8th floor, Madame Cama Road,
Mumbai-400 021,
Telephone No. 22029456 or 22029451,
Fax no. 22885369.
Physical Evidence
Physical Evidence is the overall layout of the place. How the entire bank has been designed. Physical evidence refers to all those factors that help make the process much easier and smoother. For example in case of a bank the physical evidence would be the placement of the customer service executive’s desk, or the location of the place for depositing the Cheques. It is very necessary the place be designed in such a manner so as to ensure maximum convenience to the customer and cause no confusion to him.
The experience of Physical Evidence of an SBI bank branch we visited was has follows
Very well organized
All the departments where put up in such order that a rush in one of the departments would not lead to problems to the other department.
The enquiry counters where placed right in front of the entrance so that the new visitors do not have any problem in locating the counters and the people can be helped as quickly as possible.
The work was being carried out at a very efficient pace.
People who had come to withdraw cash where given token numbers and made to sit in the comfortable sofas & chairs which where lead all around the wall of the bank so that there is enough space for the people to sit.
As we had visited the bank during rush hours we though that there would be lot of rush and we won’t be able to get the best possible information but we where totally wrong in our thinking as the bank manager gave very appropriate time and the fullest possible explanation of the topics.
There is no doubt that SBI is the one of the topmost bank as it shows what great planning has been done in even the smallest of the matters.
The only problem was the ATM counter, which had stopped functioning for about 15 to 20 minutes as the machine had some problems in it.
CONCLUSION
I was having lot of interest to know detailed information on banking. By completing this project I got a lot of satisfaction. I made the project such a way that none of the point should be missed in explaining banking concept. This project will help me in boosting my carrier.
To complete this project I have taken help of respected professors, friends, books & internet. I am very much thankful to my professors & friends for giving me such support.
If any person in this world want to know about Indian Banking than he/she can easily refer to this project. I have given my best to explain banking concept with the help of public as well as privet sector banks. How different banks are provided services to its customers & what is the motive behind formation of those banks are explained in a broader way.
ing in the banking services is substantially influenced by the happenings data, which is supplied by the marketing intelligence system. A bank manager carries on marketing intelligence mostly by reading newspaper, weeklies, trade publications and even by talking to the customers. To get an optimal result from the marketing intelligence, it is essential that the banking organizations evince interest anizations are supposed to know and understand the changing requirements of different categories of farmers.
Industrial sector: The banking organizations subserve the interests of the industrial sector. The large- sized, test the effectiveness before launching of the commercial advertisements.
priority basis and the policy makers at the apex level make possible value-orientation. The problem of inefficiency if not arrested at the beginning stage is likely to infect the entire process.
Incentives, of course, inject efficiency and the organizations offering more incentives succeed in motivating the people. In the Ie foreign banks have no option but to manage their physique and personal has played a major role in the development not of the financial product itself but of the process whereby the service is delivered. Automated queuing systems have made visits to the bank easier and more convenient. Telephone banking and insurance services such as First Direct and Direct Line are examples of telecommunications technology being used to innovate in place of a traditional branch-based service process.
Technology has also played a major role within organizations, bringing about far greater efficiency through computerized records and transaction systems and also in business development, through the setting up of detailed customer databases for effective segmentation and targeting. The Bristol and West Building Society has implemented a highly sophisticated customer database which provides staff with customer profiles so that cross-selling opportunities across a range of services can be maximized when staff are in contact with customers, or later, via direct mail for example.
The main technological developments fall within these categories, therefore:
Process developments
Information storage and handling
Database systems
Product technology is of relatively minor importance within the financial services market place as product innovations are usually in the form of a change in the terms of services offered or slightly different services at lower charges or higher rates of interest. It is easy for competitors to follow suit or make other changes and, once the decision has been made, promotion and advertising the new or revised service will help to make it successful rather than any kind of technological refinements. Some physical developments relating to technology in the production of credit cards have taken place such as the imprinting of a hologram on cards to help prevent forgery.
CATEGORISATION OF BANKS IN INDIA
The Indian banking can be broadly categorized into nationalized (government owned), private banks and specialized banking institutions. The Reserve Bank of India acts a centralized body monitoring any discrepancies and shortcoming in the system. Since the nationalization of banks in 1969, the public sector banks or the nationalized banks have acquired a place of prominence and has since then seen tremendous progress. The need to become highly customer focused has forced the slow-moving public sector banks to adopt a fast track approach. The unleashing of products and services through the net has galvanized players at all levels of the banking and financial institutions market grid to look a new at their existing portfolio offering. Conservative banking practices allowed Indian banks to be insulated partially from the Asian currency crisis. Indian banks are now quoting a higher valuation when compared to banks in other Asian countries (viz. Hong Kong, Singapore, Philippines etc.) that have major problems linked to huge Non Performing Assets (NPAs) and payment defaults. Co-operative banks are nimble footed in approach and armed with efficient branch networks focus primarily on the ‘high revenue’ niche retail segments.
The Indian banking has finally worked up to the competitive dynamics of the ‘new’ Indian market and is addressing the relevant issues to take on the multifarious challenges of globalization. Banks that employ IT solutions are perceived to be ‘futuristic’ and proactive players capable of meeting the multifarious requirements of the large customers base. Private banks have been fast on the uptake and are reorienting their strategies using the internet as a medium The Internet has emerged as the new and challenging frontier of marketing with the conventional physical world tenets being just as applicable like in any other marketing medium.
The Indian banking has come from a long way from being a sleepy business institution to a highly proactive and dynamic entity. This transformation has been largely brought about by the large dose of liberalization and economic reforms that allowed banks to explore new business opportunities rather than generating revenues from conventional streams (i.e. borrowing and lending). The banking in India is highly fragmented with 30 banking units contributing to almost 50% of deposits and 60% of advances. Indian nationalized banks (banks owned by the government) continue to be the major lenders in the economy due to their sheer size and penetrative networks which assures them high deposit mobilization. The Indian banking can be broadly categorized into nationalized, private banks and specialized banking institutions.
The Reserve Bank of India act as a centralized body monitoring any discrepancies and shortcoming in the system. It is the foremost monitoring body in the Indian financial sector. The nationalized banks (i.e. government-owned banks) continue to dominate the Indian banking arena. Industry estimates indicate that out of 274 commercial banks operating in India, 223 banks are in the public sector and 51 are in the private sector. The private sector bank grid also includes 24 foreign banks that have started their operations here. Under the ambit of the nationalized banks come the specialized banking institutions. These co-operatives, rural banks focus on areas of agriculture, rural development etc., unlike commercial banks these co-operative banks do not lend on the basis of a prime lending rate. They also have various tax sops because of their holding pattern and lending structure and hence have lower overheads. This enables them to give a marginally higher percentage on savings deposits. Many of these cooperative banks diversified into specialized areas (catering to the vast retail audience) like car finance, housing loans, truck finance etc. In order to keep pace with their public sector and private counterparts, the co-operative banks too have invested heavily in information technology to offer high-end computerized banking services to its clients.
BEST BANK 2004
The notion that banks are the only lenders in town is clearly dead, with disintermediation blurring past distinctions. If the traditional view of banks has indeed been junked, the task of picking a winner among the lot becomes that much tougher. One has to go beyond just size and balance sheet numbers, and look at how individual banks are responding to their specific market realities and challenges. The business India panel, which got down to act of selecting the best on 17th July at the Oberoi’s Belvedere, comprised eminent voices from the field of high finance.
The numbers were discussed first. The panel was unanimous in its view that a high capital adequacy ratio in itself meant little. “We should look at the future direction of these banks. Three or four years ago the bank with the highest capital adequacy would have been the winner,” observed a panelist.
The parameters
At long last the panel came to a consensus on the critical parameters: capital adequacy, net non-performing assets, the advances-to-assets and g-secs-to-advances ratio, and spread. The 12 banks that made it to the last lap were Amro Bank, Bank of Baroda, Canara Bank, Citibank, HDFC Bank, HSBC, ICICI Bank, Jammu & Kashmir Bank, Kotak Mahindra Bank, Punjab National Bank (PNB), SBI, and Union Bank of India. Two others, UTI Bank and Standard Chartered Bank, were also considered.
Of the lot ABN Amro Bank was dropped given its small size. So too Kotak Mahindra Bank, which has just rolled out its operations. It was felt that Jammu & Kashmir Bank had too narrow a focus. Of those that made it to the final list, Citibank (2002), HDFC Bank (2001), and SBI (2000) were past winners.
In the case of SBI, reference was made to its high g-secs-to-assets ratio at 38.68 per cent. “If they did not cash in, they were stupid. On the other hand, if they had cashed in, we would have said that isn’t banking.”
HSBC’s assets were found to be low when compared to its investments in g-secs. The investments-to-assets ratio was at 41 per cent. That it was a conservative bank, albeit a good one. “HSBC is not into banking. They are traders. They are not doing business.” Furthermore, it has not shaken up the retail banking space and is at the same time going through a whole lot of changes. In the case of PNB, the view was that it had a long way to go to its act right. There is also a question mark over the quality of loans on its books. Perception too was seen as an issue, even if this applied to a few other state-run banks. “Why is PNB singled out in that case? If you put PNB as the best bank, there will be surprise in RBI!” this was more or less the case with Bank of Baroda as well.
The banks, which made it to the last three, were ICICI Bank, Union Bank of India and Canara bank. ICICI Bank was the biggest with assets of Rs 1, 25,228 crore as at end-March 2004, followed by Canara Bank at Rs 99,539 crore and Union Bank of India at Rs 58,316 crore. The net profits of these banks stood at Rs 1637.11 crore, Rs 1338.01 crore, and Rs 712.05 crore respectively. In just about all-key parameters these banks were well matched. In the comparison against Union Bank of India, the majority of the panelists pressed the case of Canara Bank. One, it was the closest in size after ICICI Bank. Two, it scored over Union Bank of India across all key standards. Canara Bank lost out because of the fact that it had to carry the can for its mutual fund arm, Canfina Mutual Fund, which over promised to its investors and did not deliver. Like in the case of PNB, perception was the issue. It was also perceived not to have done much as a bank.
ICICI Bank drew all-round appreciation for its aggressive market and customer acquisition strategy. Some felt it was going overboard, and that this had the potential to land it in trouble in the days ahead. One panelist aired the point that the quest for volumes has affected the bank’s ability to service its customers. Another said that Union Bank of India was as good, if not better that ICICI Bank in terms of customer service. “Their growth is too high. They cannot cope with it.” The counterview was that when there were service volumes, a few customers will grumble. The profitability aspect was also questioned and attention was called to the fact that the bank operated on a very fine spread: 1.62 per cent. But all over the world banks work on still finer spreads.
ICICI Bank also scored on account of the fact it has shaken up just about every other segment it has forayed into; that it has in many ways forced people to wake up and take notice of it and in several cases redefined the rules of the game as well. “ICICI Bank is very exciting. It is very good in marketing. In the past five years it has changed the face of Indian banking.”
It was also pointed out that other than SBI; the new-generation private bank was the only one that had the potential to go global. Another big plus was that it been able to leverage technology in a big way. And it was ICICI Bank that finally won Business India’s Best Bank Award for 2003-04.
(Source: Business India, August 2004)
Bank Marketing in Indian Perspective
The formulation of polices is substantially influenced by emerging trends in the national and international business conditions. The level of income, expectations, the rate of literacy, the geographic and demographic considerations, the rural and urban orientation, the changes in economic systems the frequent use of technologies are some of the key factors governing the development plan of an organization. To be more specific in a welfare country like ours, the public sector commercial banks are supposed to play a decisive role in fuelling the processes of socio-economic emancipation. This makes it clear that banking organization need a new a vision, a new approach and an innovative strategy. They are supposed to bring about greater mobility in the financial resource to cater to the changing socio-economic requirements. Willingly or unwillingly, they have also to bear the social costs by advancing credit facilities to the weaker sections and the vulnerable regions. The Foreign Banks and a few of the private sector commercial banks have been found making sincere efforts to improve the quality of their services. The customers in general appreciate the functional style and service mix of foreign banks. This makes a strong advocacy in favour of practicing marketing principles in the public sector commercial banks.
In the Indian setting, the contours of development have undergone radical changes, especially after the attainment of independence and to be more specific after the adoption of the planned concept of development. The nationalization of the Reserve Bank Of India is a landmark in the development of Indian Banking system, which in a true sense paved avenues for qualitative-cum quantitative improvements. To curb concentration of economic power and promote a judicious use of the financial resources for the economic development activities, the banking system was regulate and supervised by RBI subsequently in 1969 the government acquired a direct control over a substantial segment of banking system signifying its commitment to reshape the banking system so to meet progressively and serve better the needs of development of economy in conformity with the changing national policy and objective .The fruitful results of nationalize more commercial banks in 1980. These developments necessitated a fundamental change in the functional responsibilities of the public sector commercial banks. Here it is pertinent that nationalization was with the motto of improving the quality of services but the public sector commercial banks started disappointing the masses. Quality of services provided by them was so poor that customers in general are found dissatisfied. This make sit essential hat the RBI and the policy makers of public sector commercial banks think in favour of conceptualizing modern marketing principles which would bring a radical change in the process of quality up gradation.
The first task before the public sector commercial banks is to formulate the marketing mix, which suits the national socio-economic requirements. They need to synchronise the core and peripheral services in such a way that product attractiveness is increased substantially. The designing of a sound product portfolio is found significant to maintain the commercial viability of public sector banks. The promotional measures need an intensive care so that masses come to know about the positive contributions of banks towards the development of socio-economic activities. It is pertinent that leading foreign banks are found promoting telemarketing and the public sector commercial banks need to make it possible. Since there are world-class technologies, the task becomes easier. The word of mouth promotion also needs due care and for that there is a need to improve the quality of the service. The pricing strategy need due weightage since the instrumentality of pricing as a motivational tool would help banks increasing there market share. The Reserve Bank Of India and the Indian Banking Association need an attitudinal change. The gap between services promised and services offered is required to bridge over. This requires professional excellence. The professionals need to make fair synchronization of performance – orientation and employee orientation. This is not possible unless banking regulations are made liberal. The quality of people /employers serving the banking organizations needs overriding priority. The frontline staff needs empathy in their behaviour. This requires intensive training facilities. The domination of trade unions is required to be minimized. The contractual job system needs due attention.
It is right to mention that in the face of new perception of quality developed by foreign and private sector banks; the public sector commercial banks have no option but to improve the quality of services. The marketing principles bear the efficacy of initiating qualitative improvements. Of late the foreign banks have been found promoting the use of sophisticated information technologies. This makes it essential to realize the gravity of the situation and make possible a rational use of technologies, which are not aggravating the problem of retrenchment. The marketing principles would be helpful in making the assault on the multi-dimensional problems. There are good auguries because the policy makers have been found exploring ways for implementing the marketing principles but till now, the efforts are at nascent stages. It is high time that the public sector commercial banks conceptualise innovative marketing for bringing the banking system on the rail.
Business enterprises are created for achieving one or more objectives – Profit motive being the most dominant among all objectives. For accomplishing objectives efficiently and effectively, the firm needs resources, which must be utilized. The firm faces the question on the use and allocation of resources at two levels. First, at the Macro level the firm has to compete for resources with other firms in the capital market. The criterion used by the capital market to allocate resources is efficiency, which is conventionally measured in terms of profits. A firm would thus succeed to obtain funds from the capital market if it has been profitable in the past, or has a profit making potential in the future. The capital market consists of investors – individuals and institutional – who decide about the allocation of funds to the firms on the basis of information regarding the financial performance of the firms. Accounting, through its financial reports, furnishes this information to investors. Financial Reports in the form of Balance Sheet and P&L account inform the investors how the firm has to be known performed. Accounting has come to be known as Financial Accounting when it served the purpose of reporting financial information to investors. However the information generated by financial accountancy for several purposes is not sufficient for decision making in many areas such as:
Acquisition of plant and machinery or other assets;
Determining product selection – addition or dropping or changing product combination in the case of a multi-product company;
Determining output level;
Determining or revising prices of products;
Whether profit earned is optimum as compared with competitors as well as earlier years.
The need of such data of such details led to the development of Management Accounting.
A business or firm today operates in a dynamic business environment. The main characteristics of the business environment are presence of large-scale production, expansion, products improvement and diversification, widening of the market, intense competition and narrow margin of profit. The firm needs greater co-operation and control so as to ensure survival and growth. Therefore the decisions have to be based on facts and figures. The decision-making quality improves greatly when it is based on information.
Moreover on the Micro level once the firm has been able to gather resources from the capital market, it has to decide allocation of resources to its various projects, activities and assets. The firm needs relevant information for making decisions of internal uses of resources and the cost benefit aspect of a particular use of resources. Here again accounting fills this gap. When accounting caters to the internal uses, it is known as Management Accounting.
Cost Accounting and Management Accounting
Cost accounting is mainly concerned with ascertainment of costs and the techniques of product costing and deals with only cost and price data. Management accounting however emphasizes the use of cost data for planning, control and decision making purposes. It helps the management in planning and controlling costs relating to both production and distribution activities.
In spite of differing parameters of cost accounting and management accounting, cost accounting is generally indistinguishable from what is known as management or managerial accounting. Both these accounting systems are closely linked as they use common basic data and reports to a material degree. Much of the information used to prepare accounting statements and reports in cost accounting are also used in management accounting reports. Special decision methods, use of highly quantitative techniques, behavioural techniques, information systems and budgeting are the areas of management accounting.
Management accounting involves cost accounting as well as analysis of statement of changes in financial position, financial statement analysis. However this project is concentrated towards the accounting systems used in both cost accounting and well as management accounting. Thus management accounting in this context is focused towards cost accounting methods and the cost control techniques that involve planning, organizing, controlling and decision-making.
Cost Accounting
Cost accounting is an important and ever growing discipline. It touches every aspect of economic activity, maybe industry, trade, agriculture and household. Today, it is considered a watchword of progress. It could well be stated that Sumerians in Mesopotamia practiced it in 500 BC. But as an independent area of study, it has developed only in the past 100 years or so. Cost accounting grew out of the limitations of financial accounting and in response to the needs of manufacturing enterprises for detailed information about actual costs and their estimates. During the early stages of the industrial revolution, industrial engineers dominated the scene. Companies began integrating production cost records with financial accounts, and standard cost systems emerged. It became an integral part of the financial accounting when accountants started auditing the cost accounts. Ever since, costing techniques have played a significant role in collecting and analyzing revenues and expenditures to assist management in decision-making. At the same time, due to industrialization and technological developments, there has been a shift in emphasis from cost accumulation to cost analysis. It is a change from cost-finding function to the broad managerial role of providing cost data to operate efficiently. Business firms are expected to make profit in the long run and, hence, keep costs within control. This explains the universal and ever-growing importance of cost accounting. While product costing remains an important part, its emphasis now is on managerial uses and non-manufacturing operations. On-line computerization cost accounting is already there and holds the future.
Concept of Cost Accounting
The costing terminology of I.C.M.A. London, defines cost accounting as, “ the process of accounting for costs from the point of which expenditure is incurred or committed to the establishment, of its ultimate relationship with cost centres and cost units. In its wildest sense, it embraces the preparation of statistical data, the application of cost control methods and the ascertainment of the profitability of activities carried out or planned.”
Functions or Objectives:
Ascertainment:
Ascertainment of costs is the findings regarding expenses pertaining to a particular period translated into cost of product produced and the expenses related to production. The ascertainment of costs is done through Costing, which involves some basic aspects (explained in next chapter).
Control:
Cost Control is the second function of cost accounting. It is defined as “ tool for guidance and regulation by executive action for cost of operating an undertaking” by Institute of Cost and Works Accountancy, London. This process involves:
Setting up targets for expenses and activities like production, sales, purchase etc.
Measuring actual expenses and volume of activities through cost ascertainment techniques;
Comparison of actual target and finding out deviations or differences and identifying areas of efficiencies and deficiencies;
Analyzing the causes of deviations and fixing responsibility on particular person within the organization; and
Corrective action for improvement of performance in future.
The measures adopted to control cost are known as Techniques of Costing.
Reporting:
This function is concerned with the presentation of information obtained through cost methods and techniques of costing to the management. The proper system of reporting would ensure that concerned person receives right type of information at an appropriate time. The reporting system differs from organization to organization depending on peculiar needs.
Cost Concepts and Classification
Cost represents a sacrifice of values, a foregoing or a release of something of value. It is the price of economic resources used as result of producing or doing the thing costed. It is the amount of expenditure incurred on a given thing.
Institute Of Cost And Works Accountancy (ICWA) defines cost as the amount of expenditure (actual or notional) incurred on, or attributable to a specified thing or activity.
Classification of cost
Cost classification is the process of grouping costs according to their common features. Costs are to be classified in such a manner that they are identified with cost center or cost unit.
Costs are classified as follows: (Traditional Classification)
1) On the basis of Behaviour of Cost
Fixed cost.
Variable cost.
Semi-Variable cost.
2) On the basis of Elements of Cost
Direct cost.
Indirect cost.
3) On the basis of Functions
Manufacturing Expenses.
Administrative Expenses.
Selling and Distribution Expenses.
1)
2) On The Basis Of Behaviour Of Cost:
Behaviour means change in cost due to change in output. Cost is further classified into following categories:
i) Fixed Cost:
It is that portion of total cost, which remains constant irrespective of output up to the capacity limit. It is called as period cost as it is concerned with the period. It depends on the passage of time. It also tends to be unaffected by variants in output. These costs provide conditions for production rather than cost of production. They are created by contractual obligations and managerial decisions. Rent of premises, taxes and insurance, staff and salaries constitute fixed cost. It is shown in the following diagram:
ii) Variable Cost:
This cost varies according to the output. It tends to vary in direct proportion to output. If output will decrease, the variable cost will also decrease. It is concerned with output or product, therefore it is also called product cost. For e.g direct material, direct labour, direct expenses & variable overheads. This diagram is shown below:
iii) Semi Variable Cost:
This also referred to as semi-fixed or partly variable cost. It remains constant up to a certain level and registers a change afterwards. These cost vary in some degree with volume but not in direct or same proportion. Such cost are fixed only in relation to specified constant conditions. For e.g. repairs and maintenance of building, supervision, professional tax etc. the diagram is shown below:
1) On The Basis Of Elements Of Cost:
Elements means nature of items. A cost is composed of 3 elements: material, labour and expenses. Each of these elements can be direct and indirect.
A) Direct Cost:
It is the cost which is directly chargeable to the product manufactured. It is easily identifiable. Direct cost consists of 3 elements which are as follows:
i) Direct material: It is the cost of basic raw material used for manufacturing a product. It becomes a part of the product. It is easily identifiable and chargeable to the product. For e.g. pulp in paper, sugarcane for sugar etc.
ii) Direct Labour/ Wages: It is the amount of wages paid to those workers engaged on manufacturing line for conversion of raw materials into finished goods.
iii) Direct Expenses: It is the amount of expenses that is directly chargeable to the product manufactured or which may be allocated to product directly. For e.g. cost of designing a product, architect fees etc.
B) Indirect Cost:
It is that portion of total cost which cannot be identified and charged direct to the product. It has to be allocated, apportioned and absorbed over the units manufactured on suitable basis. It consists of 3 elements:
i) Indirect Material: It is the cost of material other than direct material which cannot be charged to the product directly. It cannot be treated as part of the product. For e.g grease, oil etc.
ii) Indirect Labour: It is the amount of wages paid to those workers who are not engaged on the manufacturing line. For e.g wages of workers in administration department, sales department etc.
iii) Indirect Expenses: It is the amount of expenses which is not chargeable to the product directly. It includes factory expenses, administrative expenses.
3) On the basis of functions:
An organization performs many functions. Costs can be classified on the basis of functions as follows:
i) Manufacturing cost: It is the cost of operating the manufacturing department of an organization. It includes prime cost and overheads expenses relating to production.
ii) Administrative Expenses: It is the cost which is incurred for formulating the policy, directing the organization and controlling the operations.
iii) Selling and Distribution Cost: It is the cost of stimulating demand. It includes advertisements, Market Research etc. Distribution cost is incurred for distribution of products. It includes warehousing, cartage etc.
Costing:
The above costs are ascertained with the help of Costing. Costing means the process of ascertainment of costs. Costing involves the following basic aspects or 5 ‘A’s:
1) Ascertain: Ascertain or collect all the expenses relating to a particular period.
2) Analyze: Analyze the expenses under different heads of accounts such as material, expenses etc.
3) Allocate: Allocate or charge in full the direct expenses such as raw material, labour, to relevant product, contract or process.
4) Apportion: Apportion/distribute common expenses to each product, contract or process.
5) Absorb: Absorb the total expenses of a department over its products. So in this final step, the individual costs of each product is determined. This product cost is then reported to management.
As costing is a diverse process, costing methods have been designed and used for ascertainment of costs. The methods used are
A. Job Costing:
(1) Job order costing.
(2) Contract costing.
(3) Batch costing.
B. Process Costing:
(1) Process costing.
The above methods are used for ascertainment of costs. But this does not end the process. The most important aspect left is compiling these costs which helps to arrive at selling price and achieve the organizations objectives, this where Cost accounting comes in to the picture.
Cost accounting is term broader than costing. It covers costing plus the reporting and control of costs. Thus
Cost accounting = Costing + Cost reporting and control.
Cost Accounting can be defined as the technique of recording, classification, allocation, reporting and control of costs. The following diagram gives a clear picture of how the composition of selling price takes place on the basis of the compiled costs:
Other Costs for Decision Making and Planning:
Opportunity Cost
Opportunity Cost is the cost of opportunity lost. An opportunity cost is the benefit given up or sacrificed when one alternative is chosen over another. Opportunity costs are often market values. Alternatively, they are measured by the profit that would have been earned had the resources been used for other purposes. For E.g. choosing to attend college instead of working has an opportunity cost equal to the salary foregone. Opportunity costs are important in decision making and evaluating alternatives. Decision-making is selecting the best alternative which is facilitated by the help of opportunity cost. But opportunity costs are not recorded in an accounting system as they are not based on past payments or commitments to pay in future. Such costs do not require cash outlays and are only inputed costs.
Sunk Cost
A sunk cost is the cost that has already been incurred. It is a past or committed cost, cost gone forever. Sunk costs cannot be changed once they have been incurred and cannot be avoided by any decision making that is made in future. Any asset obtained from the incurred cost can be used or sold, but its value is its present or future value-not the cost paid. Thus for e.g. if a plant was purchased 5 years ago for Rs 5,00,000 with the expected life for 10 years and nil scarp value the its written down value will be Rs 2,50,000 if SLM method of depreciation is used. This WDV will have to be written off no matter what alternative future action is chosen. For instance if the plant is to be used in the future the WDV will have to be written off and if the plant is decided to be scrapped, again Rs 2,50,000 will have to be written off.
Relevant Cost
Relevant costs are those future costs which differ between alternatives. Relevant costs may also be defined as the costs which are affected and changed by a decision. If a cost increases, decreases, appears or disappears as different alternatives are compared, it is a relevant cost and the opposite is said to be irrelevant costs.
Differential Cost
Differential cost is the difference in total costs between any two alternatives. Differential costs are equal to the additional variable expenses incurred in respect of additional output, plus the increase in the fixed costs if any. This means that differential cost is only the difference in the amount of two costs. This cost may be calculated by taking total cost of production without the additional contemplated output and comparing it with the total costs incurred if the extra output is undertaken.
Imputed cost
Imputed costs are costs not actually incurred in some transaction but which are relevant to decision making as they pertain to a particular situation. These costs do not enter into an accounting system. But they being related to economic reality, help in making better decisions. Interest on internally generated funds, rental value of company owned property are some examples. thus for instance when the company uses internal funds, no actual interest payment is required but if the same would have been invested in some projects, interest would have been earned. Thus imputed costs are similar to the opportunity costs.
Out of pocket cost
Out of pocket costs signify the cash cost associated with an activity. Non- cash costs such as depreciation are not included in out of pocket costs. This cost concept is significant for management in deciding whether or not a particular project will at least return the cash expenditures associated with the project selected by the management. Similarly acceptance of a special order for production may necessitate the consideration of out of pocket costs that need not be incurred if the special order proposal is not accepted.
Job & Batch Costing
Job Order Costing is also known as Specific Order Costing or Job-Lot Costing. According to ICMA London it is that category of basic costing method which is applicable to where work consists of separate, Contract jobs or batches each of which is authorized by specific order or contract. Job Costing is followed by manufacturing and non-manufacturing concerns. It is employed in industries in which:
a) production is done on the basis of customer’s own specifications;
b) products are manufactured in distinguishable lots;
c) products are not uniform; and
d) it is practical to maintain a separate record of each lot from the time production is begun until it is completed.
APPLICABILITY OF JOB COSTING
Job costing is applicable to concerns engaged in Job-order production or services. It is employed by jobbing concerns. Following is a list of concerns which usually employ Job Costing Method:
a) Job printing,
b) Manufacturers of special types of equipments,
c) Design Engineering works,
d) Repair works,
e) Engineering concerns,
f) Construction companies,
g) Ship building companies,
h) Furniture makers,
i) Hardware industry,
j) Machine manufacturing industry,
k) Automobile garages and
l) Interior decoration.
FEATURES OF JOB COSTING:
a) Work is performed in accordance with customer’s orders and specifications.
b) Products are not produced for maintaining stock.
c) Every job can be identified clearly.
d) Every job is charged with its own cost.
e) Work in progress depends upon the number jobs in hand at the end of the period.
f) Each job is a separate accounting unit and separate job or production numbers are allocated to each job.
g) A separate production card is maintained for recording the costs incurred on each job or lot of production is ascertained separately.
h) Under this method, the cost incurred in respect of materials, labour overheads, etc for each job or lot of production is ascertained separately.
i) The purpose of job order costing is to segregate the cost of each product or lot or job.
j) A job or an order may extend over several accounting periods and therefore, the costs may not be related to any particular accounting period.
k) Job work is done in factory premises.
PROCEDURE INVOLVED IN COSTING
Job costing demands careful planning and control so as to avoid wastage in the use of materials, machinery and other resources. The procedure of costing involves the following steps:
a) Production Order
On receipt of an order from the customer or on receipt of communication from the sales department for manufacturing a certain product, the production-planning department prepares a suitable design for the product or job as per specifications. The production-planning department prepares a list of operations which indicates the sequence of operations and the machines or departments to whom the job is entrusted. The department also prepares an estimate of materials requirement for the product. A production order is issued to the shop instructing to proceed the job. The production order is known as “Work Order” or “Job Order Record”. It constitutes the authority for work. Production order is the point from where the production starts and the cost of a job is worked out. A production order contains all the information that is relevant to the job or products or service.
Production orders are of two types:
1. Assembly Type Order
This is applicable where components are purchased and assembled.
2. Components Production Type
This is applicable where separate production order for each component, sub assembly and final assembly are issued.
Copies of production order are sent to:
i) the stores for issue of materials;
ii) the departments concerned to undertake production; and
iii) the cost department for determining the cost of the jobs.
On receipt of the job order, the cost department prepares a job cost sheet or card which bears the production order number. For each job, a separate job cost sheet is prepared in order to ascertain costs and the profit or loss on each job.
b) Material Costs
On receipt of production order, the shop draws materials from the stores on material requisitions. The costs of the materials are recorded in the job order card. Any indirect material required can also be drawn on strength of material requisitions and there are recorded in job order card.
c) Labour Costs
On the basis of time sheets or piece-work cards, the labour costs are ascertained and classified into direct or indirect wages. They are subsequently analyzed in “wage analysis sheet” and included in job order card.
d) Completion Of Jobs
On the completion of the job, a job completion report is sent by the shop to production planning department and a copy of the same to Cost Department. The completion report indicates that the jobs are complete and the cost sheet may be closed. The various elements of cost are totaled and the total cost is divided by the number of jobs executed or units manufactured to determine the cost per job or unit.
Subsequently, the quantity recorded in the finished stock card is totaled and total number of units completed is posted to the Job Completion Report or Production Order.
Batch costing
Batch costing is a variant or type of Job Costing. In batch costing batch or output is treated as separate Job. ‘Batch’ means a group of identical items which maintains its identity throughout the production e. g a batch of identical components of radio set, a television set, watches etc. since the components are produced on a large scale in batches the unit cost of production is lower. Batch costing is used where articles are manufactured in distinct batches either for assembly or sale later on. This method is also known as ‘Lot Costing’ or ‘Assembly Cost system’.
In a pen manufacturing company, it is costly to produce one pen. Hence it is economically viable to produce pens in batches of 20,000 to 50,000 of a particular design. The procedure of batch costing is the same as job costing. Each batch is given a batch order number. Cost per unit is decided by dividing the total cost of production by the number of units in batch. The cost of each batch is ascertained in the following manner:
1. Batch No: Each batch is given a specific number. All the costs are accounted against this number. A separate account is opened to record the costs of each batch.
2. Direct Costs: The material requisition note and the Job Card bears the Batch No. This enables the allocation of direct material cost and direct labour cost to each Batch. The relevant batch account is debited with its direct material cost and direct labour cost. Direct expenses such as machinery are debited to the Batch account on the basis of cash/purchase/journal vouchers.
3. Overheads: The overheads are apportioned and absorbed by each Batch on the basis of overhead absorption rate which may be actual or pre-determined. The overheads attributable to the batch are debited to the relevant Batch Account.
4. Sale/Transfer Price: The output of the batch may be sold. In such case the sale price is credited to the Batch Account. If components are produced, they may be transferred to stores to be assembled in the final products later on. In such case transfer price if each Batch is debited to work-in-progress Account and credited to the Batch Account.
5. Profit or Loss: The Batch Account at this stage will reveal the profit or loss made on that Batch. The profit or loss is then transferred to the Costing Profit and Loss Account.
Economic Batch Quantity
In Batch Costing, determination of economic Batch size or lot size is most important work. For deciding economic batch size, the cost has to be grouped into setting up costs. Economic batch quantity is decided at the point where the carrying costs are equal to setting up costs. At this stage the total cost is also minimum. It can be decided by the following formula:
E.B.Q = 2DS
IC
D = Annual demand for the product.
S = Setting up cost per batch.
I = Annual rate of interest.
C = Unit cost of production.
The calculation of E.B.Q is explained below with the help of an example:
Annual demand = 4,000 units.
Setting up cost = Rs. 100
Manufacturing cost per unit = Rs. 200
Rate of interest p.a = 10 percent
E.B.Q = 2DS
IC
2 x 4,000 x100
= 10 x 200
= 200 Units.
JOB COSTING EVALUATED
ADVANTAGES:
Job costing enables the management to identify spoiled and defective work in respect to particular production orders, departments or groups of workers and hence the management can fix up responsibility for inefficiency.
Management can determine the trends in cost and compare the operating efficiency of men and machines in each cost center. It can also determine the completion cost of each job.
It enables preparation of estimates of costs of job before production.
It enables comparison of estimated costs with actual costs as the costs are analyzed on the basis of costs, services and production.
It makes available to the management a complete file of production orders which contains valuable statistics on cost.
It enables ascertainment of profit or loss on each job immediately after their completion.
It enables the management to indentify unprofitable jobs.
In case of cost plus contracts, job costing enables to provide precise quotations.
It helps in production planning.
It facilitates fixation of selling price.
LIMITATIONS
Job costing includes a lot of clerical work in identifying materials, labour and overheads with specific jobs and departments.
Management cannot evaluate precisely the operating efficiency of men and machines.
Since costs ascertained and compiled are historical costs, they are not of much utility to the management.
It does not apply budgetary control to important cost elements such as labour, materials and overheads.
Job costs over any period of time cannot be compared if major economic changes take place in between.
It is expensive to operate and errors are possible due to increased clerical work.
Contract Costing
Contract Costing is the method of costing used to find out he cost of each contract. It is type or variant of Job Costing. Contractor is person who undertakes the contract. Contractee is the person for whom the contract job is undertaken. Contract is the agreement (usually written) between the contractor and the Contractee, containing details such as nature of the job, time of commencement and completion, total price due, mode of payment, and so on.
Thus Contract Costing is a type of Job Costing in which a contract constitutes a unit of cost. “Contract or Terminal Costing is adopted by those business undertakings which undertake definite Contracts which take a long period of time to complete. E.g. builders and Contractors, Civil Engineering firms, ship Building companies etc”. The same principles of Job Costing are applicable to Contract Costing.
Features:
Thus a Contract is nothing but a big job having the following special features:
1) A contract involves a high price of thousands or lakhs of rupees.
2) Each Contract is considered as a separate Unit of cost.
3) A separate Contract A/c is prepared for each contract and is allotted a distinguishing number.
4) Usually the contract work is carried at the customer’s site.
5) Since major contract is done at site, most of the expenses are directly allocated to the contract. Common expenses are apportioned to all contracts as a percentage of materials and labour.
6) A contract usually takes more than one accounting year to complete.
7) Penalties may be incurred by the contractor for failing to complete the work within the specified period.
8) Calculation of profit on incomplete contract is a distinguishing feature of this method.
COSTING PROCEDURE:
As the period taken for completion may be many months or even years the contract may either be completed in the same accounting year or in latter years. So accounting procedure for Contract Costing are classified into complete and incomplete contracts and procedure varies accordingly.
Complete Contracts
1) Separate Contract Account: In contract costing each contract is treated as a separate cost unit. Each contract is given a specific Contract Number. A separate account is opened for Contract to record the costs and the income pertaining to that particular contract. Broadly speaking, the contract account is debited with its costs and credited with the contract price in order to ascertain the profit or loss on the completion of that particular Contract.
2) Cost of Contract: Each Contract account is debited with the cost of material, labour and expenses directly incurred for the particular Contract and plus its Share of Overheads.
a) Material:
Contracts are generally carried out at sites away from the head office of the contractor. So, the material required for the contract can be arranged as follows
i. Material Issued/Bought:
The cost of materials, issued by the stores or brought directly at site, is debited to Contract Account.
ii. Material Supplied by Contractee:
If any material is supplied by the contractee (e.g. cement), it is not debited to the Contract Account. A separate Memorandum Account is maintained in case of such material.
iii. Material Transferred:
If any material is transferred from one contract to another, the Contract Account which receives the material is debited and the contract account which transfers the material is credited with the cost of the material so transferred.
iv. Material returned to Stores/Suppliers:
If any material is returned to the stores or to the suppliers, the contract account is credited with the cost of material so returned.
v. Material Lost/Destroyed:
The material lost or destroyed by theft, fire, accident etc. is an abnormal loss. Just like abnormal loss in process account, the value of such abnormal loss is isolated and is not allowed to affect the cost of the contract. The cost of material lost or destroyed is debited to the costing profit and loss account and credited to the contract account.
vi. Sale of Material:
Sometimes, the surplus material or scrap etc. may be sold at a profit or loss. Such profit or loss is treated as an abnormal item and is not allowed to affect the cost of the contract. Hence the profit or loss on the sale of material is directly transferred to the costing profit and loss account. Only the cost of the material sold is credited to the contract account.
vii. Material at Site:
If some stock is lying at the site, on completion of the contract (or at the end of the accounting year) the cost such closing stock is credited to the contract account.
Thus in effect, finally the contract account is charged with the Net Cost of the materials used for the contract. The net cost of the materials is thus equal to -
b) Labour:
As the work is performed at the site itself, the payments made to all persons working at the site are directly debited to the Contract Account. This would include the wages paid to workers, salary paid to supervisors and also the remuneration paid to the engineers etc. who are directly and solely occupied with the contract.
c) Direct Expenses:
The expenses directly relating to the contract are debited to the contract concerned. For e.g. in a contract for construction of a building, fees paid to an Architect for preparing the plan and design of the building, or the payments made to sub-contractors for electrical fittings, erection of lifts in the building, sanitary fittings etc form a direct expenditure and are debited to that particular Contract.
d) Special Plant or Machinery:
Special plant means the plant and the machinery specially purchased for use on a particular Contract. The treatment of special plant and machinery in various circumstances is as follows:
i) Plant Issued/Bought:
The cost of the plant and machinery issued by the stores or bought directly at site for the specific and exclusive use of the contract is debited to the Contract Account.
ii) Plant Transferred:
If any plant is transferred from one contract to another, the contract account which receives the plant is debited and the contract account which transfers the plant is credited with the written down value (Cost less Depreciation till date of transfer).
iii) Plant returned to Stores:
If any plant is returned to Stores, the contract account is credited with the written down value of such plant.
iv) Plant Lost/Destroyed:
Plant may be destroyed by accident or fire or it may be stolen from site when the work is in progress. In such cases the contract A/c is credited by the WDV of the plant destroyed. If the plant was insured, the compensation received from the insurance company is credited to Contract A/c.
v) Sale of Plant:
Sometimes the special plant may be sold at a profit or loss. Such profit or loss is attributable to the particular Contract, since the plant was specially acquired for it. Hence the sale price received is credited to the Contract Account. Since the cost is already debited to the Contract A/c, this effect means that the difference between the cost and the sale price is automatically accounted in the Contract A/c.
vi) Plant at Site:
The residual value of the special plant lying at the site (at the end of the contract) is credited to the contract account i.e. contract account is charged with the depreciation for the use of the plant.
e) Indirect expenses:
Normally the major expenses in case of contract are Direct Expenses. However there are certain indirect expenses or overheads which have to be apportioned or distributed over all running contracts on some fair basis. For e.g. head office expenses are apportioned to each contract on the basis of direct wages or the ratio of contract price etc.
f) Common Plant or Machinery:
The plant or machinery issued by the head office or stores to a particular contract for a short period is called common plant or machinery. Such plant is used for any of the running contracts. For e.g. a crane may be used for a number of contracts for a short duration by turns. The treatment of the common plant and machinery is the same as special plant and machinery except in case of sale of plant where the profit or loss on sale of the plant is not allowed to affect the cost of the contract and the profit or loss is transferred to the costing profit and loss account. There are two methods of charging a contract for the use of common plant:
Expenses method: the contract account is debited by depreciation and share of expenses for the period for which it is used at site.
Capital Method: contract A/c is debited with the cost of plant and machinery issued to site and credited by the WDV of the plant on the completion of the work. Thus the contract A/c is charged with the depreciation.
Pro-Forma Contract A/c
Contract No - A/c
The actual procedure of Contract Costing is explained with the help of following Case:
The contract was completed in 20 weeks. The special plant was returned subject to depreciation of 20% on original cost. The value of loose tools and stores returned were Rs 1,000 and Rs 400 respectively. The WDV of tractor used for the contract was Rs 19,500 and depreciation was to be charged to this contract at 20%p.a on this value. Provide 7% for administrative expenses on Works Cost.
Solution:
Contract A/c
Incomplete Contracts
In case of large contracts, it takes many years for the contract to be complete.
The contractor cannot wait for number of years till the contact is wholly complete, to receive the full contract price which will be due only in the last year of the contract. He has to get on – account payments regularly at least to recover at least to recover the value of work completed during the accounting year, and
The contractors cannot wait for number of years till the contract is wholly complete, to book the profit which will accrue only in the last year of the contract. He has to book at least a part of the profit earned on the work completed during the accounting year, to avoid wide fluctuations in profit/ payments of dividends from year to year.
Contract Price
It is the value of the contract which is agreed to be paid to the contractor by the Contractee when the Contract is satisfactorily completed. The journal entry on completion of the contract for contract price receivable is: Debit contractee’s A/c and Credit contract A/c.
Work Certified And Retention Money
The completion of a contract takes generally more than one year. The financial resources of a contractor could be severely strained and a large amount of working capital would be required if the contractor did not receive payment until the completion of the contract. Thus, it is a normal practice for the contractee to pay the contractor some of the money on account during the period of contract. This sum is paid on the basis of certificate given by the architect acting for the contractee. The extent of the work completed is periodically checked and certified by an expert e.g. a surveyor, an architect or a Chartered Engineer. Thus, in contract for building a dam, a Chartered Engineer may be appointed by the contractee to check at fixed intervals, the extent of the work completed on the dam. The Chartered Engineer may check the work, say every 4 months, and issue a certificate of work completed stating the value of the work done. This is called Work- Certified. The amount of work certified is credited to the Contract A/c and
Debited to the Contractee’s A/c. Alternatively work certified may be carried forward as a balance in contract A/c.
Generally the contractor receives payment only of part of the value of work certified. The part payment received is expressed as a percentage of the value of Work Certified. Thus a Contractee may agree to pay the contractor 90% of the value of the work certified. Balance 10% amount, certified but not paid, is known as ‘Retention Money’. Retention Money is safe guard against the non-performance of the contract or defective work.
Value Of Work Completed But Not Certified
It is not necessary that the entire work done by the Contractor would be certified by the Architects or the contract work continues after the date of certificate and this work done since certification may remain uncertified. This is called work done but not certified. Until the work is certified by the Architect the contractor should not add any profit element to the uncertified work. So, the work done but uncertified is to be valued at cost and not at Contract Price. It is carried forward as a balance in the contract. It is considered when ascertaining the work in progress.
Thus the Total value of work certified in an Accounting Year is
equal to = Work certified + Work uncertified.
Work in Progress
Incomplete contracts are referred to as work in progress. It includes the cost of certified work and uncertified work. As the value of the plant and materials as when supplied is debited to the Contract A/c, it is also advisable to take into consideration the value of plant at site and the cost of materials at site. This is also being included in the value of work in progress. In that case the value of work in progress will consist of:
a) Work Certified, b) Work Uncertified, c) Plant at Site, d) Materials at Site.
Accordingly work in progress A/c is debited with certified as well as uncertified work, plant at site and materials at site and with these sums Contract A/c is credited. On the following date in the next accounting period, the entry is reserved. These entries are repeated year after year till the next entire work gets completed. On the completion of the
contract, Contractee’s A/c is credited with the full amount contracted. Contractee’s A/c is usually debited by the contract price on completion of work.
Work in progress will appear in Balance Sheet as follows:
Profit On Incomplete Contracts
Large contracts take number of years to complete and the cost can be ascertained only when the contract is complete and therefore, it is not possible to ascertain the profit or loss on the contract until the completion of the contract. For the purpose of Annual Accounts it is necessary to ascertain profit for the year. However this procedure would show a lot of fluctuations in the annual profits. The year in which the contract is completed would show large profits and in other years would show even losses. So at every year ending it is desirable to take into account a reasonable proportion of the estimated profit (Notional Profit) on incomplete contract subject to the following conditions:
a) When the work done is less than 25% or ¼ complete, no profit is taken into account but the entire balance is treated as reserve.
b) If the certified work is ¼ or more than ¼th but less than ½ of the contract price, then 1/3rd of the notional profit as reduced to the percentage of cash received is credited to profit/loss A/c. The balance of the notional profit is credited to reserve which is part of W.I.P.
Profit = 1/3 x Notional Profit x Cash Received
Work certified
c) If the value certified is ½ or more than ½ of the contract value, then 2/3rd of the Notional Profit as reduced to the percentage of cash received is credited to profit/Loss A/c.
Profit = 2/3 x Notional Profit x Cash Received
Work certified
d) If the value of the work certified is 100% or when the contract is complete, the entire profit is credited to Profit/Loss A/c.
e) When incomplete contract A/c shows loss, the entire amount is debited to profit and loss A/c irrespective of the stage of completion
f) For contracts which are almost complete- In this case the estimated profit is ascertained by deducting the aggregate of costs up to date and additional expenditure to complete the contract from the contract price. A portion of this estimated profit is credited to P/L A/c. This portion may be calculated by the following formula:
Estimated profit x Work Certified
Contract price
Escalation Clause
The clause is provided in the contract to cover up any changes in the price of materials, labour etc. Since the contract takes more than one year to complete, the object of incorporating this clause is to safeguard the interest of both the parties against unfavourable change in prices. The contractor has to produce sufficient proof of excess cost before the customer agrees to reimburse such costs. The contractor is entitled to increase the contract price if the cost increase beyond certain specified percentage. This clause is of importance especially when the prices of materials and labour are likely to be increased or where it is difficult to estimate the quantity of materials and labour time.
A de-escalation clause may be inserted in the agreement to take care of the interest of the contractee. It provides for the downward revision of the contract price in case the cost goes down beyond a certain agreed level.
Cost plus Contracts
When it is difficult to estimate the cost of Contract due to cost fluctuations or long period of time to execute contract or the probable cost of the contract cannot be estimated in advance, with reasonable degree of accuracy, or when the contract is absolutely new to the contractor, the cost plus contract is useful. In this, it is agreed upon that the contract would be paid the total cost of contract plus his profit at a certain percentage of cost. Though the contractor is assured of his profit, he is unable to prepare a cost budget for his contract. The customer also feels suspicious about the Contractors expenses. Moreover, the contractor has to vouch for every expense. Unscrupulous contractors may tend to inflate the cost to the disadvantage of the customers. This system puts a premium on inefficiency of the contractor because high cost would mean high profit to him. Therefore there is no incentive for cost reduction/optimization. However, the contractor’s books of accounts should be kept open for inspection by contractee and the terms of the contract should be clear.
Cost plus contracts are usually entered into for executing special type of work like construction of dams, powerhouse etc. where cost estimation is difficult. Cost plus contracts offer the following
Advantages:
To the Contractor:
There is no risk of loss.
It protects from the risk of fluctuations in market price of material, labour etc.
It simplifies the work of tenders and quotations.
To the Contractee:
The contractee can ensure fair price of contract as he can audit the account of the contractor.
Disadvantages:
To the contractor:
The contractor is deprived of the advantages which would have accrued due to favourable market prices.
The contractor has to suffer for his own efficiency.
To the Contractee:
The contractee has to pay more for the inefficiency of the contractor because the contractor has no motivation to reduce cost.
The price to be paid by the contractee is not known till the completion of the contract.
Contract costing – Case:
The actual procedure of Contract Costing (When work is incomplete) is explained with the help of following Case:
The following information is obtained from the books of the contractor relating to a contract of 75 lakhs. The Contractee pays 90% of the value of work done as certified by the Architect.
The Value of Plant at the end of the 1st year, 2nd year and 3rd year was Rs 80,000, Rs 50,000, Rs 20,000 respectively.
Solution: In the books of the Contractor
Contract A/c (1st year)
Contract A/c (2nd year)
Work certified percentage = Work Certified x 100
Contract price
= 75 %
P&L a/c = 2/3 x Notional Profit x Cash received (as work certified is more
Work Certified than 75%)
= 2/3 x 15,75,000 x 90
100
= 9,45,000
Contract A/c (3rd year)
Process Costing
A ‘Process’ means a distinct manufacturing operation or stage. In process industries, the raw material goes through a number of processes in sequence before the finished product is finally produced. For e.g. copra crushing, refining and finishing.
Process Costing is method of costing used to ascertain the cost of product at each process, operation or stage of manufacturing where processes are carried on. According to ICMA London, “ it is that form of operation costing where standardized goods are produced”. Process Costing is used to ascertain the cost of product at each stage of manufacture where material is passed through various operations to obtain a final product.
Applicability
This method of costing is used by those concerns which manufacture articles of uniform standards. These concerns manufacture articles on continuous flow basis. Under following conditions, process costing can be followed favourably:
Production of a single product.
Processing of a single product for a certain period.
Production of several products of a standard design in the same plant.
Division of a factory into separate operations or processes.
Examples:
Manufacturing Industries like Iron and Steel, Cement, Paper, Rubber, Ceramics etc.
Chemical industries for Chemical, Perfumery, Oil, Medicines etc.
Mining Industries for Mineral Oils, Coal, and Gold etc.
Public Utility Works, Electricity generation and distribution.
Features of Process Costing:
The factory is divided into processes which are the cost centers.
A separate account is maintained for each process.
All costs direct and indirect are recorded for each process separately.
The production is continuous and the final product is the end result of series of processes.
The Output of one process becomes the input of the next process and so on until the finished product is obtained.
The sequence of operations for processing the product is specific and pre determined.
Different products with or without By-Products are simultaneously produced at one or more stages.
Controllable and avoidable wastage may usually arise at different stages of manufacture e.g. evaporation, shrinkage, chemical reaction etc.
Necessity
It becomes necessary to apply Process Costing to the industries belonging to the following categories:
One Product, Many Processes: A factory may produce a single item through a number of processes or departments. It becomes necessary to find out the cost of each process or department separately to control wastage etc.
Many Products, Many Cycles: A bakery can use the same equipments to produce either bread or cakes. It may produce only bread in one cycle and change over to the production of cakes in the next cycle. Each cycle is treated as separate process so as to find out the cost of the item produced in a particular cycle or process.
Many Products, Same Process: An oil refinery can obtain many joint products such as refined oil, gas, steam etc. in the same process. Process costing is employed to ascertain the individual cost of each such product.
Costing Procedure
The factory is divided into different processes and a separate account is maintained for each process. The procedure of deciding cost is as follows:
1) Materials: Any material required for processing is taken from the stores against material requisition and the cost is debited to respective process account. If the output of previous process becomes the input of the next process, the cost is debited to the receiving process account.
2) Wages: Wages paid to workers who are employed on processes are debited to respective process accounts. If the workers are employed on number of processes, the amount of wages is allocated on proper basis and debited to respective process account.
3) Direct Expenses: Direct expenses such as machinery, power etc which are traceable with the process are debited to respective process account.
4) Overheads: Various common expenses viz rent, telephone, lighting, gas, water are apportioned to the various processes on suitable basis. These overheads are recovered at predetermined rates of recovery on a suitable basis such as ratio of material costs, labour costs or prime costs.
The net cost of the output of the process (total cost less sale value of residue) is transferred to the next process. The cost of each process is thus made up of (i) cost brought forward from the previous process and (ii) net cost of materials, labour, direct expenses and overheads added in the process less sale value of residue. The net cost of the last process is transferred to the Finished Goods Account.
Incomplete units/Equivalent units:
Given the nature of the production process, some units may remain incomplete at the time of accounting for the total cost of production. In such a situation, some units are complete while others are incomplete/ partially complete. For the purpose of cost accumulation, the units of production are to be converted into comparable units. They are referred to as equivalent units.
For instance, 100 units of inventory estimated to be 40 percent complete are considered equivalent to 40 completed units. Therefore, for cost determination purposes, 100 partially completed units will be considered equal to 40 units of equivalent production. Symbolically:
Equivalent units = Actual number of partially completed units x Stage of completion
The computation of equivalent units can be explained with the following example.
Opening inventory: Partially completed units (40% complete) 600
Units introduced during the period 10,000
Closing inventory (partially completed units: 70% complete) 2,000
Statement of equivalent units
1. Work necessary to complete opening inventory (600 x 0.60) 360
2. Work necessary to complete units introduced during the year 8,000
(10,000 – 2,000 partially completed units)
3. Work performed on closing inventory (2,000 x 0.70) 1,400
Total number of equivalent units 9,760
Waste and Losses
A manufacturing process is likely to give rise to some wastage and losses. Waste may be invisible or visible. Invisible waste means loss of material by way of evaporation, shrinkage, etc. visible waste means residue such as slag also having no sale value. Thus, waste, whether visible or invisible, has no sale value.
Losses mean scrap, residue, spoilage or defective units having some sale value. Thus sale value of scrap etc is lower than the cost of production leading to financial loss. Thus, for example the cost of production of a defective unit may be Rs. 20 leading to a financial loss of Rs. 80.
Normal loss is the process loss which is caused under normal circumstances. It is inevitable loss. It cannot be avoided. It does occur in spite of measures taken by the management. It is also referred to as non-controllable loss, for e.g. loss due to evaporation, pilferage. Normal loss is calculated at a certain percentage of the input in units introduced in the respective process. The percentage of the normal loss is determined in advance on the basis of scientific study of manufacturing process and the nature of raw materials.
Normal loss may have a scrap value. In the absence of scrap value the cost of normal loss is borne by the output of respective process. A separate normal loss account is opened in the cost records. For the scrap value of normal loss the normal loss A/c is debited and the process A/c is credited. When the scrap value of normal loss is realized the cash A/c is debited whereas the normal loss A/c is credited.
Any loss above this figure (Normal loss) is treated as Abnormal Loss. It is the part of the process loss which is caused due to abnormal circumstances in the factory, for example labour strike, working to rule, Go slow, Break down of machinery, power failure, Accidents etc. Any loss below this figure is treated as abnormal gains. Abnormal gain arises when actual wastage (loss) is less than Normal wastage or when the actual output is more than the normal output. Abnormal gain arises due to rise in efficiency of the production department. Normal loss is treated as normal cost of production. But cost of abnormal loss or gain is taken out from the process account. The net financial loss on account of abnormal loss is debited to the costing profit and loss A/c. The net profit on account of abnormal gains is credited to costing profit and loss A/c. Thus Management can analyze the causes of Abnormal Loss/Gain and find out which process needs better control and supervision. This also ensures that the efficiency of inefficiency of one process is not passed on to the next process through the cost of units transferred. Further ‘normal’ cost per unit remains constant over a period of time.
Joint Products and By – Products
When a single process using the same inputs gives us two or more products they are either joint products or by-products. They are considered as joint products, if they are of importance. Joint products are equally significant. Thus it is difficult to designate or call any of the joint products as the main product. Thus, coke and coal gas produced by a coke plant are called joint products. Where there are joint products, the total cost of process is apportioned over them on an equitable basis such as units produced, sale value cost at the point of separation, technical estimates etc.
A by-product is an item incidentally produced along with the main product in the same process. A by-product is minor, secondary or residual product having a much lower value as compared to the main product. Thus, tar in a coke plant, oil cakes in oil manufacturing etc. are by products.
In this case the cost of materials, labour etc are debited to the process account in the usual manner. The value of the By-Product may be accounted by any of the following methods:
The sale value of the by-product is credited to the Process A/c. No attempt is made to find out the separate cost of the by-product. The cost of the main product is directly reduced by the sale value of the By-Product.
In this method the separate cost of by-product is ascertained by the following formula
Cost of by-product
= Total cost of process x Units of by-product
Total units produced (Main + by-product)
The sale value of the by-product is credited to the process account and the profit on the sale of by-product is debited to the to the process A/c and credited to P&L A/c. Thus only the cost of the by-product and not its sale value is credited to process account.
In this the cost of the by-product is first derived by the above formula and is credited to process A/c and debited to separate account called by-product recovery A/c. The sale price of the by-product is credited to the by-product recovery A/c. The balance in the by-product recovery A/c at this stage represents profit or loss on sale of by-products. This profit or loss is transferred to P&L A/c.
Flow of Cost in Process Costing
Process A A/c
Process B A/c
Process C A/c
Finished Stock A/c
Process Costing -Case:
The actual procedure or the flow of cost in process costing can be explained with the following case:
The manufacture of a product goes through two processes A and B. Some extra raw material is also purchased from outsiders. Process A and Process B yield by-product B respectively. These by-products are sold out directly from the factory. The figures concerning the processes are as follows:
Solution:
Flow of cost in Process Costing:
Process A Account
Process B Account
Cost per unit = Normal cost
Normal Output
= Cost of process – Sale Value of Normal Loss
Input – Normal Loss
Over heads are calculated as a percentage of addition of Raw Material and Wages- Prime Cost
Standard Costing
The managerial process basically consists of planning, organizing directing and controlling. This process is applicable in all the functional areas of management. The effectiveness of management is ultimately judged in financial terms, particularly in business or industrial firms. Therefore, the constant endeavor of the management is to control the cost of scarce resources used in a firm. Controlling presupposes planning well in advance and ensures that the actual results adhere to the targeted results. One of the important sciences employed by the management for this purpose is cost accounting. One of the most important objectives of cost accounting is to help management in controlling cost. Effective control requires planning in advance. Historical costing does not assist management in controlling costs and performance evaluation. Standard costing has emerged out of the following limitations of historical costing:
It indicates the cost actually incurred;
It is available too late for correction of mistakes and deviations;
It does not help management in evaluation of performance;
It does not bring to light the reasons for cost deviations, such as available wastage of raw material, etc;
It does not help much in fixation of selling price as the cost fluctuates frequently.
Standard Cost
Standards are the expectations in regard to the performance. Standard costs can be defined as a measure of acceptable performance in regard to cost. It is a predetermined cost which is computed in advance of production on the basis of specifications of all the factors affecting cost.
According to I.C.W.A., London standard cost “ is a predetermined cost which is calculated from the managements standards of efficient operations and the relevant necessary expenditure”.
Therefore, Standard Costs are predetermined costs and relate to each elements of cost. The costs are predetermined costs and relate to each elements of cost. The costs are predetermined in respect of material, labour and overhead. These are based on technical estimate and the costs are scientifically determined. But at the same time it cannot be and will not be absolutely the correct and the ideal cost. These are determined on the assumption that normal conditions will prevail during the plan period and that efficiency expected would be attained. They are the “ predetermined costs based on technical estimates for material, labour and overhead for a selected period of time and for a prescribed set of working conditions.
Features Of Standard Cost
Standard cost is a predetermined cost;
It is based on past experience;
It is used for measuring the efficiency of future production;
It may be expressed in terms of money or quantity.
Standard Costing
Standard costing is a system of Cost Accounting which makes use of predetermined standard costs relating to each element of cost-material, labour and overhead. Under the system Standard Costing standard costs form the basis of cost records. Actual costs are compared with standard costs. Variations, if any, are analyzed and appropriate action is taken to correct adverse tendencies. Standard costing as per I.C.M.A.London is “ the preparation and the use of standard costs, their comparison with actual cost and the analysis of variance to their causes and points of incidence”.
Applicability
The technique of standard costing is applicable under certain conditions only which are as follows:
There should be production of sufficient volume of standard product.
Methods, operations and processes should be capable of standardization.
Cost should be capable of being controlled.
Industries producing standardized products and following process-costing method adopt this technique. For e.g. fertilizers, cement, sugar etc. In jobbing Industries, the technique cannot be applied with much advantage.
The technique of Standard Costing can be summarized as follows:
a) Determination of standard cost for each element of cost, i.e. material, labour and overhead.
b) Comparison of actual cost with standard cost and determining the difference between two which is known as “Variance”.
Determination of Standard Costs
Preliminaries to the establishment of standard cost:
The following preliminaries are to be considered before establishment of standard costing system:
a) Establishment of cost centers: A cost center is a location of item or equipment for which cost is ascertained. These cost centers may be personal (person) as well as impersonal (item, equipment etc). Establishment of cost centers is necessary for determination of responsibilities and defining lines of authority.
b) Classification of accounts: Accounts are to be classified for the purpose of collection and analysis of the cost properly. For this purpose codes may be given to accounts. A code represents a symbol of a particular item of information.
c) Type of standards: There are two types of standards viz, Basic standards and Current standards.
Basic standards are determined for an infinite period. It remains unaltered for a longer period. It is established and operated for a number of years. Variance from basic standard shows trend of deviations of the actual cost. This type of standard is not useful for controlling cost. It is suitable for those items which are fixed in nature, such as rent, staff salaries etc.
Current Standards is a type of standard which remains in operation for a limited period. It is related to current conditions. It is revised at regular intervals.
There are three types of current standards
Ideal Standard: This is a thorough standard which is rather difficult to attain. It presupposes the fact that performance of men, materials and machines is perfect. It does not make any allowances for loss of time, accidents, machine breakdown, wastage of materials etc. This idealistic standard is unrealistic. It has the advantage of a goal which is aimed at, though it may not be attained in practice.
Expected Standard: This type of standard is anticipated to be attained during a stipulated period. It is based on expected performance. It makes a reasonable allowance for unavoidable losses. Hence, while setting this standard, the known causes of inefficiency, viz. machine breakdown, idle time etc. are anticipated. Expected standards is therefore, more meaningful and realistic. It is useful for controlling cost.
Normal Standard: This is also known as ‘past performance standard’ as it is based on average performance in the past. The basic purpose of this standard is to eliminate the variations in cost which arise due to trade cycle. It is used for planning and decision-making. It is difficult to apply in practice.
d) Setting Standards: In a small company a single person sets the standard. But in a large company a standard committee is appointed to do this job. While setting standards there should be close co-operation and co-ordination amongst the various departments and managers. The standard committee consists generally consists of Production Manager, Purchasing Manager, Personnel Manager, Production Engineer, Sales Manager, Cost Accountant, Marketing Manager, Finance Manager etc. Of all these functional heads, Cost Accountant will have to play a very important role. He has to supply necessary cost data and ensure that the standards set are as accurate as possible. Standard should be set for each element of cost separately.
i) Direct Material: Standard direct material costs involves deciding upon:
Standard Materials Specifications: This requires consideration of design, quality, policy range of availability of material. This also involves determination of which components should be bought and which should be made.
Standard Material Usage: It requires consideration of finished sizes (or volumes) and the unavoidable losses that arise in the course of processing the materials. Such loss is called standard loss. This loss also covers, overages, where materials are likely to lose their potency over their life. Sometimes test runs may be necessary to decide the standard quantity, i.e. usage. The production engineer will help the cost accountant in the determination of material usage.
Standard Material Price: after deciding the standard usage of materials, the cost accountant has to determine the standard material prices. A standard material price is a forecast of the average prices of materials during the plan period (Budget period). Necessary allowance should be made for bulk discount and other discounts and also freight and other handling charges. Thus, standard material price will be deter-mined after considering-
Price of materials in store,
Materials already contracted for,
Future trends of prices,
Discounts to be received,
And cost of transport.
ii) Direct Labour Cost: Determination of standard labour cost involves the following:
Standard Labour Cost: this requires the considerations of various operations involved, skills required and the expected volume of work, the type of labour, i.e. skilled and unskilled that would be required and the availability of particular grade of labour. The work study and personnel department will assist in this respect.
Standard Labour Time (Standard Hours): In this case the usage of labour is measured in hours. The cost accountant has to determine the hours required for each grade of labour for each process or stage and each operation in cost center to manufacture the units. This is a major task which involves time and motion study, systematic time setting, estimates and past performance of labour. The most common method of setting time standards for labour is to use stopwatch in making time and motion studies of each operation. The standard time for each operation should involve consideration of waste and idle time. The time of determining time standards should be fair to both employees and the employer. It should be reasonable and attainable and aiming at efficiency.
Standard Wage Rates: the customary procedure is to select the rates paid in the past which the management considered the rates should be. If standard labour rates are to be of any value to the management in future, they must be as close as possible to the actual labour rates which will be in existence during the future period. Standard labour rates should be fixed after considering the expected increase in the rates of pay or wage board recommendations. If overtime is necessary to complete the job within the required target time, such overtime payment should also be considered while setting labour rates. Standard wage rates are decided in a different manner when price rate and incentive or premium plans are in operation in company.
iii) Standard Direct Expenses: If there are any direct expenses relating to any cost centre, a standard should be set. In this case, setting the standard is a manner of common sense.
iv) Standard for Overhead: Determination of standard for overhead is more complex than that of material and labour. This involves two problems:
Estimation of the overhead components, such as indirect material, indirect labour, rent, rates, taxes, depreciation, etc.
Determination of estimates of production which forms the basis for setting overhead rates.
Standard Cost Card:
All the above standards are recorded on a standard cost card. Such card is prepared for each unit is produced. It discloses the various operations through which the product passes. Standard cost card also gives standard unit cost of a product. Maintenance of this card is an important aspect of standard costing technique. It serves as a valuable aid in the preparation of price list and formulation of production and pricing policies.
Revision of Standards:
Accountants differ widely in their opinion relating to the revision of standards. One group of accountants feels that if standards are revised during the accounting period, the yard stick which is used to measure efficiency is destroyed. Therefore, they feel that revision of standards should be delayed until the end of the accounting period. The second group feels that the standards should be changed immediately as soon as it is found to be defective or no- workable. Incorrect standards adversely affect initiative and incentives of the employees of the organization.
The third group feels that no change should be made in the quantity standards of materials unless there is a change in the type of materials, quality of materials and the method of production. However, the standard should be revised if there is a mistake in the original standard or a permanent change in the costs has taken place such as increase in duty or tax imposed by government authority, changes in minimum wages fixed by the government. Similarly minor changes are constantly made in labour and machine operations which may cause a small variation between the standards and the actuals.
In every organization people at the top are constantly busy in bringing technological changes in business in order to improve efficiency. When such changes are made, standards are to be changed immediately. Price standards for materials labour should be revised when there are significant changes in the market price of material and labour. Outdated standards do not help the management. Specific standards may be modified without disturbing the entire standard costing system
Variance Analysis:
This is the most important managerial report of Standard Costing. Variance may be defined as the difference between the standard cost and actual cost. Variance analysis is the process of analyzing variances by sub-dividing them in such a way that management can locate responsibility for a particular performance. The variance may be favourable or unfavourable. The variance is said to be favourable when actual cost is less than standard cost and unfavourable when actual cost is more than the standard cost. The management can achieve cost control through variance analysis. Variance analysis can pinpoint the responsibilities of individuals and departments. For e.g. the purchase manager will be held responsible for unfavourable material price variance, the production manager for unfavourable material usage variance, etc. Broadly the variances may be divided into two categories:
A) Price Variance
1. Material price variance;
2. Labour rate variance;
3. Variable overhead variance;
4. Sales price variance
B) Volume variance or usage variance
1. Material usage variance;
2. Labour efficiency variance;
3. Fixed overhead volume variance;
4. Sales volume variance.
As each of the above variances has vast coverage, the emphasis in this chapter is on the material and labour cost variance.
Essentials of sound variance analysis:
Standard should be meaningful and set accurately.
Operating conditions should be controllable.
There should be an effective system to measure performance objectives.
Responsibility for variances should be clearly defined.
Variances must be based on scientifically established standards.
A) MATERIAL COST VARIANCE:
It is the difference between the standard cost of material and the actual cost of material used. For deciding material cost variance it is necessary to know the-
1. Actual quantity of material used.
2. Actual price per unit.
3. Standard quantity of material.
4. Standard price per unit.
i) Material Price Variance:
It is that portion of the material cost variance, which is used due to difference between the standard price specified and the actual price paid. It is given by the following equation:
= (Standard price – Actual price) x Actual quantity of material used
Material price variance is caused due to following reasons:
Change in purchase price;
Change in delivery cost;
Change in landing cost;
Failure to obtain quantity discount.
ii) Material Usage Variance:
This is also known as quantity variance. This is found by comparing the actual usage with the standard usage of materials. It is given by the equation as under:
= (Standard quantity – Actual quantity) x Standard price per unit
Usage variance is caused due to the following reasons:
Use of different grade of materials;
Change in the design of the product;
Change in the performance of labour;
Carelessness in handling of materials;
Wastage of scrap;
Defective materials;
Rejection of completed work necessitating additional material, withdrawals from stores;
Pilferage;
Non-Standard materials used;
Incorrect booking of material usage.
iii) Material Mix Variance:
It is the portion of usage variance which is due to the difference between the standard and the actual composition of a mixture. It is given by the formula:
= Standard Unit Price X (Standard Quantity Mix – Actual Quantity Mix)
This formula is used when the actual weight of mix and the standard weight of mix do not differ. When there is a change in the actual weight of mix and the standard weight of mix, the following formula should be used:
= Standard Price per unit X (Standard Quantity – Revised Standard Quantity)
This variance is caused due to the following reasons:
Non-Availability of expected mix.
Policy to change the mix.
iv) Material Yield Variance:
In a process industry, loss in production may be normal and abnormal. Normal loss is taken into account while setting the standard. However, actual output differs from the standard output due to abnormal loss. This difference is termed as yield variance. Yield variance is the difference between the standard yield and the actual yield obtained. This is basically a portion of material usage variance. Symbolically it is:
= Standard material cost x (Standard Yield (output) – Actual Yield) per unit of output
Yield Variance is caused due to changes in waste, scrap, etc.
B)
C) Labour Cost Variance:
This is the difference between standard cost of labour and the actual cost of labour employed.
i) Labour Rate Variance
It is the portion of the labour cost variance. It is due to the difference between the standard rate specified and the actual rate paid. It arises due to following reasons:
Payment of wages at a higher rate;
Change in the grade of labour;
Addition to workers;
Change in the method of payment of wages.
Labour rate variance is given by the following formula:
= (Standard Rate – Actual Rate) X Actual Hours
ii) Labour Efficiency Variance
This variance is portion of labour cost variance. It is due to the difference between the standard labour hours specified and the actual labour hours expended. It is given by the formula:
= (Standard Hours – Actual Hours) x Standard Rate per hour
Following are the causes of efficiency variance:
Slow workers;
Employees delay by factors beyond their control;
Poor Working conditions;
Employees restrict the output;
Abnormal length of run;
Quality of supervision;
Change in the method of production;
Change in tools;
Quality of materials;
Incorrect booking of labour time.
iii)
iv) Labour Mix Variance
This variance is similar to material mix variance. It arises only when the composition of workers differs from that is specified. It shows how much is the variance due to changes in the composition of workers. It is calculated as follows:
Labour Mix Variance = Standard Cost of - Standard Cost of
Standard Mix Actual Mix
v) Idle time Variance
Idle time variance is that portion of wage variance which is due to specified idle time of the workers. It is calculated as under:
= Abnormal idle hours x standard wage rate.
Idle time variance will be always unfavourable. Idle time variance is caused by the following:
Strikes;
Lockouts;
Breakdown of machines;
Interruption in power supply;
Lack of raw materials/tools, etc.
Analysis Of Variances
After calculation of variances they are analyzed to determine:
i) Where did the variances occur?
ii) Which cost elements were at a variance?
iii) What were the causes of these variances?
iv) Who were responsible for the variances?
Significance Of Variance Analysis
Variance analysis is significant in evaluating individual performance.
It helps in assigning responsibilities to individuals.
It provides motivation to individuals.
Variances are analyzed to find out their causes.
Corrective action can be taken immediately to improve performance in future.
It facilitates to reveal difficulties quickly.
It ensures cost control.
It makes it possible to manage by exceptions.
Presentation Of Variance Analysis To Management
The effectiveness of a control system depends upon how quickly the necessary data are reported to the management. After analyzing the variances, the report is prepared for presentation of information to management. This facilities management to take corrective action quickly. The variance analysis may be presented to the management in a systematic manner. There is no hard and fast rule for presentation of information to management in a systematic manner. However, the form of presentation should be suitable, appropriate to the level and purpose.
Following points should be remembered while reporting Standard Costing:
The reports should be simple, clear and quick.
The reports should disclose the level of efficiency achieved.
There should be a comparison between the results achieved and the standard set.
Variance arising out of each factor should be segregated correctly. Controllable and non-controllable variances should be separated.
Principle of exception may be followed.
Wherever possible charts and graphs should be used for reporting about variances.
Variance Analysis - Case
The Procedure of variance analysis (Material cost Variance) can be shown with the help of following case:
Consumption per 100 units of product is as below -
Variances:
1. Material Cost Variance = Standard Cost – Actual Cost.
= 4,400 – 5,200
= 800 (Adverse)
2. Material Price variance = Actual Quantity (Standard price – Actual
price)
For A = 50 (50 –50) = 0
For B = 60 (40 –45) = 300 (Adverse)
Total = 300 (Adverse)
3. Material Usage variance = Standard price Standard – Actual
Quantity Quantity
For A = 50 (40 – 50) = 500 (Adverse)
For B = 40 (60 – 60) = 0
Total = 500 (Adverse)
4. Material Mix variance = Standard Rate Revised Standard - Actual
Quantity Quantity
Revised Standard Quantity = Standard Input of a material X Total actual
Total Standard Output Input
For A = 40/100 X 110 = 44 units.
For B = 60/100 X 110 = 66 units.
Material Mix variance =
For A = 50 (44 – 50) = 300 (Adverse)
For B = 40 (66 – 60) = 240 (Favourable)
Total = 60 (Adverse)
5. Material Yield variance = Standard Price (Actual Yield – Standard
Yield)
Standard Price = Total Standard cost
Total Standard Output
= 4,400
100
= Rs 44
Analysis:
Variance from standard can be seen in material cost due to deviations from standards in the material price which may be due to change in price, delivery cost etc and material usage due to due to deviations in the material mix and the yield of material. This may be due to use of different grades of materials, change in design of the product, wastage of scarp etc.
The management must be informed about the variances and its proper causes. Corrective action should be taken immediately to improve the performance in future.
Marginal Costing
Cost can be classified into fixed and variable cost. Variable cost varies with the changes in the volume of output or level of activity. Fixed cost on the other hand relates to time and does not vary with the changes in the level of activity. Because of inclusion of fixed cost in determination of total cost of a product, the cost per unit or process varies from period to period according to the volume. This has given rise to the concept of Marginal Costing. Marginal Costing is concerned with determination of product cost which consists of direct material, direct labour, direct expenses and variable overheads. Variable costs per unit are fixed and fixed costs per unit are variable with changes in level of output. Marginal costing or Direct Costing is in contra distinction to Absorption Costing/Total Costing.
In Absorption costing technique, all types of costs, fixed as well as variable, are charged to products. The drawback is that since all costs are charged to a product, it is possible that cost units are burdened even with the costs which are not caused by them. Due to this, sometimes, profitable jobs may be rejected.
The ICMA has defined Marginal cost as “ as the amount at any given volume of output by which aggregate costs are changed if the volume of output is increased or decreased by one unit”. From the analysis of this definition it is clear that increase/decrease in one unit of output increases/reduces the total cost from the existing level to the new level. This increase or decrease in variable cost from existing level to the new level is called as marginal cost.
Suppose the cost of producing 10 units is Rs. 200. If 101 units are produced the cost goes up by Rs.2 and becomes 202. If 99 units are produced, the cost is reduced by Rs.2 i.e. to Rs. 198. With the increase or decrease in the volume the cost is increased or decreased by Rs.2 respectively. Thus Rs.2 will be called marginal cost.
Marginal Costing means “ the ascertainment of marginal cost and of the effect on profit on changes in volume or type of output by differentiating between fixed and variable costs”.
Marginal costing is not a method of costing. It is a technique of controlling by bringing out relationship between profit and volume.
Features:
Elements of cost are differentiated between fixed costs and variable costs.
Only the variable or marginal cost is considered while calculating product costs. Fixed costs do not find place in product cost.
Prices are based on marginal cost plus contribution.
It is a technique of cost recording and cost reporting.
Profitability of various products is determined in terms of marginal contribution.
Concept of Profit
Profit is known as ‘Net Margin’. Net Margin is calculated after deducting fixed cost from total contribution or gross margin. Profit is an excess of contribution over fixed cost.
Profit = Contribution – Fixed Cost
Contribution
Contribution margin concept indicates the profit potential of a business enterprise and also highlights the relationship between cost, sales and profits. Contribution margin is the excess of sales revenue over variable expenses. From the contribution margin, fixed expenses are deducted giving finally operating income or loss. Contribution is thus to recover fixed costs. Once the fixed costs are recovered, any remaining contribution margin adds directly to the operating income of the firm. Contribution margin is a highly useful technique for planning and decision making by the management.
Thus the equation of contribution margin can be stated as follows:
C = S – V
Where C = Contribution, S = Sales, V = Variable Cost.
Profit/Volume Ratio
This is popularly known as P/V Ratio. It expresses the relationship between the contribution and sales. P/V Ratio is given by the formula:
S – V x 100 = C X 100
S S
P/V Ratio can be determined by expressing change in profit or loss in relation to change in sales. P/V ratio indicates the relative profitability of different products, processes and departments.
P/V ratio is most important to watch in business. It is the indicator of the rate at which the organization is earning profit. A high ratio indicates high profitability and low ratio indicates low profitability. It is also useful for calculating Break Even Point, profit at given level of sales, sales required to earn a given level of profit etc.
Break-Even Analysis
The break-even analysis is an extension of the technique of marginal costing. The main objective of break even-analysis is the determination of that level of output, where the sales and total costs are equal i.e. they are break- even. At this level, therefore, there will be no profit and no loss and hence it is known as break-even point. This the point at which the ‘ contribution’ is just sufficient to meet the ‘Fixed costs’. It is also known as ‘Equilibrium Point’ or ‘Balancing Point’ or No-profit, no loss point’. It is that stage at which the losses stop and profits begin.
Thus, break-even analysis magnifies a set of relationship of fixed costs, variable costs, sales price and costs, on profit can be estimated with reasonable accuracy.
The management is always interested in knowing the effect of an increase in selling price or costs, on the profits. It would also like to know the level of output at which the business breaks even i.e. it does not incur any losses. The management would also like to know, whether the business can accept any order at a price lower than normal price. All these questions are answered by the break-even analysis.
The break-even analysis is based on the behaviour of the fixed and the variable costs due to change in production/output. Within a given capacity, if the production and sales increase, the variable costs per unit remain constant, but fixed costs per unit decline. As a result, the profitability increases with increased production and sale. Break-even point can be calculated by the following formula:
In terms of output = Fixed Cost
Contribution per unit
In terms of sales value = Fixed Cost
P/V ratio
Assumptions
Costs can be classified into fixed and variable categories.
Fixed costs remain fixed for the entire volume.
Variable costs change according to the change in output.
Selling price per unit remains the same for the entire volume.
Market is sufficient to absorb the entire output.
Break Even Chart
A break-even chart is a graphical representation of the break-even analysis and the break-even point. It shows the profitability of an enterprise at all levels of output. It indicates the break-even point as well as the points at which certain profit or loss is made. Thus the break-even chart indicates the fixed costs, variable costs, total cost, sales value, profit or loss, break-even point and the margin of safety. However the construction of the break-even chart is based on certain assumptions which are as follows:
Fixed cost, method of production and the product mix will remain constant.
Prices of variable cost factors will remain unchanged.
Semi-variable cost is segregated in to variable and fixed costs.
Operating efficiency will remain unchanged.
There will be no changes in the pricing policy.
Sales equal production.
The break-even point can be shown with the help of the following illustration:
Fixed costs = Rs. 40,000
Variable costs per unit = Rs. 10
Selling Price per unit = Rs. 20
B.E.P = 40,000 = 40,000
(in units) 20 – 10 10
= 4000 units
B.E. P = 4000 x 20 = Rs 80,000
(In value )
The horizontal axis of the graph indicates the output in number of units and the vertical axis represents the amount in rupees. The first step is to draw the fixed cost line. This line has to be parallel to the horizontal axis, as the total variable costs increase with every increase in output. The variable cost curve is drawn just above the fixed cost line. This will be a rising curve, as the total variable costs increase with every increase in the output. The selling price curve will also be drawn accordingly. It will start at ‘0’ point, as at zero level of output the selling price is zero. The point where the sales line intersects the total cost line at the B.E.P is known as the Angle of Incidence. It shows the rate at which the organization is earning profit once the B.E.P is reached. The wider the angle, the greater is the rate of earning profits with increase in sales.
Margin of safety:
It is the difference between sales and the break-even point. If the distance is relatively short, it indicates that a small drop in production or sales will reduce profit considerably. If the distance is relatively short it indicates that a small drop in production or sales will reduce profit considerably. If the distance is long it means that the business can still make profits even after a serious drop in production. it is important that there should be reasonable margin of safety , otherwise a reduced level of production may prove dangerous.
Uses of Break Even Analysis
It facilitates determination of selling price which will give the desired profits.
It makes possible to divide the sales volume to cover a given rate on capital employed.
The management can forecast profit and volume at levels of activity.
It suggests making change in sales mix.
It helps the management to do inter-firm comparison of profitability.
It shows the impact of changes in costs on profit.
It enables the management to plan for the optimum utilization of capacity.
Limitations
Break-even analysis is based on the assumption that costs can be classified into fixed and variable categories, which in reality is very difficult to distinguish.
It assumes that fixed cost remains constant. However in practice it may change. Variable costs may not vary in direct proportion to the volume.
The assumption regarding production and sales does not realize in practice. Selling price may not remain constant.
The assumption that only one product is produced does not hold true in practice.
The analysis is static. However, circumstances are dynamic. Break-Even analysis becomes complicated when all these changes are to be incorporated.
It does not consider capital employed in business. It presents only one fact of profit planning.
Cost Volume Profit Analysis
Cost Volume Profit analysis is an important tool that provides management with useful information for managerial planning and decision-making. Profits of a business firm are a result of interaction of many factors. Among them the many factors influencing the level of profits, the following are considered the key factors:
Selling prices.
Volume of sales.
Variable costs on a per unit basis.
Total fixed costs.
Sales Mix (proportion or combinations in which different products are sold).
To do an effective job in planning and decision-making, management must have analyses which allow reasonably correct prediction of how profits will be affected by a change in any one of these factors. Also, management needs an understanding of how revenues, costs and volume interact in providing profits. All these analyses and information are provided by Cost Volume Profit analysis.
The objective of any organization is to earn profit. Profit depends upon a large number of factors, the most significant being cost of manufacture and the volume of sales affected. Both these factors depend on each other. Volume of sales depends upon production which is related to cost. Cost is affected by many factors viz
1) Volume of Production;
2) Product Mix;
3) Internal efficiency;
4) Methods of production; and
5) Size of plant etc.
Of the above factors, volume is the most significant factor which has got greater influence on costs. Cost is divided into two categories viz. fixed costs and variable costs. Volume is affected by many factors. There are some outside factors which are beyond the control of the management.
Profits are affected by cost and volume. The management must have at its disposal the analysis which allows reasonably accurate presentation of the effect of a change in any of these on profits.
Cost volume profit analysis furnishes a picture of the profit at various levels of activity. It helps the management to distinguish between the impact of sales fluctuations and the results of price or cost upon profits. It enables the management to understand the change in profits in relation to output and sales.
Volume is expressed in terms of sales capacity i.e. percentage of maximum sales, value of sales, unit of sales. Production capacity is expressed in terms of percentage of maximum production, production in physical terms, direct labour hours and machine hours.
Objectives:
To forecast profit accurately.
To facilitate setting up of flexible budgets.
To assist in performance evaluation for the purpose of control.
To help in formulating price policies.
To know the amount of overhead costs which would be charged to product at different levels of operation.
Limitations of C.V.P.A
C.V.P.A Analysis is subject to certain limitations and assumptions which are to be kept in mind in order to do proper interpretation. The main limitations and assumptions are given below:
It is assumed that the production facilitates for the purpose of the analysis do not change.
Analysis will be realistic if material price, labour rates and selling price remain fairly constant.
The efficiency of plant and other production facilities assumed to remain as expected.
It is assumed that costs can be correctly classified into fixed and variable costs.
It is assumed that variable costs are variable at all levels of activity.
Profit Chart
This is a variation of Break Even Chart. It is also called as profit volume chart or profit volume analysis graph. In this chart the horizontal axis shows the sales and vertical axis shows profit or loss. The profit line is plotted by computing the profit or loss at each level. The point at which the profit line intersects the horizontal axis is the break even point. Profit chart is a pictorial presentation of cost volume profit relationship.
Benefits
It shows the break-even point and also shows the effect on profits of changing prices of a product.
It indicates the effect of a product mix on profits.
It points out any deviations of actual performance from changes in volume.
Make or Buy Decision
Make or buy decisions arise when a company with unused production capacity considers the following alternative:
To buy certain raw materials or subassemblies from outsiders.
To use available capacity to produce the items within the company.
The objective of make or buy decision should be to utilize the firms productive and financial resources. Costs that will be incurred under both analysis are not relevant to the analysis. Make or buy decision is explained with the following example:
Stoner co uses 3 different components (materials) in manufacturing its primary product. Stoner manufactures 2 of the components and purchases one from outside suppliers. The company is currently developing the annual profit plan and the sales are highly seasonal. Component 2 cannot be acquired from outside. However component 3 can be purchased. The 3 components have critical specifications. The annual profit plan provided the following data:
Component 3 unit cost (at 12,000 units) & average inventory level at 500 units.
Materials(direct) Rs 1.40
Labour (direct) Rs 2.20
Fixed O/H Rs 0.40
Annual machine rental Rs 0.50
(Specially used for component 3)
Variable factory O/H Rs 1.00
Average storage cost Rs 0.40
(Fixed)
Rs 5.90
The purchase manager investigated outside suppliers and found one who would like to sign a contract for one year for 12,000 top quality units as needed during the year at Rs 5.2 per unit. Serious consideration is being given to this alternative. Should Stoner Co make or buy component 3.
Statement of cost per unit
Cost of purchasing component 3 - Rs 5.20
Excess of purchase price over variable cost – Rs 0.10
Since purchase price is higher than variable cost it is not advisable to purchase component 3. Stoner Co should produce this component.
In the above analysis the fixed overhead has not been considered because it will be incurred under both alternatives i.e. the cost will be incurred even if component 3 is purchased from outside. The fixed overhead is a sunk cost which is not relevant to decision making. Logically, the costs that will be increased or decreased as result of making the part should not be considered.
Costs that will be incurred under both alternatives are not relevant in the analysis. The firm should make an analysis of the cost, quality, and quantity considerations of the individual make or buy decisions. Other potential use of available capacity should also be considered; and qualitative factors should be evaluated in the process. These include price stability from the suppliers, reliability of delivery and the quality of the material or the component involved.
Make or buy decisions are often complex, involving not only present costs but also future costs resulting from such factors such as capacity, trade secrets, technological improvements etc. It is the responsibility of the top management to determine the basic factors that should be taken into consideration in make or buy decisions.
Advantages of Marginal costing:
Cost-volume profit analysis and other data required by the management for profit planning are readily available.
Cost reports are easier to understand for the management and the impact of fixed costs can be better under stood.
Relative Appraisal of products, product mix, and exports possibilities is facilitated.
Closing stock valuation corresponds to the direct costs required to be incurred on them. The fixed costs are not included therein.
It can be easily combined with standard costing and budgetary control.
It helps in profit planning by break-even charts and profit volume-cost relationships.
Disadvantages in Marginal Costing:
It is very difficult to fully segregate costs into fixed and variable. It may give misleading results.
The valuation of stocks and W.I.P are on the lower side and hence they are understated. The profit and loss account would not, therefore, show a true and fair view.
Contribution is no the final guide for determining the profitability.
In practice, the selling price, fixed costs and variable costs vary. Hence the basic assumption of marginal costing does not hold good.
For long range pricing and other policy decisions, impact of fixed costs on marginal income should be considered.
Marginal Costing – Case
An enthusiastic marketing manager suggests to his managing director that only if he is permitted to reduce the selling price of a product by 20% he would be able to achieve a 30% increase in sales volume. The managing director, finding that the sales volume increase exceeds in percentage the extent of requested reduction in price, gives the clearance. You are given the following information:
Present selling price Rs 7.50
Present volume of sales 2,00,000 nos.
Total variable costs Rs 10,50,000.
Total fixed costs Rs 3,60,000.
Assuming no changes in the costs pattern in the coming period:
a. Examine the consequences of the managing directors decision assuming that 30% increase in sales is realized.
b. At what volume of sales can the present quantum of profits be sustained, after effecting price reduction.
Solution:
Proposed result:
Reduction of selling price by 20%
New Selling Price: 7.50 - 20 % of Rs 7.50
= 7.50 – 1.5
= Rs 6
Increase in volume by 30%
New volume of sales: 2,00,000 + 30% of 2,00,000
= 2,00,000 + 60,000
= 2,60,000.
Statement showing the present result and the result after price reduction
The above statement shows that account of reduction in the selling price there will be loss of Rs 1,65,000 as compared to the present profit of Rs 90,0000 in spite of increase in the sales volume. Thus, there will be an effective drop of Rs 2,55,000 on account of the decision taken by the managing director on the suggestions made by the marketing manager.
The drop in profits of proposed result can be attributed to increase in total variable cost (due to increase in the number of units) and corresponding decrease in selling price by 20%. As a result the proportion of contribution to sales or the Profit volume ratio has reduced from 30% to 12.5%.
Statement showing the volume of sales at which the present profit can be retained after price reduction.
Volume of sales for the profit of Rs 90,000 = Fixed cost + Desired profit
Contribution per unit
The above statement shows that to retain the present profit after price reduction the volume of sales need to be 6,00,000 units (200% increase is required) to justify a reduction of selling price by 20% without in any way affecting the present profit.
Capital Budgeting
Financial Management focuses on mainly two things – Sources of funds and the Application of funds. The application of funds involves a decision regarding what assets are to be invested into. This investment decision involves decision regarding investment in Fixed Long Term Assets or Short-Term Assets. The first type of decision (Regarding Fixed long term assets) is widely called as capital budgeting or a capital expenditure decision whereas the second decision is called as Working capital decision.
Thus, Capital Budgeting decision means a decision relating to planning for capital assets as to whether or not money should be invested in long tem projects e.g. setting up a factory or purchase of a new machine. It involves an analysis of the various proposals regarding a capital expenditure and to choose the best out of the various proposals regarding a capital expenditure and to choose the best out of various alternatives. Thus Capital Budgeting decision involves a series of cash outflows over a number of years in return for an anticipated flow of future returns over a period of time longer than one year. There is relatively long time period between the initial outlay and the anticipated returns.
Importance of Capital Budgeting
The capital budgeting decision involves acquisition of fixed assets which are relatively costly and therefore the decision affects the financial stability and condition of any organization to a greater extent.
The decision and its correctness shape the destiny of a company’s financial health. A wrong decision can endanger the very survival of the organization.
The decision, once taken is not easily reversible since the fixed asset bought may not be suitable for any alternative usage.
This decision is not very easy to make as its benefits accrue only in the future. The future being uncertain, an element of risk is involved. A failure to estimate future cash inflows accurately can lead the entire organization into a financial crunch.
Most of the organizations have a limited Capital Budget and a large number of projects compete for these limited funds. The firm must, therefore, ration them in a way to maximize long-term returns. Projects are therefore, to be ranked on the basis of criteria’s like rate of return, risks involved and the number of years over which its return is expected to accrue. Thus, the decision gathers even more importance in times of Capital Rationing.
Most firms face difficulties in getting adequate finance. Hence available finance has to be used in such a manner that it will improve profitability of the organization.
Evaluation Techniques
The various methods and criteria’s involved in a Capital Budgeting decision can be broadly classified as follows:
I. Pay-Back Method (PB)
This is the simplest quantitative method for appraising capital expenditure decisions. This method evaluates the number of years it takes for the future cash inflows to pay back the initial cash outflow i.e. the original cost of an investment. The cash inflows here mean the annual profits after tax but before depreciation. Depreciation is deducted from the profits as its is valid allowable expenditure, which gives us the profits before tax from which the tax liability for the year is deducted to get the profits post tax. However, depreciation does not involve any outflow of cash since it is not to be paid and is only an accounting charge. Therefore, in order to find the actual effective cash inflow it is then added back to profits post tax before comparing the same with initial outflow to take the capital budgeting decision. There are two ways of calculating Pay-Back periods.
a) When the Cash inflows are uniform every year
Here the initial cost of investment is divided by the constant annual cash inflow to get the PB period. For Example, an investment of Rs 40,000 in a machine is expected to produce a cash inflow of Rs 8,000 p.a then the PB period = 40,000 / 8000 = 5 Years.
b) When the projected cash inflows are not equal every year
In such situation, PB is calculated by a process of cumulating cash inflows till they equate the original investment outlay. For example supposing the initial cost is Rs 50,000 and the annual inflows after tax before depreciation is –
Year I = Rs 10,000
Year II = Rs 15,000
Year III = Rs 20,000
Year IV = Rs 25,000.
The initial cost of Rs 50,000 will be recovered between year 3 and 4. Therefore PB period will be 3 years plus a fraction of the 4th year. By the 3rd year, Rs 45,000 is recovered. The remaining Rs 5,000 would be recovered in the 4th year whose annual inflow in Rs 25,000. Therefore the fraction of the 4th year needed to reach the cost would be 5,000 / 25,000 i.e 1/5. Therefore PB period = 3 1/5 years.
The project or expenditure with a lower pay-back period is normally preferred. An alternative way of expressing the payback period is the “payback period reciprocal”. Higher the reciprocal, more profitable will be the project. The reciprocal is expressed as –
1 x 100
Payback period
Merits:
This method is quite simple and easy to calculate. It clarifies that there is no profit unless the payback period is over as till then, the only cost is recovered.
It favours projects with shorter payback periods since risks normally stand to be greater in long-term projects as future is uncertain.
The method is very useful in situations of liquidity crunch and high cost of capital as faster recovery of initial investment is necessary.
It indicates to the prospective investors when their funds are likely to be repaid.
It does not involve assumptions about the future interest rates.
Limitations:
The method stresses on capital recovery ignoring the overall profitability. It fails to consider the returns which accrue after the payback period is over. Two projects with equal PB periods will be given the same ranking although their inflows after the PB period may be different both in terms of years and quantum. Moreover projects with larger cash inflows in the latter years may be rejected in favour of projects with larger inflows in their earlier years.
This method ignores the time value of money since the cash inflows are not discounted for the decision making process.
It doe not consider the salvage value of an investment.
It makes no attempt to measure the percentage return on capital employed.
II. Average Rate of Return (ARR)
This method is also called Accounting Rate Of Return. It is based on the average annual accounting yield of a project. The average profit after tax and depreciation as a percentage of total investment is considered. Here the depreciation is not added back to the annual profits.
How much is earned on the investment every year is the decider.
A.R.R = Average annual Profits after Tax and Depreciation.
Average Investment
The average investment is determined by dividing the net Investment by two assuming that by SLM method of depreciation, the cost of investment at the end of its life will become zero. Therefore, on average one-half, of the initial cost will be invested on which average annual return should be calculated. In case there is an estimated salvage value then average is done by dividing the depreciable cost (cost – salvage) by two. The salvage value will however, remain tied up in the project throughout its lifetime.
Average Investment = Salvage + 1 (cost – salvage)
2
The project with a higher A.R.R is accepted. Sometimes, the management compares this rate with a pre-determined minimum rate (called cut-off point). Any capital project below that rate will be rejected.
Merits:
The method is simple and easy to calculate.
It considers the incomes form the project throughout its life and not just the initial years unlike the PB method.
When a number of investments proposals are considered a quick decision can be taken on the basis of this method.
Limitations:
It considers only the accounting return after depreciation and not the actual cash flows which neutralize the effect of non-cash items like depreciation. Moreover it does not consider the time value of money.
This method doesn’t differentiate the projects on their size of investments required. It is likely that different projects with different sized investments may have the same ARR and therefore, the firm would not be able to take the required decision under such a situation.
It is biased under short-term projects.
There is no full agreement on the proper measure of the term investment.
It does not indicate whether an investment should be accepted or rejected unless the rates are considered with the target.
Problems can arise in determination of profit which depends on several factors.
Techniques which recognize time value of money:
These methods consider the fluctuations in the value of money due to efflux of time and here the cash inflows are first discounted at the rate as per the Present value table. There are four methods under this criteria:
i) Net Present Value (NPV) method
ii) Internal Rate of Return (IRR) method
iii) Profitability Index method
iv) Discounted Payback Period method.
i) Net Present Value Method (NPV) Method
This method recognizes that cash flows at different points of time differ in value and are comparable only when they are first brought down to a common denominator i.e. present values. For this purpose every cash inflow and outflow are first discounted to bring them down to their present value. The discounting rate normally equals the opportunity cost of capital. The Net Present Value (NPV) is the difference between the Present value of cash inflow and the Present value of cash outflow. The decision rule for a project here is to accept that project if the NPV is positive and reject if it is negative. In case of alternative projects decision, the project with highest NPV would be assigned the first rank followed by others in descending order.
Merits:
It explicitly considers the time value of money and the cash inflows over the entire life of a project.
This is the best method for decision making for mutually exclusive projects.
It leads to maximization of shareholders wealth. The market price of the shares will be affected by the trends of future expected inflows and the present value of these inflows will reflect a more accurate prediction for e.g. if NPV > 0 means that the return would be higher than invested for by the shareholders which might lead to increase in share prices.
It considers the total benefits arising out of the proposal over its life.
It is instrumental in achievement of financial objective.
Limitations:
It is more difficult to calculate than PB or ARR method.
The accuracy of this method depends on the authenticity of the discounting rate for calculating the present values. There is a lot of difference of opinion regarding the method of calculating it.
This method may not give satisfactory results where two projects having different effective lives are being compared.
It emphasizes the comparison of net present value and disregards the initial investment involved. Thus it may not give dependable results.
ii) Internal Rate of Return (IRR) method
This is the second time-adjusted rate of return method for appraising capital expenditure decisions. It is the discount rate at which the aggregate present value of inflows equal the aggregate present value of outflows i.e. the rate at which NPV = 0.
In the NPV method, the discount rate is normally equal to the cost of capital which is external to the project under consideration. But in this method, the discount rate depends on the initial outlay and cash inflows of the project under consideration. It is therefore, called the Internal Rate of Return. The IRR, once calculated is then compared to the required rate of return known as cut-off rate. The project is accepted if the IRR exceeds the cut-off rate. Otherwise it is rejected.
Merits
It considers the time value of money and the cash flows over the entire life of a project.
It does not use the cost of capital to determine the present value. It itself provides a rate of return indicative of the profitability of the proposal.
It would lead to a rise in share prices and to maximization of shareholders wealth in the same way as NPV method.
Limitations
The procedure for calculating is complicated and at times tedious.
Sometimes it leads to multiple rates which further complicate its calculation.
In case of more than one project, the project with the maximum IRR may be selected which may not turn out to be one which is the most profitable in the long run.
Projects selected on the basis of higher IRR may not be profitable.
Unless the life of the project can be accurately estimated, assessment of cash flows cannot be done.
iii) Profitability Index Method
This is also called as cost benefit ratio. Profitability Index is the present value of an anticipated cash flows divided by the initial outlay. The only difference between NPV and P.I method is that under NPV method the initial outlay is deducted from the present value of anticipated cash flows, whereas under Profitability Index, initial outlay is used as divider. A project is accepted when the Profitability Index is greater than one. Profitability Index can be measured as follows:
Profitability Index = Present value of cash inflows
Present value of cash outflows
iv) Discounted Payback period method
Under this method cash flows involved in a project are discounted back to present value terms. Then the cash flows are compared with the original investment to find out the payback period. This method allows for timing of the cash flows but it does not take into account the cash flows after the payback period.
Capital Budgeting - Case:
Jaypee electricals is considering purchasing one of the two machines. From the following information, using the Accounting rate of return method advice jaypee electricals regarding which of the two will be more profitable. The average rate of tax is 50 percent.
Solution:
Calculation of cash flows - Machine A
Calculation of cash flows - Machine B
The Accounting rate of return for Machine A (75 %) is more than that of Machine B (51 %). This point out that the rate of return for Machine A is higher and it gives more returns than Machine B, per year as compared with its investment. According to the Accounting rate of return Jaypee electricals should consider purchasing Machine A as it is more profitable.
Budgetary Control
Budgetary Control implies the use of various budgets in planning and controlling. The term ‘Budget’ is derived from a French word ‘Bougetts’ which means the purse in which funds are collected for meeting anticipated expenses.
The Institute of Cost and Management Accountants, London, defines budget as “A financial and/or quantitative statement prepared prior to a defined period of time, of the policy to be pursued during that period for the purpose of attaining a given objective.”
Thus, budget is cost plan for a period of time. Time/period is the most important factor in a budget and it provides the plan in terms of cost. Cost is the value of economic resources. Therefore, Budget is essentially a resource plan in terms of value, for a future fixed period. Forecast is a prediction of what will happen in a given set of circumstances. A Budget is a planned result that an organization aims to achieve/ attain. It is the objective of an organization set by the management. It is an instruction and sanction to the employees to work to achieve the objective.
Budget Characteristics
A period of time to be fixed to achieve the objective.
Forecast preparation.
Determination of the policies - sales to be achieved, profit to be made, investment to be made etc.
Computation of requirements in terms of quantities and values, to achieve the objectives and fulfill the policies of the management i.e. materials required for the forecast, men required etc. in quantity and value for Preliminary Budget.
Review of the forecast, policies and the preliminary budget; amend or modify the forecasts and policies, if necessary, and consequently the preliminary budget, until the acceptable budget emerges.
Acceptance of the budget – Which becomes the approved budget – “Master Budget” – to work with and attain. It becomes an executive order and sanction for the activities.
Budget Period
Budget period is the period for which the budget is prepared and followed to attain the objective. Budget period will depend upon the type of budget concerned and on the circumstances.
Objectives of setting budgets:
It serves as a declaration of policies.
It defines the targets for executives, at all the levels of management.
It provides a means of co-ordination of business activities.
It provides a means of communication.
It facilitates centralized control.
Budgetary Control
The Institute of Cost & Works Accountants, London defines the term, “Budgetary Control” as, the establishment of (departmental) budgets relating to the responsibilities of executives to the requirements of a policy, and the continuous comparison of actual with budgeted results either to secure by individual action objective of that policy or to provide a basis for revision.”
From the above definition it becomes clear that the process of budgetary control involves the following stages:
Fixing the responsibilities on executives/ managers.
Setting up of various budgets.
Recording of actual performance.
Comparison of actual results with the budgets
Calculation of deviations and investigation into causes of deviations.
Taking corrective measures, if and where necessary, to bring the actuals close to the budgets.
Thus, budgeting is an art of planning; budgetary control is the act of adhering to the plan.
Objectives of Budgetary Control
Planning: Budgeting helps management in preparing the detailed plan pertaining to production, sales, raw material, capital expenditure etc. While planning many problems are anticipated. Budgetary control helps management at all levels, in planning properly.
Co-ordination: In an organization, there are various departments carrying out different functions. Unless there is a co-ordination among the various activities of these departments, it is not possible to achieve the objectives. A department while planning cannot work in isolation . Proper co-ordination requires joint thinking and effort. There has to be effective communication among departments. A budgetary control system helps to have effective communication and co-ordination.
Control: Control is necessary to see that performance takes place according to standards. The function of controlling cannot be performed unless standards are set i.e. pre-determined. Budgetary control system consists of establishment of standards and finding out the deviations. The management can take corrective actions on the deviations reported, and to bring actual performance, close to the desired performance.
Communication: A budget is a communication device. It communicates information about the plans and policies of the organization.
Essential conditions For Budgetary Control
The company must have proper Organizational structure to get the maximum benefits from budgetary control. The organization chart should clearly define the responsibility of each executive.
The objectives of the business should be clearly defined.
There should be an effective system of accounting. It should provide relevant data quickly whenever required.
The organization should have a proper system of communication which enables the top management to communicate and receive feedback quickly. Based on the feedback, the top management should issue instructions for correcting the situations.
Effective implementation of the budgetary control system depends upon the budget manual which gives information about the plans, policies, procedures and operations of the organization.
While preparing budgets, the top management and other responsible executives should be consulted. It should allow the people of lower cadre to participate in the budget preparation process. A separate budget committee should be formed to look after the establishment of the budget and its implementations.
There should be an assurance from the top management, of co-operation and acceptance of the system.
The cost of the system should not exceed the benefits accruing.
The budget should be continuous, complete and realistic.
Budgeting Process
The budgeting process differs widely from one organization to another. Difference in management style, organization objectives, structure of competition and similar factors affect the procedures companies adopt in budget preparations. However there are a set of guidelines which are used in budgeting process by a large number of organizations which are as follows:
a) Obtaining estimates of sales, production level, expected cost and availability of resources from each sub-unit or division.
b) In many organizations, the budget committee evaluates the different plans submitted by various organizational units to determine the potentiality of plans in the overall interest of the company and the resources can be fairly allocated among the various units of the organization.
c) Communicating the budgets to responsible managers and the concerned departments.
d) The final budget is presented to the managers concerned and adopted as the plan of operation for the coming budget period.
e) As a feedback in the budgeting process, performance reports are prepared to inform departmental managers and the top management about the performance achieved in terms of budgeted figures. Such an investigation may call for a need to revise the budget during the year. This feedback of information can also be used as a basis for preparing the next year’s budget.
Steps in Budgetary Control System:
Preparation of Organization chart defining responsibilities of each member.
Establishing a Budget Committee consisting of senior executives of different departments, which decides the objectives of the organization and the methods to be followed for attainment of objectives.
Appointment of Budget Officer .The Budget officer prepares a budget manual which clearly defines responsibilities and its scope and policies of the organization and provides complete instruction for preparation of the budget.
Budget Centres (Departments for which budgets are to be prepared) will have to be decided.
Fixation of the budget period and ensuring the presence of a proper accounting system to record, analyze the information required, to assist the management in evaluating and controlling the performances.
Determining the Key factor which lays down the boundary within which the budget has to be drawn. The functional budgets cannot go beyond key factor. Sales, is most often the key factor in most industries
Types of Budget
There are various types of budget. On a broad perspective budget can be divided into two types:
1) Functional Budgets
2) Master Budget.
1) Functional Budgets:
A functional budget is one which relates to any of the functions or activities of an organization. The functions determine the scope of activities of various departments. Each department has to prepare its own budget. The following are the various functional budgets:
i) Sales Budget:
This budget is prepared by a sales manager. Preparation of sales budget is the most difficult job since it is very difficult to estimate future demands for a product. This is probably the most important budget as all other budgets depend upon the sales budget. The sales manager has to consider-
Analysis of past sales.
Market analysis.
Type of customers.
General trade and business conditions.
Special conditions.
Sales Budget is usually prepared in quantities and is based on products, territories, type of customers and salesmen.
ii) Production Budget:
This Budget is prepared by the production manager. It shows the quantity of products to be manufactured. It is based on:
The Sales budget
The Factory capacity
The budgeted stock requirements.
Policy of the management
Samples required for free issue.
The budget is classified into categories of products, manufacturing departments and months. While preparing production budget, allowance is made for a normal loss in production. This is required in order to see that net output is sufficient to meet the sales requirements and the year- end inventories. Production budget is used for computing the requirements of raw materials and components.
iii) Production Cost Budget:
This is also known as manufacturing budget and one based on cost standards. It is the quantity of goods to be manufactured, expressed in terms of cost. This budget consists of three subsidiary budgets:
Materials Budget
Labour Cost Budget
Manufacturing overhead Budget.
iii) Plant Utilisation Budget:
This budget indicates the capacity of plat required to execute the production programme as per the production budget. This budget is prepared simultaneously with production budget. Plant utilization and production budgets are interconnected. It determines:
The machine load in each department during the budget period.
The problem of overloading. Overloading may be sorted out by taking actions such as shift working, overtime working, sub-contracting, purchase of new machinery etc.
iv) Capital Expenditure Budget:
This budget is prepared for estimating the expenditure on fixed assets required during the budget period. This is based on the following:
Overloading indicated by plant utilization budget.
Report of the production manager requesting new machinery.
Report from distribution manager requesting new transport.
Report from the works engineer requesting for new machinery.
Report from Accounts and other Departments requesting new office equipments, etc.
Decision of management to expand.
v) Selling & distribution cost budget:
This a forecast of selling and distribution cost during a stipulated period. This budget is based on the sales budget. In addition to sales volume, other points to be considered while preparing this budget are, advertising planned during the budget period, distribution expenses etc. This budget is prepared by grouping the costs according to elements as under:
Direct Selling expenses consisting salaries & Commission of salesmen, motor car expenses etc.
Sales Office expenses consisting salaries, rent, rates, electricity, depreciation, postage, stationery, telephone, general expenses etc.
Distribution expenses consisting wages of warehouse staff, rent & rates of warehouse, electricity, insurance, export duty, packing etc.
Advertising expenses consisting radio, window display, coupon, offers, leaflets, etc.
vi) Purchasing Budget (Procurement Budget):
This budget lays down the quantity of materials to be purchased from month to month. It is necessary to ensure smooth production. Preparation of purchase budget requires drawing complete list of raw materials required to produce goods, the opening and closing inventories. Unless such a comprehensive list of requirements is prepared, purchases cannot be done properly. This budget is prepared for each type of material.
viii) Cash Budget:
This represents the cash receipts and cash payments and estimating cash balance for each month of the period for which budget is prepared. Cash budget is device for controlling and coordinating the financial side of a business. Cash budget serves the following purposes:
To ensure that sufficient cash is available whenever required,
To point out any possible shortage of cash so that necessary steps can be taken to meet the shortage by making arrangements with the bank for overdraft for loan.
To point out any surplus cash so that management can invest it in interest fetching securities.
This budget is based on several factors such as:
Several functional budgets particularly sales, purchases etc.
Credit terms on sales, purchases and expenses.
Preparation Of Cash Budget
Usually the responsibility of preparing the cash budget lies on the Treasurer or other Financial Executive. Cash budget has to be prepared by estimating cash receipts and payments.
Estimating Cash Receipts
Cash sales
Collection of debtors
Interest/Dividend on investment
Sale of assets etc.
Loans, advances, deposits etc.
Estimating Cash Payments
Payment for purchases
Payment for overheads
Purchase of assets
Payment to creditors
Payment for taxes
Payment for dividends/interest etc.
Repayment of loans/advances/deposits etc.
2) Fixed and Flexible Budget
The Institute of Cost & Management Accountants defines a Fixed Budget as the budget designed to remain unchanged irrespective of the level of activity actually attained. It is based on a single level of activity. A fixed budget performance report compares data from actual operations with a single level of activity reflected in the budget. Fixed budgets do not change when the production level changes.
However in practice fixed budgeting is rarely used as units are overlooked, a cost to cost comparison without considering the units may give misleading results. A fixed budget can be usefully employed when the budgeted output is close enough to the actual output. Maximum managerial control may be exercised by making comparisons with the actual operating figures.
A Flexible Budget is a budget that is prepared for a range i.e. for more than one level of activity. It is a set of alternative budgets to different expected levels of activities. The flexible budget is also known as variable budget, step budget, expense formula budget etc. The underlying principle of flexible budgets is that every business is dynamic, ever changing and never static. It has the following features:
It covers a range of activities.
It is flexible, i.e. easy to change with variations in production levels.
It facilitates performance measurement and evaluation.
The flexible budget provides a reliable basis for comparisons because it is automatically geared to changes in the production activity.
3) Master Budget
It is defined as “ the summary budget, incorporating its component, -functional budgets, - which is finally approved, adopted and employed”. Master budget summarises all the functional budgets. It means, a master budget can be prepared only when all the functional budgets are prepared and approved. Master budget is the overall plan of operations to be followed during the budget period. Master budget also takes the form of budgeted profit and loss account and the balance sheet.
Budget reports
Evaluation of performance and reporting of deviations from the budget is an integral part of budgetary control system. Establishment of budget will have no value unless the actual performance is compared with budget and variances with causes is ascertained, and reported to management for necessary action. For this purpose, budget reports showing the comparison between actual and budget should be prepared periodically in a columnar form. The report prepared should reveal the responsibility of the person and the possible reasons for the variance.
Advantages Of Budgetary Control
As budgetary control is an essential element in an organization it has several benefits. Some of the important ones are given below:
It aims at maximization of profits through effective utilization of resources & creating cost consciousness among the executives.
It reveals the weak points and deficiencies and helps management in taking corrective action.
It ensures the availability of working capital whenever required.
It provides a basis for internal check and develops the habit of thinking and analysis among the executives.
It facilitates bank credit and effective delegation of authority.
Limitations Of Budgetary Control
Since budgetary control is prepared on the basis of estimates, the effectiveness of the system depends upon the accuracy of the estimates.
Budgets are formulated on certain assumptions about the business conditions which are, in reality, changing. The budgets may bring about rigidity in future planning and hence there should be flexibility in the system particularly under changing circumstances.
It is costly system particularly for small concerns.
It is at times, regarded as the solution of all business problems and may lead to lukewarm human effort resulting into its failure.
It may be resented by the executives as it places control on human initiatives.
The limitations only suggest that the system of budgetary control should be dynamic and realistic.
Recent Developments
Cost Accounting is a developing discipline. The old order is giving way to the new concepts and techniques. There is more orientation toward decision-making and control. The practitioners are convinced that cost ascertainment and inventory valuation are not the sole objectives of cost accounting. The techniques of costing should help the management in controlling and reducing the costs. They should help the undertaking to survive better and grow faster. As a result, some new tools and techniques have been incorporated.
Just In Time (JIT)
JIT is the abbreviation of Just In Time. Its basic principle is that production components should be received as they are required, rather than building up inventories. Instead of stockpiling inventory to have when needed, the JIT approach depends on orders arriving regularly and on time. This concept is based on short, rapidly changing production runs operating in a timely manner rather than long, inflexible runs. The prime objective of JIT is minimizing inventory levels while eliminating stock outs.
Cost Audit
Audit is an attest or review function; it is an independent appraisal or certification. It is the process of examining evidence regarding a report or a statement to determine its correspondence to established criteria. It could also be described as systematic examination of books and records of a business with a view to ensuring that they show true and fair view and are not misleading.
Cost Auditing is the scrutiny of the recorded information to verify the recording of cost accountants and the appropriateness of the analysis. It seeks to ensure that all the routines and directions relating to cost accountants have been duly complied with, and the cost has been correctly ascertained with reference to circumstances and relevant data available.
In conducting a cost audit, the cost auditor does not only satisfy himself that the costs as compiled are correct as per the basic records, but also starts with the verification of basic records through independent means such as technical estimates, etc., and arrives at what the cost should have been. He probes into the principles followed in the ascertainment of costs. Clearly, this involves checking that:
The figures themselves are correct. It is not simply verification or confirmation of correctness of the cost accountants, but the verification of cost accountants themselves.
The cost accountants, cost centers and cost units are correctly charged. That is, it probes whether overheads have been allocated and distributed, closing stocks and work in progress correctly valued, etc. The ultimate objective of cost audit, therefore, is to reflect a true or near about true view of the cost of production, and a check on the adherence of cost accounting principles.
Mechanization of Accounts
In the application of the methods and techniques of cost accounting various kinds of mechanical devices have come to occupy an important place. In large organizations, the cost data have become so heavy that the manual operations cannot process it satisfactorily and with speed. It is the mechanical devices like summaries and reports that can be prepared promptly without errors and at a low cost and a large number of routine accounting functions could be carried out well which otherwise are a drudgery.
Three broad types of machines and equipments have been used in this connection:
(1) Key-driven machines: these include various kinds of adding machines, which, of course, perform subtraction, multiplication, and division work. Some are of the listing type where the results obtained by the machines are printed on a paper or tape. Accounting machines do not simply calculate but also do posting and bookkeeping work.
(2) Punched card machines: these obviously use punched cards which pass through three phases of punching, sorting and tabulation. From the original documents, data is is transcribed into specially designed cards by punching holes which machines can read. These are then sorted out, i.e., grouped or regrouped and arranged in alphabetical sequence. The arranged cards are now fed into the accounting machine called the Tabulator. The tabulator is an electrically operated machine which senses, one by one, the information given the holes in the punched cards, does the arithmetical calculations and finally prints the results in the form desired. The equipment designed to handle the punched card is called the unit record equipment, because the data punched in a card relate to a single or unit record.
(3) Electronic computers: these represent the most significant step in the mechanization of accounts. Data collected in a coded form (known as the input) are fed into the computer and processed at a very high speed. The results are then produced in the form of reports and documents (known as the output) in code or plain language as desired. These are two basic types of computers: analogical and digital. The fourth generation computer has also appeared with many improvements both in hardware and software.
Uniform Costing and Inter – Firm Comparison
Central to the methods and techniques of accounting is the ability to undertake intra-firm and inter firm comparisons. It is only through such comparisons that the management of the business can know whether it is operating above or below the general industry level. But before such comparisons are made, it is necessary that several members of the group of similar companies or a complete industry have adopted a uniform costing system. They have to follow more or less the same techniques, the same element of cost units, the same bases of overhead absorption, depreciation and scrap and losses. Uniform Costing stands for forsaking the alternative method of record keeping of cost in various enterprises. Instead it stands for the application of identical costing methods by different firms within an industry or a group. It denotes the se, by several undertakings, of the same costing principles and/or practices so as to produce comparable figures. The essence of uniform cost accounting is the formulation of standard concepts and the methods of cost accounting and their acceptance for the preparation of the costing figures. Hence, it can be practiced not only within an industry but also in respect to the operations of various plants, divisions and departments within a business. The main benefits of uniform costing are:
Higher standard for cost planning and control,
Inter-firm comparison,
Standard price list,
Reduced staff cost,
Better informed competition,
Inspires confidence in public,
Insurer of profits,
Representation to regularity authority.
Inter-Firm Comparison
The twin objectives of uniform costing are comparison and consolidation. Once the data of the group or the industry are consolidated they afford and intra-firm comparisons. Inter-firm comparison is a technique of evaluating the performances, efficiencies and cost of firms in an industry. It provides an objective and realistic measurement of efficiencies of companies inter se. Its principal function is to locate those areas in which an organization is working satisfactorily and those in which it is lagging behind others and needs improvement.
Conclusion
Modern day business is greatly influenced by competition, continuous improvement, technological changes, customer focus, process reengineering. In this complex and dynamic environment organizations have to take adequate steps to face major challenges and to formulate appropriate strategies to keep pace with the changing scenario. Management Accounting provides information to managers, decision makers and others within the organization to enable them to overcome organizational problems and deal successfully with the changing environment. Thus management accounting is concerned with gathering, classifying, developing and reporting information to the managers and others within an organization to help them in all their managerial activities.
The Cost Accumulation Systems focus on the cost concepts, the accumulation of cost data and the accounting procedure of cost allocation and absorption. Using the five aspects of costing the costs are classified in different categories such as fixed, variable, direct, indirect etc. These costs are then allocated to the respective process or the production procedure adopted. As different firms are engaged in different trade or business it is obvious that the accounting procedure may vary according to the nature of the business or manufacture. For example a firm engaged in construction business cannot use process costing as the work is not carried out in processes and its nature of operations is not standardized. Hence contract costing is best suited for this purpose.
Job and Batch costing are the types of costing/accumulation of cost data where the work consists of separate jobs-which in most circumstances is according to customer specifications. The costing procedure begins when an order is received from the customer and ends with the production of the final product.
Contract costing is a type of job costing where each contract is treated as a separate unit of cost. Due to the nature of activity the contract may be complete or incomplete at the end of the accounting year. Moreover the financial resources of the contractor would be severely strained if he does not receive payment until the completion of the contract. For this purpose the contractor receives some payment in proportion of work certified. As the contract is still in the stages of completion it would not be appropriate to transfer the entire amount of profit (Notional profit) to the Profit and loss account and hence the contract costing makes provision to transfer a part of profit to the P&L account and the rest is treated as reserve to meet future contingencies in the contract, this is an unique feature of contract costing.
Process costing is adopted by those firms where products are manufactured through continuous flow of materials in processes. The important feature needed for this type of costing is standardization of processes. The concept of Equivalent unit enables a firm to convert the incomplete units (or work in progress) into comparable units which helps the management to get the actual cost incurred on production. Process costing helps the management to know the extent of materials lost in the processes. The management comes to know the materials lost on account of abnormal loss which is not inevitable and can be avoided and hence can take appropriate action to reduce the same in future.
Standard costing serves as a tool for control and performance measurement. Here standards are formulated on the basis of experience, technological knowledge etc. These standards are then compared with the actual performance and deviations are found out. The deviations are then presented before management and corrective action is taken to improve performance in future. A prerequisite of standard costing is the standardization of process. This type of costing can be applied when the prices remain fairly constant in the course of time, for example it is difficult to apply standard costing in a firm trading in gold as the prices of gold are fluctuating and hence there will always be a variance in the price. Another important aspect to be considered is that the standards set should be realistic, which would other wise bring discontent among the employees.
Information for decision-making is provided by Marginal costing. Marginal costing is based on the fact that the fixed costs remain fixed irrespective of change in output and thus any change in a given sales brings a larger change in profits. The break even point aids the management to derive the point or the volume of sales required to break even i.e. at least recover the cost incurred on the production of those units. At this point there is no profit no loss. Marginal costing also provides information or guidance regarding the proposition of making or buying a particular component- which affects the profitability of the company and helps to utilize the resources available in the firm.
Cost Volume Profit analysis furnishes a picture of the profit at various levels of activity. It helps the management to distinguish between the impact of sales fluctuations and the result of price or cost upon profits. It enables the management to understand the change in profits in relation to output and sales.
Budgetary control is a tool used by the management for planning, control and performance measurement. Here various budgets are formulated by a committee and then approved by respective departments. It enables the management in computation of requirements in terms of quantities and values and takes proper action if there is a deviation from the budget or budgeted figures. Budgetary control should be realistic for its proper implementation and acceptance by respective departments in an organization.
Capital Budgeting is an essential method which enables the management to enquire into feasibility of long term investment i.e. fixed assets or entering into long term projects. Depending upon the suitability the firm decides to use a method e.g. payback period, net present value method etc. This method is then used to compare the return to be received from the particular investment. This is an important decision considering that an investment once made cannot be altered and hence a wrong decision would severely strain the financial resources of the firm.
Management accounting is thus a developing discipline. As any other field, this field too is experiencing the emergence of new methods and techniques such as JIT, Cost audit, uniform costing and inter firm comparison. Older techniques have given way to modern machines and hence we find key driven machines which have fastened the pace of accounting by providing quick and reliable data by omission of human errors.
The methods and techniques of Management Accounting discussed above help the management at different levels to monitor their performance and are vital to organizational growth. Thus Management Accounting contributes to the organizational aim of maximization of profit, by providing tools for achieving the same. Though management accounting follows an accounting process to accumulate and design information, it is more of a managerial tool for formulating and executing business strategy than mere an accounting process or activity.
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