Simple and Compound Interest

The lending and borrowing of money has been happening since thousands of years. Any sum of
money, borrowed for a certain period, will invite an extra cost to be paid on the money
borrowed; this extra cost at a fixed rate is called interest. The money borrowed is called
principal. The sum of interest and principal is called the amount. The time for which money is
borrowed is called period.
Amount = Principal + Interest
The interest paid per hundred (or percent) for a year is called the rate percent per annum. The
rate of interest is almost always taken as per annum, in calculations we will always consider it
per annum unless indicated.
The interest is of two types, one is simple, the other is compound:
Simple interest
It is the interest paid as it falls due, at the end of decided period (yearly, half yearly or quarterly),
the principal is said to be lent or borrowed at simple interest.
Simple Interest, SI = PRT / 100
Here P = principal, R = rate per annum, T = time in years
Therefore Amount, A = P + PRT/100 = P [1 + ( RT / 100 )]
If T is given in months, since rate is per annum, the time has to be converted in years, so the
period in months has to be divided by 12. if T = 2 months = 2/12 years)
Example 1: Find the amount on S.I. when Rs 4000 is lent at 5 % p.a. for 5 years.
By the formula, A = P (1 + RT/100) = 4000( 1 + 5 x 5/100 ) = Rs 5000
Compound Interest
The compound interest is essentially interest over interest. The interest due is added to the
principal and that becomes the new principal for the interest to be levied. This method of interest
calculation is called compound interest, this can be for any period (yearly, half yearly or
quarterly) and will be called Period compounded like Yearly compounded or quarterly
compounded and so on.
First periods principal + first periods interest = second periods principal
Compound interest = principal {1 + Rate/100}time - Principal
CI = P { 1 + R/100 }T P
Here Amount = principal {1 + Rate/100 }time

Example 2: Find the compound interest on Rs 4500 for 3 years at 6 % per annum
Using the formula, A = P (1 + R/100)T = 4500(1 + 6/100)3 = 4500 (1.06)3 = 5360
Compound interest = 5360 4500 = Rs 860
THE RULE OF 72
The rule of 72 is a quick way to show how long it will take to double your money under
The equation for the rule of 72 is:
Number of years for money to double = (72/Annual Interest Rate) interest rate
At 8% interest, it will take 72/8 = 9 years for your money to double.
Here are more examples:
At 6%, it will take 12 years ( 72/6 = 12)
At 12%, it will take 6 years ( 72/12 = 6)
The rule of 72 is a short cut to estimate the magic of compound interest that makes your money
grow.
Remember that the rule of 72 is an approximation and its accuracy reduces as the interest rate
becomes high.
Important notes
1. In case interest is paid half yearly, then the interest is divided by 2, and used as (R/2) in the
formula and the time is multiplied by 2, and used as 2T in the formula, given by A = P [ 1 + ( R /
200 ) ]2T
Example 3: Find the compound interest on Rs 5000 for 3 years at 6 % per annum compounded
half yearly.
Using the formula, A = P [ 1 + ( R / 200 ) ]2T
= 5000(1 + 6/200)3x2
= 5000 (1.03)6 = 5971
Compound interest = 5971 5000 = Rs 971
2. In case interest is paid quarterly, then the interest is divided by 4, and used as (R/4) in the
formula and the time is multiplied by 4, and used as 4T in the formula, given by A = P [ 1 + ( R /
400 ) ]4T payable quarterly (rate = R/4, time = 4T)
Example 4: Find the compound interest on Rs 5000 for 3 years at 6 % per annum compounded
quarterly.
Using the formula, A = P [ 1 + ( R / 200 ) ]2T
= 5000(1 + 6/400)3x4
= 5000 (1.015)12 = 5978
Compound interest = 5978 5000 = Rs 978

3. In case the rates are different(R1, R2, R3.) for different years, the amount is given by P{1 +
R1/100}{1 + R2/100}{1 + R3/100}
Example 5: Find the compound interest on Rs 5000 for 3 years at 6 % per annum for first year,
7% for the second year and 8% for the third year
Using the formula, P{1 + R1/100}{1 + R2/100}{1 + R3/100}
= 5000(1 + 6/100) (1 + 8/100) (1 + 9/100)
= 6125
Compound interest = 6125 5000 = Rs 1125
4. For population increase the formula to be used is P {1 + R/100 }T, and for decrease P { 1 R/100 }T. It can also be used for depreciation factor.
Example 6: The death rate of a town with population of 100000 is 5 %, considering there are no
new births, what is the population of town in next three years?
Using the formula, P { 1 - R/100 }T
= 100000(1-5/100)3
= 100000(0.857) = 85738
5. In case the period is a fraction like 3 and years, or a and b/c years, then the amount should
be calculated by this formula
A = P { 1 + R/100 }3{1+(1/2 x R)/100}
Or A = P { 1 + R/100 }a{1+(b/c x R)/100}
Example 7: The birth rate of a town with population of 100000 is 5 %, considering there are no
deaths in the town, what is the population of town in next three years and fours months?
Three years and four months mean 3 1/4
Using the formula, A = P { 1 + R/100 }a{1+(b/c x R)/100}
= 100000(1+5/100)3(1+ x 5/100)
= 100000(1.157) (1.012)
= 117210 will be the population
6. The SI and CI earned during the first period remains the same.
Example 8: The compound interest on a certain sum of money in 2 years is 210 and the simple
interest on the same amount is 200, what are the principle and the rate of interest
Since SI and CI for first year is the same, and SI for each year is the same, so SI for the first year
= 200/2 = 100, CI for year I = 100, that means CI for the year II = 210 100 = 110. Here the
excess of interest over year I = 10. Since the excess of interest in CI is interest over first years
interest, assuming I is the interest, I/100 x 100 = 10, so I = 10, and the principal is obviously
1000.(calculate yourself)
Example 9: A sum of money placed at Compound Interest doubles in every 5
years, then in how many years it will become 16 times?
Now, it is given that the principle gets doubled in every 5 years.
So, if we start from initial amount P, then in first 5 years it will become 2P.

In the next 5 years 2P will become 4P, next 5 years 4P will become 8P and finally
in next 5 years 8P will become 16P.
So, it will take (5+5+5+5) = 20 years.
Net present value (NPV)
Money received or paid today is not the same as money received or paid after a period. This is
because the money has an opportunity cost of interest in the same period. What it simply means
is that you can earn interest on money if you have it now, and if you get the money later, you
loose the opportunity to make interest on that. For example, if the going interest rate in the
market is 10%, and someone has to pay me Rs. 1000, and he pays after an year, so he should pay,
1100 (100 has the interest), Here 1100 is called the future value and 1000 is called the present
value.
Here the Future value (FV) = Present value (PV) {1 + Rate/100 }time, which is the basic formula
for amount in the case for compound interest, this is the formula to be used for calculating
present value. From here
PV = FV / {1 + Rate/100 }time
This is the same formula as of the compound interest; herein we are calculating principal from
the amount, whichs it!
Practical applications of the NPV
1. Installment schemes
Today there are all kinds of loans and financing of various products right from two wheelers to
houses. When a loan is taken, customer generally pays a monthly installment, his dues reduced
by that amount and the interest is charged only on the balance amount which is known as
reducing balance. Also there are many other concepts like floating rates etc, but they are out of
purview of CAT. Here is the monthly installment formula for a fixed rate of interest (fixed means
which does not change over time, floating means which changes with market conditions):
Monthly Installment, M = [A/(1-B)] x P
Here A = R/1200 (where R is the rate of interest)
B = [1/(1+A)]T (Where T is time in months)
And P is the principal amount that is the amount of loan taken
The installment can be calculated with this formula by using concept of NPV also. This formula
is derived from there only. You can find this formula in Microsoft excel also under PMT in the
formula section. But these annuity formula questions will not be asked in CAT.
Example 10: If Ram takes a home loan of 500000 for 3 years at the rate of 7.5%, what will be
his monthly installment?

T = 12 x 3 = 36 months
R = 7.5%
P = 500000
Using the formula, M = [A/(1-B)] x P
A = 7.5/1200 = 0.00625
B = [1/(1+A)]T = [1/(1+0.00625)]36
M = [0.00625 / {1 - [1/(1+0.00625)]36}] x 500000
M = 15553

Time Value of Money

Introduction
Time Value of Money (TVM) is an important concept in financial management. It can be used to
compare investment alternatives and to solve problems involving loans, mortgages, leases,
savings, and annuities.
TVM is based on the concept that a dollar that you have today is worth more than the promise or
expectation that you will receive a dollar in the future. Money that you hold today is worth more
because you can invest it and earn interest. After all, you should receive some compensation for
foregoing spending. For instance, you can invest your dollar for one year at a 6% annual interest
rate and accumulate $1.06 at the end of the year. You can say that the future value of the dollar
is $1.06 given a 6% interest rate and a one-year period. It follows that the present value of the
$1.06 you expect to receive in one year is only $1.
A key concept of TVM is that a single sum of money or a series of equal, evenly-spaced
payments or receipts promised in the future can be converted to an equivalent value today.
Conversely, you can determine the value to which a single sum or a series of future payments
will grow to at some future date.
You can calculate the fifth value if you are given any four of: Interest Rate, Number of Periods,
Payments, Present Value, and Future Value. Each of these factors is very briefly defined in the
right-hand column below. The left column has references to more detailed explanations,
formulas, and examples.

Interest

Simple

Compound

Interest is a charge for borrowing money, usually stated as a

percentage of the amount borrowed over a specific period of time.
Simple interest is computed only on the original amount borrowed.
It is the return on that principal for one time period. In contrast,
compound interest is calculated each period on the original amount
borrowed plus all unpaid interest accumulated to date. Compound
interest is always assumed in TVM problems.

Number of Periods

Periods are evenly-spaced intervals of time. They are intentionally

not stated in years since each interval must correspond to a
compounding period for a single amount or a payment period for an
annuity.

Payments

Payments are a series of equal, evenly-spaced cash flows. In TVM

applications, payments must represent all outflows (negative
amount) or all inflows (positive amount).

Present Value

Present Value is an amount today that is equivalent to a future

payment, or series of payments, that has been discounted by an
appropriate interest rate. The future amount can be a single sum that
will be received at the end of the last period, as a series of equallyspaced payments (an annuity), or both. Since money has time value,
the present value of a promised future amount is worth less the
longer you have to wait to receive it.

Single Amount

Annuity

Future Value

Single Amount

Annuity

Future Value is the amount of money that an investment with a

fixed, compounded interest rate will grow to by some future date.
The investment can be a single sum deposited at the beginning of
the first period, a series of equally-spaced payments (an annuity), or
both. Since money has time value, we naturally expect the future
value to be greater than the present value. The difference between
the two depends on the number of compounding periods involved
and the going interest rate.

If you're like most people, you would choose to receive the $10,000 now. After all, three years is
a long time to wait. Why would any rational person defer payment into the future when he or she
could have the same amount of money now? For most of us, taking the money in the present is
just plain instinctive. So at the most basic level, the time value of money demonstrates that, all
things being equal, it is better to have money now rather than later.

But why is this? A $100 bill has the same value as a $100 bill one year from now, doesn't it?
Actually, although the bill is the same, you can do much more with the money if you have it now
because over time you can earn more interest on your money.
Back to our example: by receiving $10,000 today, you are poised to increase the future value of
your money by investing and gaining interest over a period of time. For Option B, you don't have
time on your side, and the payment received in three years would be your future value. To
illustrate, we have provided a timeline:

If you are choosing Option A, your future value will be $10,000 plus any interest acquired over
the three years. The future value for Option B, on the other hand, would only be $10,000. So
how can you calculate exactly how much more Option A is worth, compared to Option B? Let's
take a look.

Future Value Basics

If you choose Option A and invest the total amount at a simple annual rate of 4.5%, the future
value of your investment at the end of the first year is $10,450, which of course is calculated by
multiplying the principal amount of $10,000 by the interest rate of 4.5% and then adding the
interest gained to the principal amount:
Future value of investment at end of first year:
= ($10,000 x 0.045) + $10,000
= $10,450
You can also calculate the total amount of a one-year investment with a simple manipulation of
the above equation:

Original equation: ($10,000 x 0.045) + $10,000 = $10,450

Manipulation: $10,000 x [(1 x 0.045) + 1] = $10,450

Final equation: $10,000 x (0.045 + 1) = $10,450

The manipulated equation above is simply a removal of the like-variable $10,000 (the principal
amount) by dividing the entire original equation by $10,000.
If the $10,450 left in your investment account at the end of the first year is left untouched and
you invested it at 4.5% for another year, how much would you have? To calculate this, you
would take the $10,450 and multiply it again by 1.045 (0.045 +1). At the end of two years, you
would have $10,920:
Future value of investment at end of second year:
= $10,450 x (1+0.045)
= $10,920.25
The above calculation, then, is equivalent to the following equation:
Future Value = $10,000 x (1+0.045) x (1+0.045)
Think back to math class and the rule of exponents, which states that the multiplication of like
terms is equivalent to adding their exponents. In the above equation, the two like terms are
(1+0.045), and the exponent on each is equal to 1. Therefore, the equation can be represented as
the following:

We can see that the exponent is equal to the number of years for which the money is earning
interest in an investment. So, the equation for calculating the three-year future value of the
investment would look like this:

This calculation shows us that we don't need to calculate the future value after the first year, then
the second year, then the third year, and so on. If you know how many years you would like to
hold a present amount of money in an investment, the future value of that amount is calculated
by the following equation:

Future Value is largely the same as present value but in reverse. The basic idea is the same except
here instead of determining what something is worth today, we want to find out how much
something is worth in the future. For example how much will I have if I invest today.
The basic formula is
8 FV =
Example: you invest $1000 today at 10% in one year you will have 1000*(1.1)1=$1,100
In two years you will have 1,000*(1.1)2= 1,210. In three years you will have $1,331, This is
based on the implicit assumption of compound interest. Which means you earn interest on your
interest. This is a powerful concept and can lead to very large amounts when you have enough
time periods over which to accumulate more interest.
Like in the present value discussion we also can use tables to determine a future value factor.
Table A3 gives us future value factors. These are abbreviated as FVIF(r,n). Thus
FV= PV * (FVIF(r,n)) If r=10%, n=3
= $1,000 * 1.331 = $1,331 which is the same we calculated above.
We also have annuities when calculating future values. These are often used in retirement
planning. For example if you invest $1000 a year for three years how much will you have at the
end of three years? Use table A4. If r=10%, n=3 (as before)
FV= CF * (FVAF(r,n))
= $1000 * 3.3100
= $3,310.00
How is the future value of an annuity calculated? (that is where are the numbers coming from?)
Remember the future values for single payments at 10% for 1 and 2 years these plus the last
payment of $1000 sum to $3310. Still uncertain as to the logic? Draw a timeline. Your first
payment occurs at the end of year one and earns interest for two years ($1210), the second cash

flow occurs at the end of the second year and earns interest for 1 year ($1100), while the third
cash flow occurs at the end of the third year and therefore earns no interest ($1000).
Present Value Basics
If you received $10,000 today, the present value would of course be $10,000 because present
value is what your investment gives you now if you were to spend it today. If $10,000 were to be
received in a year, the present value of the amount would not be $10,000 because you do not
have it in your hand now, in the present. To find the present value of the $10,000 you will receive
in the future, you need to pretend that the $10,000 is the total future value of an amount that you
invested today. In other words, to find the present value of the future $10,000, we need to find
out how much we would have to invest today in order to receive that $10,000 in the future.
To calculate present value, or the amount that we would have to invest today, you must subtract
the (hypothetical) accumulated interest from the $10,000. To achieve this, we can discount the
future payment amount ($10,000) by the interest rate for the period. In essence, all you are doing
is rearranging the future value equation above so that you may solve for P. The above future
value equation can be rewritten by replacing the P variable with present value (PV) and
manipulated as follows:

Let's walk backwards from the $10,000 offered in Option B. Remember, the $10,000 to be
received in three years is really the same as the future value of an investment. If today we were at
the two-year mark, we would discount the payment back one year. At the two-year mark, the
present value of the $10,000 to be received in one year is represented as the following:
Present value of future payment of $10,000 at end of year two:

Note that if today we were at the one-year mark, the above $9,569.38 would be considered the
future value of our investment one year from now.
Continuing on, at the end of the first year we would be expecting to receive the payment of
$10,000 in two years. At an interest rate of 4.5%, the calculation for the present value of a
$10,000 payment expected in two years would be the following:
Present value of $10,000 in one year:

Of course, because of the rule of exponents, we don't have to calculate the future value of the
investment every year counting back from the $10,000 investment at the third year. We could put
the equation more concisely and use the $10,000 as FV. So, here is how you can calculate today's
present value of the $10,000 expected from a three-year investment earning 4.5%:

So the present value of a future payment of $10,000 is worth $8,762.97 today if interest rates are
4.5% per year. In other words, choosing Option B is like taking $8,762.97 now and then
investing it for three years. The equations above illustrate that Option A is better not only
because it offers you money right now but because it offers you $1,237.03 ($10,000 - $8,762.97)
more in cash! Furthermore, if you invest the $10,000 that you receive from Option A, your
choice gives you a future value that is $1,411.66 ($11,411.66 - $10,000) greater than the future
value of Option B.
Present Value of a Future Payment
Let's add a little spice to our investment knowledge. What if the payment in three years is more
than the amount you'd receive today? Say you could receive either $15,000 today or $18,000 in
four years. Which would you choose? The decision is now more difficult. If you choose to
receive $15,000 today and invest the entire amount, you may actually end up with an amount of
cash in four years that is less than $18,000. You could find the future value of $15,000, but since
we are always living in the present, let's find the present value of $18,000 if interest rates are
currently 4%. Remember that the equation for present value is the following:

In the equation above, all we are doing is discounting the future value of an investment. Using
the numbers above, the present value of an $18,000 payment in four years would be calculated as
the following:
Present Value

From the above calculation we now know our choice is between receiving $15,000 or
$15,386.48 today. Of course we should choose to postpone payment for four years!

Present Value
The time value of money principle says that future dollars are not worth as much as dollars
today.
You should be able to explain why! If you do not understand, please go back and reread the
above example. It is extremely important and influences almost everything we do from now on.
In the vernacular (I love that word) what this means is that you are unwilling to make an interest
free loan. Fortunately we can compare present and future values with a rather simple equation.
1
This will give you the present value of a single future cash flow (CF) . In fact for ease down the
road we will generally use CF instead of FV. Future Value (FV) will be reserved for when we are
actually solving for a future value. (For example how much will we have in 5 years). A simple
Present value example follows:
What is the present value of $8,000 to be paid at the end of three years if the correct (risk
adjusted interest rate) is 11%?
2
= 8,000/(1.11)3
= 8,000/1.36
=$5,849
Note that if you had so desired you could write this equation as
3 PV = CF * (1/(1+r)t )
Which would be:
PV = 8,000 * (1/1.11)3)
=8,000 * .7312
= $5,849
The second term in equation 3, (1/(1+r)t ), is known as the present value discount factor or
present value interest factor. It is usually abbreviated PVIF(r%, N periods). You can find this
number either mathematically or from present value tables. Specifically this is the present value

of a dollar and can be found on table A-1. (Note the higher the required interest rate, i.e. the more
risk, the lower the present value.)
Continuing our example, suppose that you were willing to make a loan where you would get
$8,000 back at the end of the third year, and $10,000 at the end of the fourth year. What is the
present value of this? Correct, you find the present value of each cash flow and then add the
present values. Thus,
PV = 8,000/(1.11)3 + 10000/(1.11)4
= $12,436.84
Generically, we can thus rewrite equation #2 as:

4
Whereby we calculate the present value of each cash flow and then sum the present values. As
you can imagine this can get quite cumbersome if we had many future cash flows. As a result
many short cuts have been devised. Chief among these is when all of the cash flows are identical.
This we call an annuity. When we have an annuity we do not need to add up each individual
value but can use the present value (and later future value) tables.
Examples of annuities include loan payments and certain long term contracts such as pensions,
leases, and certain sports contracts.
Example what is the present value of an annuity of $250 a year at the end of year for 6 years if
interest rates are 12%?
To solve this we could add each individual present value up, or can use the following discount
factor and then multiply by the cash flow.

5 PVIFA(r,n)=PVAF(r,n)=
Thus if interest rates are 12% and you will receive 6 payments, the discount factor is 4.114. Thus
the Present Value (PV) of 6 payments of $250 if interest rates are 12% is
PV = PVAF(r,n) * CF
= 4.114 * $250
= $1,028.50

This answer will be the same whether you solve the problem mathematically, as we just did, or
using the table A2. (try it!)
An important assumption in using the annuity discount factors is that the cash flows occur at the
END of each year. If the cash flows are occurring at the beginning of each year, the cash flows
are called an annuity-due. Stop and think for a second what we are doing in an annuity due. The
first cash flow occurs today. Thus the present value of the first cash flow is equal to the cash
flow. One year from now you will receive another cash flow. This second cash flow occurs at the
same time (or technically 1 day later) than the first cash flow of a regular annuity. To the present
value of an annuity due is
6 PV = CF + PVAF(r,n-1) * CF
Using the above example but assuming the first payment is made today (rather than in one year).
we can value the cash flows using the annuity-due equation.
PV = 250 + PVAF(12%, 5)* CF
= 250 + 3.6048 * 250
= $1,151.20
Note that the present value is greater than before. Why? Because the payments were all shifted
up one year, thus allowing you (the lender) to reinvest sooner and make more money.
Alternatively if you were the borrower you are paying earlier so you lose interest that you could
have earned by keeping your money invested.
Another shortcut that you will be responsible for is a perpetuity. A perpetuity is a stream of cash
flows that goes on forever. Or at least we assume it does. This may or may not be a good
assumption (why?-forever is a very long time!) but is very easy to use.
7 PV of a perpetuity = CF/r
Note the cash flow does not have a subscript. Why? Because the definition of a perpetuity says
that all cash flows are identical.
Example: To pay for a new highway the local government sells a perpetuity that promises to pay
$1000 a year from now until the end of time. If interest rates are 10%, what is the most that you
would be willing to pay to get these future cash flows?
PV = CF / r
= $1000 / (.1)
=$10,000

An interesting (this is interesting, right?!?!?!) extension of this is that you can also value a
growing perpetuity. This is a series of cash flows that grows at a constant rate. For example
suppose that the above perpetuity were promised to grow by 4% per year. Thus this year you get
$1000, the next year you get 1000(1.04)=$1,040 etc.
PV=CF1 / (r-g) where CF1 is the cash flow you will receive in one year.
Example: suppose you JUST received $1000 and now want to sell your growing perpetuity.
What is the least you should accept for the claim on these future cash flows if the growth rate is
4% and the correct risk adjusted interest rate is 10%.

PV =
= $1,040/(.1-.04)
= $17,333

The Bottom Line

These calculations demonstrate that time literally is money - the value of the money you have
now is not the same as it will be in the future and vice versa. So, it is important to know how to
calculate the time value of money so that you can distinguish between the worth of investments
that offer you returns at different times.

What is Engineering Economics?

It deals with the concepts and techniques of analysis useful in evaluating the worth of systems,
products, and services in relation to their costs.

It is used to answer many different questions.

Which engineering projects are worthwhile?
Has the mining or petroleum engineer shown that the mineral or oil deposits is worth
developing?
Which engineering projects should have a higher priority?
Has the industrial engineer shown which factory improvement projects should be funded
with the available Rupees?

How should the engineering project be designed?

Has civil or mechanical engineer chosen the best thickness for insulation?

Basic Concepts

Cash Flow
Interest Rate and Time Value of Money
Equivalence Technique

Engineering projects generally have economic consequences that occur over an extended
period of time
--For example, if an expensive piece of machinery is installed in a plant were brought
on credit, the simple process of paying for it may take several years
--The resulting favorable consequences may last as long as the equipment performs
its useful function

Each project is described as cash receipts or disbursements (expenses) at different points

in time

The expenses and receipts due to engineering projects usually fall into one of the
following categories

--First cost: expense to build or to buy and install

--Operations and maintenance (O&M): annual expense, such as electricity, labor, and minor
repairs
--Salvage value: receipt at project termination for sale or transfer of the equipment (can
be a salvage cost)
--Revenues: annual receipts due to sale of products or services
--Overhaul: major capital expenditure that occurs during the assets life

Cash Flow Diagrams

The costs and benefits of engineering projects over time are summarized on a cash flow
diagram (CFD). Specifically, CFD illustrates the size, sign, and timing of individual cash
flows, and forms the basis for engineering economic analysis

A CFD is created by first drawing a segmented time-based horizontal line, divided into
appropriate time unit. Each time when there is a cash flow, a vertical arrow is added
pointing down for costs and up for revenues or benefits. The cost flows are drawn to
relative scale

Drawing a Cash Flow Diagram

In a cash flow diagram (CFD) the end of period t is the same as the beginning of period
(t+1)
Beginning of period cash flows are: rent, lease, and insurance payments

End-of-period cash flows are: O&M, salvages, revenues, overhauls

The choice of time 0 is arbitrary. It can be when a project is analyzed, when funding is
approved, or when construction begins

One persons cash outflow (represented as a negative value) is another persons inflow
(represented as a positive value)

It is better to show two or more cash flows occurring in the same year individually so that
there is a clear connection from the problem statement to each cash flow in the diagram

Example of Cash Flow Diagram

A man borrowed Rs1,000 from a bank at 8% interest. Two end-of-year payments: at the
end of the first year, he will repay half of the Rs1000 principal plus the interest that is
due. At the end of the second year, he will repay the remaining half plus the interest for
the second year.
Cash flow for this problem is:
End of year

Cash flow

+Rs1000
- Rs580 (-Rs 500 Rs 80)

- Rs540 (-Rs 500 Rs 40)

Cash Flow Diagram

Rs1,00
0

Rs5
80

Rs
540

Future Value of a loan with Compound Interest

Amount of money due at the end of a loan
F = P(1+i)1(1+i)2..(1+i)n or F = P (1 + i)n

Where,
F = future value and P = present value

Referring to slide #10, i = 9%, P = $100 and say n= 2.

Determine the value of F.

F = $100 (1 + .09)2 = $118.81

Notation for Calculating a Future Value

Formula:
F=P(1+i)n is the
single payment compound amount factor.

Functional notation:
F=P(F/P,i,n)

F=5000(F/P,6%,10)

F =P(F/P) which is dimensionally correct

Notation for Calculating a Present Value

P=F(1/(1+i))n=F(1+i)-n is the
single payment present worth factor.

Functional notation:
P=F(P/F,i,n)

P=5000(P/F,6%,10)

Interpretation of (P/F, i, n): a present sum P, given a future sum, F, n interest periods hence at an
interest rate i per interest period

Example of Future Value

Example: If $500 were deposited in a bank savings account, how much would be in the
account three years hence if the bank paid 6% interest compounded annually?
Given P = 500, i = 6%, n = 3, use F = FV(6%,3,,500,0) = -595.91
Note that the spreadsheet gives a negative number to find equivalent of P. If we find P
using F = -$595.91, we get P = 500

Example of Present Value

Example 3-5: If you wished to have $800 in a savings account at the end of four years,
and 5% interest we paid annually, how much should you put into the savings account?
n = 4, F = $800, i = 5%, P = ?
P = PV(5%,4,,800,0) = -$658.16
You should use P = $658.16

Economic Analysis Method

Three commonly used economic analysis methods are

Present Worth Analysis

Annual Worth Analysis

Rate of Return Analysis

Present Worth Analysis

Steps to do present worth analysis for a single alternative (investment)

Select a desired value of the return on investment (i)

Using the compound interest formulas bring all benefits and costs to present
worth

Select the alternative if its net present worth (Present worth of benefits Present
worth of costs) 0

Steps to do present worth analysis for selecting a single alternative (investment)

from among multiple alternatives
Step 1: Select a desired value of the return on investment (i)

Step 2: Using the compound interest formulas bring all benefits and costs to present
worth for each alternative

Step 3: Select the alternative with the largest net present worth (Present worth of benefits
Present worth of costs)

Numerical on Present Worth Analysis

A construction enterprise is investigating the purchase of a new dump truck. Interest rate
is 9%. The cash flow for the dump truck are as follows:
First cost = $50,000, annual operating cost = $2000, annual income = $9,000, salvage
value is $10,000, life = 10 years. Is this investment worth undertaking?

P = $50,000, A = annual net income = $9,000 - $2,000 = $7,000, S = 10,000, n = 10.

Evaluate net present worth = present worth of benefits present worth of costs

Solution

Present worth of benefits = $9,000(PA,9%,10) = $9,000(6.418) = $57,762

Present worth of costs = $50,000 + $2,000(PA,9%,10) - $10,000(PF,9%,10)= $50,000 +
$2,000(6..418) - $10,000(.4224) = $58,612

Net present worth = $57,762 - $58,612 < 0 do not invest

What should be the minimum annual benefit for making it a worthy of investment at 9%
rate of return?

Present worth of benefits = A(PA,9%,10) = A(6.418)

Present worth of costs = $50,000 + $2,000(PA,9%,10) - $10,000(PF,9%,10)= $50,000 +

$2,000(6..418) - $10,000(.4224) = $58,612

A(6.418) = $58,612 A = $58,612/6.418 = $9,312.44

Cost and Benefit Estimates

Present and future benefits (income) and costs need to be estimated to determine the
attractiveness (worthiness) of a new product investment alternative

Annual Cost and Income for a Product

Annual product total cost is the sum of annual material, labor, and overhead (salaries,
taxes, marketing expenses, office costs, and related costs), annual operating costs (power,
maintenance, repairs, space costs, and related expenses), and annual first cost minus the
annual salvage value.
Annual income generated through the sales of a product = number of units sold
annuallyxunit price

Rate of Return Analysis

Single alternative case

In this method all revenues and costs of the alternative are reduced to a single percentage
number

This percentage number can be compared to other investment returns and interest rates
inside and outside the organization

Steps to determine rate of return for a single stand-alone investment

Step 1: Take the dollar amounts to the same point in time using the compound
interest formulas

Step 2: Equate the sum of the revenues to the sum of the costs at that point in time
and solve for i

Numerical on Rate of Return Analysis

An initial investment of $500 is being considered. The revenues from this investment are
$300 at the end of the first year, $300 at the end of the second, and $200 at the end of the
third. If the desired return on investment is 15%, is the project acceptable?
In this example we will take benefits and costs to the present time and their present
values are then equated

Solution

$500 = $300(PF, i, n=1) + 300(PF, i, n=2) + $200(PF, i, n=3)

Now solve for i using trial and error method

Try 10%: $500 = ? $272 + $247 + $156 = $669 (not equal)

Try 20%: $500 = ? $250 + $208 + $116 = $574 (not equal)

Try 30%: $500 = ? $231 + $178 + $91 = $500 (equal) i = 30%

The desired return on investment is 15%, the project returns 30%, so it should be
implemented

Payback Period (Definition and Explanation):

The payback is another method to evaluate an investment project. The payback method focuses
on the payback period. The payback period is the length of time that it takes for a project to
recoup its initial cost out of the cash receipts that it generates. This period is sometimes referred
to as" the time that it takes for an investment to pay for itself." The basic premise of the payback
method is that the more quickly the cost of an investment can be recovered, the more desirable is
the investment. The payback period is expressed in years. When the net annual cash inflow is the
same every year, the following formula can be used to calculate the payback period.

Formula / Equation:
The formula or equation for the calculation of payback period is as follows:
Payback period = Investment required / Net annual cash inflow*
*If new equipment is replacing old equipment, this becomes incremental net annual cash inflow.
To illustrate the payback method, consider the following example:
Example:
York Company needs a new milling machine. The company is considering two machines.
Machine A and machine B. Machine A costs $15,000 and will reduce operating cost by $5,000
per year. Machine B costs only $12,000 but will also reduce operating costs by $5,000 per year.
Required:

Calculate payback period.

Which machine should be purchased according to payback method?

Calculation:
Machine A payback period = $15,000 / $5,000 = 3.0 years
Machine B payback period = $12,000 / $5,000 = 2.4 years
According to payback calculations, York Company should purchase machine B, since it has a
shorter payback period than machine A.

Pay Back Period

The payback method is defined as the time, usually expressed in years, it takes for the cash
income from a capital investment project to equal the initial cost of the investment.
The choice between two or more projects is to accept the one with the shortest payback time.
The determination of the payback period is a simple calculation of dividing the amount of the
investment by the projected cash inflow per year.
A shorter payback period equates to a higher return on the capital investment. Many companies
have a maximum acceptable payback period and will only consider those projects whose
payback period is less than the target number of years.
Advantages
The payback method is popular with business analysts for several reasons. The first is its
simplicity. Most companies will use a team of employees with varied backgrounds to evaluate
capital projects. Using the payback method and reducing the evaluation to a simple number of
years is an easily understood concept. Identifying projects that provide the fastest return on
investment is particularly important for companies with limited cash that need to recover their
money as quickly as possible. Managers use the payback method to make quick evaluations of
projects with small investment. These small projects do not necessarily involve a group of
employees, and it is not necessary to conduct a rigorous economic analysis.
Disadvantages
The payback method ignores the time value of money. The cash inflows from a project may be
irregular, with most of the return not occurring until well into the future. A project could have an
acceptable rate of return but still not meet the company's required minimum payback period. The
payback model does not consider cash inflows from a project that may occur after the initial
investment has been recovered. Most major capital expenditures have a long life span and
continue to provide income long after the payback period. Since the payback method focuses on

short-term profitability, an attractive project could be overlooked if the payback period is the
only consideration.
Payback period
Payback period is a capital budgeting concept which refers to period of time which is required
for a project to generate a return on investment which will cover the original investment made by
a company on the initial project cost. So for example if the initial project cost is $50000 and
annual cash flow from such project is $10000 then it implies that payback project would be 5
years.
The advantage of using payback period is that its ease of use and anybody who is having limited
financial knowledge can apply it. It is also beneficial for those companies who are recently
established and want to know the time frame in which they would recover their original
investment, therefore those companies which do not want to take risk and want quick return on
their investments can select those projects which have low payback period and ignore those
projects which require long gestation projects.
While disadvantage of payback period is that ignores an important concept which is time value
of money and therefore may not present true picture when it comes to evaluating cash flows of a
project. It also ignores cash flows beyond the payback period and therefore it does not take into
account the complete return which a project can generate and therefore it may reject a project
which in the long term may be beneficial for a company.

Cost Benefit Analysis

Identify & evaluate all costs & benefits

Discount
Assess project(s) by calculating
Benefit/Cost Ratio (B/C)
Net Present Value (NPV)
Internal Rate of Return (IRR)

Evaluation

Identification (what are they?)

Evaluation (what are they worth?)
Measurement issues:
Direct & indirect (i.e. externalities) effects
Tangible & intangible effects
Pecuniary effects

Discounting

Policies & projects last a long time

Frequently costs & benefits occur at different times
Money has a time value, i.e. ceteris paribus, current dollars are more valuable than future
dollars
Thus, we need to place current & future costs & benefits on an equal basis for
comparison
This is done by discounting, that is by reducing future dollars to present value by
applying a discount (or a negative interest) rate

Discount Rate Vs Interest Rate

$100,000 invested at a 3% interest rate today will be worth roughly $115,927 in five
years
$100,000 in anticipated benefits five years from now is worth roughly $86,260 today,
when discounted by 3%

Discount Rate Matters

$100,000 in anticipated benefits five years from now is worth roughly $86,260 today,
when discounted by 3%
$100,000 in anticipated benefits five years from now is worth roughly $78,352 today,
when discounted by 5%
The difference grows larger as
Multiple years are accounted for
Benefits accrue further into the future

What to use as a Discount Rate?

There are various approaches to selecting one

o Givens (i.e. some authority imposes one)
o Bank interest rates
o Rates of return on certain investments (e.g. government bonds)
o Social discount rates

Net Present Value

The difference between total discounted benefits and total discounted costs
NPV = (PVB - PVc)
NPV: decision criteria
o For a single project, a positive NPV indicates acceptability
o For multiple (competing) projects, the project(s) with the highest NPVs should
receive highest priority

Benefit/Cost Ratio

B/C = (PVB / PVC)

Benefit/Cost ratio: decision criteria
o For a single project, a B/C ratio which is greater than 1 indicates acceptability
o For multiple (competing) projects, the project(s) with the highest B/C ratios
(greater than 1) should receive highest priority

Internal Rate of Return

The discount rate at which the present value of benefits is equal to the present value of
costs
Internal Rate of Return: decision criteria
o For a single project, an IRR which is greater than the selected (for B/C and/or
NPV analysis) discount rate indicates acceptability
o For multiple (competing) projects, the one with the largest IRR is the most
desirable

NPV and B/C Comparison

NPV measures totals, indicates the amount by which benefits exceed (or do not exceed)
costs (total benefit or loss)
B/C measures the ratio (or rate) by which benefits do or do not exceed costs (efficiency)
They are clearly similar, but not identical
With multiple projects, some may do better under NPV analysis, others under B/C

Problems with IRR (Internal Rate of Return)

It has a certain attraction, but also has some problems

o The argument that an IRR which is greater than the selected discount rate is
desirable can be questioned - discount rates can be arbitrary!
o Calculation (by hand) is tedious & prone to error (but modern spreadsheets are a
help)

o Under certain conditions there may be more than one correct solution to an IRR
problem
Depreciation
Net investment
Cash flow after interest and taxes
Definitions (2)
1. A noncash expense that reduces the value of an asset as a result of wear and tear, age, or
obsolescence. Most assets lose their value over time (in other words, they depreciate), and must
be replaced once the end of their useful life is reached. There are several accounting methods that
are used in order to write off an asset's depreciation cost over the period of its useful life.
Because it is a non-cash expense, depreciation lowers the company's reported earnings while
increasing free cash flow.
2. A decline in the value of a given currency in comparison with other currencies. For instance, if
the U.S. dollar depreciates against the Euro, buyers would have to pay more dollars in order to
obtain the original amount of euros before depreciation occurred.
Definition:
Depreciation is a non-cash expense that reduces the value of an asset over time. Assets depreciate
for two reasons:

Wear and tear. For example, an auto will decrease in value because of the mileage, wear
on tires, and other factors related to the use of the vehicle.
Obsolescence. Assets also decrease in value as they are replaced by newer models. Last
year's car model is less valuable because there is a newer model in the marketplace.

Break Even Analysis

Introduction
Break-even analysis is a technique widely used by production management and management
accountants. It is based on categorizing production costs between those which are "variable"

(costs that change when the production output changes) and those that are "fixed" (costs not
directly related to the volume of production).
Total variable and fixed costs are compared with sales revenue in order to determine the level of
sales volume, sales value or production at which the business makes neither a profit nor a
loss (the "break-even point").
The Break-Even Chart
In its simplest form, the break-even chart is a graphical representation of costs at various levels
of activity shown on the same chart as the variation of income (or sales, revenue) with the same
variation in activity. The point at which neither profit nor loss is made is known as the "breakeven point" and is represented on the chart below by the intersection of the two lines:

In the diagram above, the line OA represents the variation of income at varying levels of
production activity ("output"). OB represents the total fixed costs in the business. As output
increases, variable costs are incurred, meaning that total costs (fixed + variable) also increase. At
low levels of output, Costs are greater than Income. At the point of intersection, P, costs are
exactly equal to income, and hence neither profit nor loss is made.

Fixed Costs
Fixed costs are those business costs that are not directly related to the level of production or
output. In other words, even if the business has a zero output or high output, the level of fixed
costs will remain broadly the same. In the long term fixed costs can alter - perhaps as a result of

investment in production capacity (e.g. adding a new factory unit) or through the growth in
overheads required to support a larger, more complex business.
Examples of fixed costs:
- Rent and rates
- Depreciation
- Research and development
- Marketing costs (non- revenue related)
- Administration costs
Variable Costs
Variable costs are those costs which vary directly with the level of output. They represent
payment output-related inputs such as raw materials, direct labour, fuel and revenue-related costs
such as commission.
A distinction is often made between "Direct" variable costs and "Indirect" variable costs.
Direct variable costs are those which can be directly attributable to the production of a particular
product or service and allocated to a particular cost centre. Raw materials and the wages those
working on the production line are good examples.
Indirect variable costs cannot be directly attributable to production but they do vary with output.
These include depreciation (where it is calculated related to output - e.g. machine hours),
maintenance and certain labour costs.
Semi-Variable Costs
Whilst the distinction between fixed and variable costs is a convenient way of categorising
business costs, in reality there are some costs which are fixed in nature but which increase when
output reaches certain levels. These are largely related to the overall "scale" and/or complexity of
the business. For example, when a business has relatively low levels of output or sales, it may
not require costs associated with functions such as human resource management or a fullyresourced finance department. However, as the scale of the business grows (e.g. output, number
people employed, number and complexity of transactions) then more resources are required. If
production rises suddenly then some short-term increase in warehousing and/or transport may be
required. In these circumstances, we say that part of the cost is variable and part fixed.

Breakeven analysis
Breakeven analysis is the relationship between cost volume and profits at various levels of
activity, with emphasis being placed on the breakeven point. The breakeven point is where the

business neither recieve a profit nor a loss, this is when total money recieved from sales is equal
to total money spent to produce the items for sale.
Uses of a breakeven analysis
Breakeven analysis enables a business organization to:
1. Measure profit and loses at different levels of production and sales.
2. To predict the effect of changes in price of sales.
3. To analysis the relationship between fixed cost and variable cost.
4. To predict the effect on profitablilty if changes in cost and efficiency.
Even though breakeven has these advantages or uses, there are also several demerits of break
even analysis.
Disadvantages of breakeven analysis
1. Assumes that sales prices are constant at all levels of output.
2. Assumes production and sales are the same.
3. Breakeven charts may be time consuming to prepare.
4. It can only apply to a single product or single mix of products.

Break Even Formula

P(X) = f + V(X)

F = fixed costs
V = variable costs per unit
X = volume of output (in units)
P = price per unit

If we rearrange the where the breakeven is X then the formula look like this.
X = F /( P V)
This formula says that the breakeven point is where the number of sales needed to make the cost
equal to the revenue.

Example of BEP Question

Lets say you own a business selling burgers

It costs $1.00 to make one burger
Thats your V or Variable cost
You sell each burger for $2.80
Thats your P or price per unit
Your cost for rent, utilities, overhead, etc... is $100,000 per month
That's your F or fixed cost

V = $1.00 P = $2.80
F = $100,000

X = F /( P V)
X = 100,000 / ( 2.80 - 1 )
X = 100,000 / ( 1.80 )
X = 55,555
To breakeven you would need to sell 55,555 burgers
Process Costing Introduction
Process costing is a form of operations costing which is used where standardized homogeneous
goods are produced. This costing method is used in industries like chemicals, textiles, steel,
rubber, sugar, shoes, petrol etc. Process costing is also used in the assembly type of industries
also. It is assumed in process costing that the average cost presents the cost per unit. Cost of
production during a particular period is divided by the number of units produced during that
period to arrive at the cost per unit.
Process costing is a method of costing under which all costs are accumulated for each stage of
production or process, and the cost per unit of product is ascertained at each stage of production
by dividing the cost of each process by the normal output of that
process.

Definition
CIMA London defines process costing as that form of operation costing which applies where
standardize goods are produced
Features of Process Costing
(a) The production is continuous
(b) The product is homogeneous
(c) The process is standardized
(d) Output of one process become raw material of another process
(e) The output of the last process is transferred to finished stock
(f) Costs are collected process-wise
(g) Both direct and indirect costs are accumulated in each process
(h) If there is a stock of semi-finished goods, it is expressed in terms of equivalent units
(i) The total cost of each process is divided by the normal output of
that process to find out cost per unit of that process.
Advantages of process costing
1. Costs are be computed periodically at the end of a particular
period
2. It is simple and involves less clerical work that job costing
3. It is easy to allocate the expenses to processes in order to have
accurate costs.
4. Use of standard costing systems in very effective in process
costing situations.
5. Process costing helps in preparation of tender, quotations
6. Since cost data is available for each process, operation and
department, good managerial control is possible.
Limitations of Process Costing
1. Cost obtained at each process is only historical cost and are not
very useful for effective control.
2. Process costing is based on average cost method, which is not
that suitable for performance analysis, evaluation and
managerial control.
3. Work-in-progress is generally done on estimated basis which
leads to inaccuracy in total cost calculations.
4. The computation of average cost is more difficult in those cases
where more than one type of products is manufactured and a
division of the cost element is necessary.

5. Where different products arise in the same process and common costs are prorated to various
costs units. Such individual products costs may be taken as only approximation and hence not
reliable.

Distinction Between Job Costing and Process Costing

Job Costing
Job costing is the process of assigning costs to custom products or services. Direct materials and
direct labor are traced to individual jobs, and production overhead is allocated. Manufacturers
that use job costing include aircraft builders, custom motorcycle and automobile manufacturers,
and custom designed jewelers, among others. Job costing is also frequently used in service
industry organizations such as hospitals, accounting firms, and repair shops. We first learn about
job costing in a manufacturing setting. Later in the chapter, we learn about job costing for
services.

Operating Cost
It is a method of costing applied by undertakings which provide service rather than production of
commodities. Like unit costing and process costing, operating costing is thus a form of operation
costing. The emphasis under operating costing is on the ascertainment of cost of rendering
services rather than on the cost of manufacturing a product. It is applied by transport companies,
gas and water works, electricity supply companies, canteens, hospitals, theatres, school etc.
Within an organisation itself certain departments too are known as service departments which
provide ancillary services to the production departments. For example, maintenance department;
power house; boiler house; canteen; hospital; internal transport.

Operating Costs and Its Features

Operating Costs are the costs incurred by undertakings which do not manufacture any product
but provide a service. Such undertakings for example are Transport concerns, Gas agencies;
Electricity Undertakings; Hospitals; Theatres etc. Because of the varied nature of activities

carried out by the service undertakings, the cost system used is obviously different from that
followed in manufacturing concerns.
The essential features of operating costs are as follows:
(1) The operating costs can be classified under three categories. For example in the
case of transport undertaking these three categories are as follows:
(a) Operating and running charges. It includes expenses of variable nature. For
example expenses on petrol, diesel, lubricating oil, and grease etc.

(b) Maintenance charges. These expenses are of semi-variable nature and

includes the cost of tyres and tubes, repairs and maintenance, spares and
accessories, overhaul, etc.

(c) Fixed or standing charges. These includes garage rent, insurance, road
licence, depreciation, interest on capital, salary of operating manager, etc.
(2) The cost unit used is a double unit like passenger-mile; Kilowatt-hour, etc.
It can be implemented in all firms of transport, airlines, bus-service, etc., and by all firms
of Distribution Undertakings.

There are two ways to assign proper units to operating cost

1. Simple Cost Unit
2. Composite Cost Unit

Simple Cost Unit

1) Transport-Per Km, Per Passenger
2) School/colleges-Per student
3) Hospital-Per Bed
4) Canteen-Per cup of tea

Composite Cost Unit

1) Transport-Per passenger km
2) Hospital-Per bed per day
3) Cinema-Per seat per show
4) Electricity-Per KWH
5) Airlines-RPM (Revenue Passenger Miles)No of filled seats x No of miles flown

STANDARD COSTING
It may be defined basically as a technique of cost accounting which compares the standard cost
of each product or service with the actual cost, to determine the efficiency of the operation, so
that any remedial action may be taken immediately. The standard cost is a predetermined cost
which determines what each product or service should cost under given circumstances.

Steps in Standard Costing

The setting of standards

Ascertaining actual results

Comparing standards and actual costs to determine the variances

Investigating the variances and taking appropriate action where necessary

Reporting to the management

Preliminaries in establishing a system of standard costs

The establishment of cost centers with clearly defined areas of responsibility.

The classification of accounts, with provision for standard and actual costs with
variances.

The type of standard to be operated.

The setting of standard costs for each element of cost.

Advantages of standard costing

Provides a yardstick against which the actual costs can be measured.

The setting of standards is involves determining the best materials and methods, which
may lead to economies.

A target of efficiency is set for employees to reach, and cost consciousness is

stimulated.

Variances can be calculated which enable the principle of management by

exception to be operated.

Costing procedures are often simplified.

Provides a valuable aid to management in determining prices and formulating policies.

The evaluation of stock is facilitated.

The operation of cost centers defines responsibilities.

Disadvantages of Standard Costing

Variation in price

Varying levels of output

Changing standard of technology

Attitude of technical people

Mix of products

Do not reflect the true value and exchange

Based on theoretical maximum efficiency, attainable good performance & average past
performance

Budgetary Control
It is the process of utilizing the various budgets like production budget, sales budget, etc,. for the
purpose of internal control. This is done with intention of minimizing the wastage & maximizing the
efficiency of various departments.
According to ICMA terminology budgetary control as the establishment of budgets relating the
responsibilities of executives to the requirements of the policy & the continuous comparison of actual

with the budgeted results either to secure by individual actions the objective of that policy to provide
basis for its revision.

Steps involved in the Budgetary Control Techniques:

Define the objectives clearly.

Formulating the necessary plans to ensure that the desired objectives are achieved.

Translating the plans into budgets.

Relating the responsibilities of executives to the budgets.

Continuous comparison of the actual results with that of the budget & the ascertainment of
deviations (Positive/negative).

Investigating into the deviations & establishing the causes.

Presentation of information to the management relating the variances to individual

responsibilities.

Corrective action of the management to present recurrence of variance

Points of Difference:
In spite of so much similarity between standard costing and budgetary control, there are some important
differences between the two, which are as follows:

Scope

Standard Costing
Standard costs are developed mainly for the
manufacturing function and sometimes also
for making and administration functions

Intensity

Standard costing is intensive in application as

it calls for detailed analysis of variances

Relation to accounts

In standard costing, variances are usually

revealed through accounts

Usefulness

Standard costs represent realistic yardsticks

and, are therefore, more useful for controlling
and reducing costs.

Basis

Standard cost are usually established after

considering such vital matters as production

Budgetary Control
Budgets are compiled functions of the
business such as sales, purchase,
production, cash, capital expenditure,
research & development, etc.,
Budgetary control is extensive in nature and
the intensity of analysis tends to be much
less than that in standard costing.
In budgetary control, variances are normally
not revealed through accounts and control is
exercised by statistically putting budgets
and actuals side by side.
Budgets usually represent an upper limit on
spending
without
considering
the
effectiveness of the expenditure in terms for
output.
Budgets may be based on previous years
costs without any attention being paid to

Projection

capacity, methods employed and other factors

which require attention when determining an
acceptable level of efficiency.
Standard cost is a projection of cost accounts

efficiency.
Budget is a projection of financial accounts.

Decision Making
It is a reasoning process which produces a final choice. This final choice is known as decision making
Definitions
According to Haynes and Massie Decision making is a course of action which is consciously chosen for
achieving a desired result
According to R.A. Killian: A decision making in its simplest form is a selection of alternatives

Steps in Decision Making

1. Identification of problem
2. Identification of Decision Criteria
3. Allocation of weights to criteria
4. Development of alternatives
5. Analysis of alternatives
6. Decide on an alternative
7. Implementation of decision
8. Evaluation of decision
Factors Affecting Decision Making Process
1. Information should be authentic, adequate and reliable
2. Decision must be taken at the right time
3. Various external factors influence decision making such as economic, political, social,
cultural and legal
4. Internal factors such as rules, regulations, procedures within the organization also affect
decision making
5. Personality of decision maker, his attitude, perceptions and nature also affect decision
making
6. Experience of decision maker

7. Power to decide

Relevant and irrelevant Costs

Relevant Costs
These are costs that are relevant with respect to a particular decision. A relevant cost for a
particular decision is one that changes if an alternative course of action is taken. Relevant costs
are also called differential costs.

Irrelevant Costs
A managerial accounting term that represents a cost, either positive or negative, that does not
relate to a situation requiring management's decision.

General Principles
There are three general principles used for determining the relevant costs and revenues relating
to a one off decision. These are:
Relevant costs/revenues are the:
1FUTURE. What is past and what is future is determined by reference to the time at which
the decision is being made.
2INCREMENTAL. The word incremental refers to financial changes as a result of the
decision at hand
3CASHFLOWS. Exclude any non-cash, or notional items from consideration e.g. depreciation.

Specific Rules
In support of the three general principles for determining relevant costs, there are a number of
specific rules that should be followed to help accurately determine the relevant costs and
revenues pertaining to a decision. These include:
1a) Sunk costs are irrelevant on the basis as relate to the past
2b) Committed costs are irrelevant on the basis that the decision will not change this
commitment
3c) Fixed costs are generally irrelevant, unless the decision involves a stepping up/down in
decision specific fixed costs.
4d) Variable costs are relevant as they are typically incremental
5e) When limiting factors exist there are two relevant elements, namely: the cost of factor
resource itself and the opportunity cost i.e. the contribution (SP-VC) forgone. In effect,
the price achieved in the next most profitable use of the limited resource.
6f) Apportioned/absorbed central costs are generally irrelevant as they are non-incremental
7g) Stock Costs. There are a three potential scenarios to be considered here, namely:
81) If the stocks must be replaced (in constant use), the relevant cost is the replacement cost
(irrespective of original cost)
92) If the stocks are not to be replaced (not in constant use), and they have another economic
value and/or residual value. The relevant cost is the higher of the economic value and/or
residual value.
103) If the stocks are not to be replaced (not in constant use), and they have no other
economic value or residual value. The relevant cost is nil.

Cost Reduction and Cost Control

Cost Reduction
Cost reduction may be defined as the achievement of Real and Permanent Reduction in the unit
cost of goods manufactured or services rendered without impairing their suitability for the use
intended or diminution in the quality of the product.
Cost reduction, should therefore, not be confused with cost saving and cost control. Cost saving
could be a temporary affair and may be at the cost of quality. Cost reduction implies the retention
of essential characteristics and quality of the product and thus it must be confined to permanent
and genuine savings in the costs of manufacture, administration, distribution and selling, brought
about by elimination of wasteful and inessential elements form the design of the product and
from the techniques and practices carried out in connection therewith.
In other words, the essential characteristics and techniques and quality of the products are
retained through improved methods and techniques used and thereby a permanent reduction in
the unit cost is achieved. The definition of cost reduction does not however include reduction in
expenditure arising from reduction or similar govt. action or the effect of price agreements.
The three fold assumption involved in the definition of cost reduction may be summarized as
under:1. There is saving in a cost unit
2. Such saving is of a permanent nature

3. The utility and quality of goods remain unaffected, if not improved

Areas of implementation of cost reduction

raw material procurement

logistics - inbound and outbound

production ( process ,time and work study,maintenance ,automation)

energy

human resource ( out sourcing )

sales & marketing

finance

Cost Control and Cost Reduction

The regulation by executive action of the cost of operating an undertaking particularly

where such action is guided by cost accounting.
Cost Control aims at reducing inefficiencies and wastages and setting up
predetermined costs and in achieving them.

Elements of Cost Control Scheme

Set down a standard/ target.

Select a yardstick.
Ascertain the actual performance.
Compare the actual performance.
Analyze the variances by causes.
Take corrective action.
Periodically review the standards.

Essentials for success of Cost Control:

Firm should have definite plan of organization.

Costs should be collected for each of responsibility.
Report should draw managements attention.
Good performance should be rewarded.
Proper setting of standards.

Advantages of Cost Control:

Achieving the expected return of capital

Increase in productivity of the available resources
Job opportunity
Economic use of limited resources of production.

Following are the main differences between cost control and cost reduction:
1. Focus
Cost control focuses on the minimization of wastage than the reduction of cost. Cost
reduction focuses on minimization of cost through new production process, improved
plant layout, scientific material handling etc.
2. Basis of Application
Cost control is routinely applied on a continuous basis. Cost reduction is applied when an
opportunity for cost reduction is identified which offers a competitive advantage for a
longer time.

3. Use of Accounting Techniques

Cost control heavily relies on accounting techniques. Cost reduction may not involve the
use of accounting technique.
Variance

A variance is the difference between the standards and the actual performance

When the actual results are better than the expected results, there will be a favourable
variance (F)

If the actual results are worse than the expected results, there will be an adverse variance
(A)

Profit variance

Selling and Total production

Total sales margin varian
administrative
Cost variance
Cost variance

Sales margin
Sales margin
Price variance
volume variance
Materials Labour Variable
Cost
Overhead
cost
variance variance variance

Fixed
Overhead
variance

Materials cost variance

Material Price variance

Material Usage variance

Labour cost variance

Labour rate
variance

Labour Efficiency variance

Variable
Overhead
variance
VO Expenditure
variance

VO Efficiency
variance

Fixed Overhead
variance

Fixed
Expenditure
variance

Fixed Volume
variance

Cost Variance

Cost variance = Price variance + Quantity variance

Cost variance is the difference between the standard cost and the Actual cost

Price variance = (standard price actual price)*Actual quantity

A price variance reflects the extent of the profit change resulting from the change in activity
level

Quantity variance = (standard quantity actual quantity)* standard cost

A quantity variance reflects the extent of the profit change resulting from the change in activity
level

Three types of Cost Variance

Material cost variance

Labour cost variance

Variable overheads variance

Material Cost Variance

Material price variance

= (standard price actual price)*actual quantity

Material usage variance

= (Standard quantity actual quantity)* standard price
= (Standard quantity for actual production actual quantity production) * standard price