Agenda for discussion ..

Day 2

Cost & Cost Classification Target Costing

Fixed & Variable Costs Time Value of Money
Marginal Cost, Contribution
Annuities
Break-even Point Analysis
Capital Structure
Operating Leverage
Direct & Absorption Costing Cost of Capital
Transfer Pricing Economic Value Added
Budgeting Investment Appraisal techniques
Management Information System Overview of Financial Markets
Activity Based Costing
Cost

Cost is a resource sacrificed or foregone

Compensation expressed in monetary terms paid to a
supplier of any service or goods
Costs are no longer looked at on a piecemeal basis but
rather holistically
 Cost Classification

By Cost Elements
By Directness
Costs & their revenue linkages
Fixed vs. Variable
Elements of Cost

Material
Labour
Expenses
Cost classification by Directness

Direct Cost
Costs which can be economically traced to a Cost Object
Indirect Costs
Costs which cannot be economically traced to a Cost
Object
Combination of elements &
directness

Direct Material
Direct Labour
Direct Expenses
Overheads
Indirect Material
Indirect Labour
Indirect Expenses
Cost Elements & Final Product

Product 1
Material
Product 2
Labour
Product 3
Expenses
Cost Center 1 Product 4
Overheads
Cost Center 2 Product 5

Cost Center 3 Product 6

Cost Center 4 Product 7

 Behaviour of Costs

Some costs are linked with time

They are called as Fixed Costs

Some costs are linked with volume of work or activity

They are called as Variable Costs
Variable Costs

Change in direct proportion to changes in activity

Examples,
Cost of Materials
Fuel
Cost per unit of activity remains the same whereas the
aggregate cost changes with activity / volumes
Aggregate
Variable
Costs Costs
Per Unit
Variable Costs
Activity/ Volume
Management of Variable Costs

Variable costs directly impact contribution

Small changes could result in high impact

Examples :
Negotiating for a lower price
Substitution of raw materials or change in mix without
change in quality
Alternate sourcing of raw materials
Technological breakthrough
Improved efficiency in energy utilization
Improvement in input-output ratio
Realizing higher value for by-products or wastages
Marginal Cost

The cost of producing one extra unit

Usually, marginal cost = variable cost

When capacity is constrained, marginal cost could be

more than variable cost due to the cost of capacity
creation
Fixed Costs

Remains unchanged for a given time period, may step up

beyond a certain activity level
Costs of capacity creation
Aggregate is first known, per unit is derived based on the
activity / volume

Aggregate
Costs Fixed
Costs
Per Unit
Fixed
Costs
Activity/ Volume
Management of Fixed Costs

Linked to capacity build up

Land and building
Plant and Equipment
Human Resources

Capacity utilization is the key

The other is tighter control on time
Contribution Income Statement

Sales/ Revenue
(-) Variable Costs
Contribution (1)
(-) Fixed Cost
Profit Before Interest and Tax
or Operating Income (2)
(-) Interest
Profit Before Tax (3)
(-) Tax
Profit After Tax (4)
Contribution Margin %

Contribution
____________________ X 100
Total Revenue
Break Even Point (BEP)

A level of volume or activity at which profit is 0

At BEP, the organization has, on the positive side, the
critical mass to move into a profit zone and on the
negative side, the risk of slipping into losses
Lower the break-even point the better
Each organization has to monitor how far it is from it :
Check its safety zone
Break Even Chart

2500
Costs and Revenue ( Rs. )

2000
Variable Costs
1500
BEP Fixed Costs
FC + VC
1000 Revenues

500

0
0 250 500 750 1000
Output
Calculation of Break Even Point

Break-even Number of Units (in a single product co.)

Fixed Costs
______________________
Contribution Margin Per Unit
Break-even Revenue Level
Fixed Costs
______________________
Contribution Margin %
 Margin of Safety

Margin of Safety in units =

Current level of activity in units Break Even Point in Units
Margin of Safety expressed in Revenue Level (Rs.)
Current Level of revenue - Break even revenue level
Operating & Financial Leverage

Contribution 150
Fixed Costs 50 O/L

Earnings Before Interest & Taxes 100

Less : Interest 20
F/L
Earnings (Profit) Before Tax 80
Operating Leverage = 150/100 = 1.50
Financial leverage = 100 / 80 = 1.25
Total Leverage = 1.50 x 1.25 = 1.875
This can also be arrived at as = 150 /80
Operating & Financial Leverage

Contribution 150
Fixed Costs 50
Earnings Before Interest & Taxes 100 T/L
Less : Interest 20
Earnings (Profit) Before Tax 80
Operating Leverage = 150/100 = 1.50
Financial leverage = 100 / 80 = 1.25
Total Leverage = 1.50 x 1.25 = 1.875
This can also be arrived at as = 150 /80
 Direct & Absorption Costing

Inventory valuation influences reported profit

Direct costing: Overheads ignored for valuation
Thus, overheads charged to the year in which incurred
Absorption costing: Manufacturing overhead included
Overheads included in stock get transferred to next year
Some firms have started following direct costing for internal
reporting & incentive calculations
 Transfer Pricing

Business Segments supplying/sourcing from each other

Freedom to sell outside / buy from outside?
Pricing has a major bearing on outcome for the firm, particularly
when there is freedom
Market driven pricing will tend to optimize for the firm as a whole
Budgeting Process

Strategic Emergence of
Environment Clarity Action Plans
Assessment & their
ownership

Opportunities Involvement of Operational

Assessment people at Budgets
various levels

Team Work &

f
Organisational better Financial
Assessment understanding Budgets
of business
Requisites of Management
Information System

Key MIS on time is more valuable than lengthy reports with

much of delay
Includes both formal & informal MIS
Both Financial & Operational MIS is important
Wherever possible, the two should be integrated
Required at various levels, based on who could make a
difference
 Activity Based Costing
Measures cost and performance of activities, resources and
cost objects
Recognizes causal relationships of cost drivers to activities
ABC refines costing systems by focusing on individual
activities as the fundamental cost object
Provides much better understanding of overheads
 Cost Drivers

Output volume is quite often believed to be the most significant

cost driver
Multiple drivers affect costs
Each is called a Cost Driver
Cost Drivers are further classified into Resource Drivers & Activity
Drivers
 What things Cost ?

Resources Work Activities

consume
Resources Cost Resources
Assignment
Why
Cost Manage
things Activities ABM
Drivers Activities
Cost ?
Activity Cost
Assignment
Product, Objects
Cost Objects consume
Channel, (Output) Work
Customer Activities

ABC
Target Costing

We calculate cost carefully.. But no one knows what the

cost ought to be : Henry Ford, 1923
Traditional: Cost + Profit = Price
Target Costing: Price Profit = Cost
Target Costing channelizes organizational energy to
reduce costs
Time Value of Money

A rupee received today is more valuable than a rupee

received tomorrow

Interest

Present Future

Discount
 Present & Future Values

Future Value:
Equal to Principal X (1 + r)n
N = Number of periods, R = Rate of interest
Present Value:
Equal to Principal / (1 + r)n
N = Number of periods, R = Rate of interest

Sensitivity to both period, frequency of compounding &

rate of interest
Future Value

Today 1 years later 2 years later 3 years later

Rs. 10,000
Rate of Interest 9%

ANNUAL
Rs. 10,900 Rs. 11,881 Rs. 12,950

QTRLY
Rs. 10,931 Rs. 11,948 Rs. 13,060

MNTHLY Rs. 10,938 Rs. 11,964 Rs. 13,086

DAILY
Rs. 10,942 Rs. 11,972 Rs. 13,099
Present Value

Today 1 years later 2 years later 3 years later

Rs. 10,000
Rate of Interest 9%

ANNUAL
Rs. 10,900 Rs. 11,881 Rs. 12,950

QTRLY
Rs. 10,931 Rs. 11,948 Rs. 13,060

MNTHLY
Rs. 10,938 Rs. 11,964 Rs. 13,086
DAILY Rs. 10,942 Rs. 13,099
Rs. 11,972
Annuity

The same amount recurs at a regular interval

Life Insurance Policy, Housing Loan, Recurring Deposit,
Systematic Investment plans are all examples of this
Annuity factor tables are constructed using time values
of the respective periods
Let us go through some time value tables provided to
you
Key messages from Time value concept

Seek early collection

Delay payments by agreeing contractually
Analyze two amounts only after adjusting for time value
Factor time value in all decisions
In decision making, use only relevant revenues & costs;
ignore sunk costs
Capital Structure
&
Cost of Capital
Sources of Finance

Equity Debt

Equity Debentures

Preference Term Loan

Reserves Cash Credit

Convertible CP
Debentures Leasing
Foreign Cy.
Borrowings
 Principles in financing

Finance long term uses with long term sources

Finance core requirement of short term uses (working capital)
out of long term sources
Finance fluctuating short term requirement out of short term
sources
Match currency of assets & liabilities
Match character of interest earnings & expenditure (particularly
for financial service enterprises)
Advantages of equity
form of financing

No commitment of fixed returns

Increase in corporate earnings (through increase in stock
price) can provide returns to shareholders, dividend only
a small fraction
Reduces risk of financing if Operating Leverage is
already high
Advantages of debt
form of financing

Financial Leverage effect: The difference between return

on investment and debt interest is kept by shareholders
Tax break on interest cost
No dilution of ownership
Operating & Financial Leverage

Contribution 150
Fixed Costs 50
Earnings Before Interest & Taxes 100
Less : Interest 20
Earnings (Profit) Before Tax 80
Operating Leverage = 150/100 = 1.50
Financial leverage = 100 / 80 = 1.25
Total Leverage = 1.50 x 1.25 = 1.875
This can also be arrived at as = 150 /80
20% increase in contribution

Contribution 180
Fixed Costs 50
Earnings Before Interest & Taxes 130*
Less : Interest 20
Earnings (Profit) Before Tax 110**

* 20% X 1.5 = 30% increase

** 20% X 1.875 = 37.5% increase
20% decrease in contribution

Contribution 120
Fixed Costs 50
Earnings Before Interest & Taxes 70*
Less : Interest 20
Earnings (Profit) Before Tax 50**

*20% X 1.5 = 30% decrease

**20% X 1.875 = 37.5% decrease
Sources of Finance
Equity vs. Preference

Preference:
Indicative returns
Only out of profits
Preference in payment of dividend
Preference in repayment of capital
Can be of various types: cumulative, non-cumulative,
participating, non-participating

Provide leverage effect to equity shareholders

Term Loans

For financing specific equipment or for financing core

working capital
Fixed or floating rate interest
Usually secured through mortgage
Domestic currency or foreign currency term loans (FCNR
B)
Foreign currency term loans create a currency exposure
Debentures

Securitized loan
Fixed or floating rates
Publicly offered or privately placed
Convertible Debentures

Hybrid Instrument with both equity & debt features

Used for attracting debt funds at a lower rate of interest
with a sweetener of equity
Conversion option to be exercised by the investor
 Cash Credit

Pay as you use

Provides an opportunity to use liquidity in a smart way
(liquidity: unutilized credit limit)
In a multi-location company, cash can be pooled to this
account to reduce interest burden
Sub-limits can be set up in different locations
Commercial Paper

A cheaper way of arranging short term funds

Significant interest cost savings
Credit rating requirement
Stamp duty & credit rating fees are additional costs but
adequately compensated
Equipment Leasing

Finance Lease and Operating Lease

Sale and Lease Back and Direct Lease
Single Investor Lease and Leveraged Lease
Domestic Lease and International Lease
Dry Lease and Wet lease
Cost of Capital
Firms Cost of Capital

Weighted Average of various sources

Influenced by cost of each source
Also, be weightage of that source in the overall capital
mix

WACC = Wi . Ci
Weighted Average CoC

Used as a hurdle rate for capital budgeting i.e. for

making investment decisions
If the risk of new investments is higher than existing
investments then the hurdle rate should be suitably
upped
Key guiding factors
for cost of capital calculations

Post-tax computations
Implicit cost as reflected in current market values is recognized
rather than just the agreed coupon rate
Incidental costs relating to sourcing of finance also relevant
Average cost calculated with reference to market values
 Cost of Debt

Cost of debt (pre-tax) = such a rate of interest which if used

for discounting future coupons and the redemption amount
would equal the current price
This is called as Yield to maturity (YTM)
Post tax cost is calculated by multiplying the YTM by (1 tax
rate%)
 Cost of Debt

Quick way of calculation is by using the approximate yield

formula
Coupon + (Face ValuePrice)/Periods
= ---------------------------------------------- X (1 t%)
0.4 X Face Value + 0.6 X Price

The interest should be annualized if coupon paid half-yearly

Cost of Preference Capital

Similar to Debt except that no post-tax adjustment is

required
Quick way of calculation is by using the approximate
yield formula
Pref. Div + (Face Value Price)/Years
= --------------------------------------------------------
0.4 X Face Value + 0.6 X Price
Cost of Equity

Arrived at on the basis of the equilibrium principle viz.

Required Rate of Return = Expected Rate of Return

Required based on relative risk with reference to market

Expected as reflected in current price & growth
Cost of Equity can be estimated by using either route
and if the two are equal the price is at equilibrium
Securities Market Line Approach

Re= Rf + Be (Rm Rf)

Re= Return on Equity
Rf= Risk Free Return
Be= Beta of the security: volatility relative to the volatility
in the market
Rm= Return on the Market Portfolio

Required rate of return

Dividend Growth Model Approach

Derived from Constant Growth Model referred to in

equity valuation
D0 x (1+g)
Re= ------------------ + g
P 0

* Where there is a share issue proposed, the price should

be adjusted for issuance cost.

Expected rate of return

Cost of reserves

Reserves are not free since they are built into the equity
price
Cost of reserves treated the same as cost of equity
except that issue cost is not required to be taken into
account
Determining proportions

Book Values
Readily available
Does not reflect market determined values

Target Capital Structure

Market Values
Preferred approach
In some cases, market value may not be available
 Weighted Marginal Cost of
Capital

More the firm borrows, higher would be the cost of capital

The ranges in which the cost of capital may change is not the
same for each source
One can therefore develop slabs in which cost of capital would
move up
At each slab, a weighted cost of capital can be worked out
 Economic Value Added (EVA)*
Central Idea: Economic value addition by a firm is the profit earned by it after
taking into account the cost of capital.

EVA is calculated by reducing from Net Operating Profit After Taxes (NOPAT),
the cost of capital. NOPAT is calculated as follows:
Revenue
Less: Operating Costs
_________________________
Operating Profit Before Tax
Less : Taxes
_________________________
Net Operating Profit After Tax

EVA can be calculated at business segment or divisional level

* Trademark of Stern Stewart & Co.
Investment Decisions
Basic Principles

Invest If Yield > Hurdle Rate

Hurdle rate should be higher for riskier projects

If marginal investment yield < hurdle rate, return cash to

shareholders
Dividend
Buy-back

Base decisions using Time Value principle

 Investment Criteria

Investment Criteria

Discounting Non-discounting Criteria

Criteria

Net Benefit Internal Accounting

Payback
Present Cost rate of rate of
period
Value Ratio return return
 Net Present Value (NPV)

The net present value of a project is the sum of the present values of all the cash
flows- positive as well as negative that are expected to occur over the life of a
project

n
NPV of project = Ct
- Initial Investment
t=1 (1+r)t

Ct = cash flow at the end of year t

n = life of the project
r = discount rate

The net present value represents the net benefit over and above the
compensation for time and risk
 Internal Rate of Return (IRR)

The internal rate of return (IRR) of a project is the discount rate which
makes its NPV equal to zero
Discount rate which equates the present value of future cash flows with the
initial investment
It is the value of r in the equation
n
Ct
Investment =
t=1 (1+r)t
Ct = cash flow at the end of year t
r = internal rate of return (IRR)
n = life of the project

In the IRR calculation, we set the NPV equal to zero and determine the
discount rate that satisfies this condition
 Payback Period

Payback period is the period within which the return from the project will
be sufficient to cover investment
In case of a project having equal annual inflows, it is calculated as :

Cash Outflow
Payback Period =
Annual Inflows

In case the inflows are not uniform, it is calculated by taking the

cumulative cashflows for the various years
 Profitability Index (PI) or
Benefit-Cost ratio (B/C ratio)

It is similar to the NPV approach

Profitability index approach measures the present value of returns per
rupee invested
It may be defined as the ratio which is obtained dividing the present
value of future cash inflows by the present value of cash outflows
PVB
BCR = PVB = (Present value of Benefits)
I
Net BCR = PVB -I = BCR -1
(NBCR) I I = (initial investments)

Its also called Benefit/Cost ratio because the numerator measures

benefits & the denominator costs