Engineering Economy and Finance

8/7/2019 Engineering Economy and Finance

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ENGINEERING ECONOMY AND FINANCE

Prof. Jitesh ThakkarINUSTRIAL MANAGEMENT (IM41081)

Department of Industrial Engineering & Management

Indian Institute of Technology Kharagpur



Function of finance department

Is concerned with money

± Bringing into company

±

Looking at how it used± Paying it out

The Aim of finance department is to ensure

that it provides the organization with the

financial stability to meet it corporate goals



Organization of finance department

� Medium and large size organization : usually withdirector of the company

� Small company under owner or an executive director

� Other staff:±

Accountants� Ledger clerk

� Payroll clerk

� Taxation clerk/ officer

� Purchasing clerk/ officer

�

Defining spending limits and procedure of committingexpenditure

� Deal with other organizations such as revenue, banks,customers and suppliers



Activities of finance department

1. Bringing money into company

2. Using money

3. Paying money out




1. Bringing money into company:

i. Capital planning

ii. Indication of implications of proposed plans

iii. Manage funding e.g. taking loans, using reserves

or increasing share holding

iv. Accounting activities

v. Invoicing for payments of the goods




2. Using money:

To ensure that its money is being usedeffectively

± How much its products cost± Sales prices to be set

± Cash flow requirements

The data is provided by operations departments

products costprofit margin, turnover budgets

Production data cash flow forecasting




3. Paying money out:

i. Payments for goods and services

ii. Payments to labours (taxes, insurance, PF, etc)




4. Reporting on financial activitiesi. Financial information for internal use

Budgets

Sales figures

Capital spend

Cost of overheads Cash flow

ii. Preparation for financial statements required bylaw Balance sheet

Profit and loss accounts

iii. Financial information for other external sourcese.g. for loan



The ideal financial system

� The most cot effective method of ensuring that the

organization can operate its financial affairs in such a way

that the organization goals may be best served

± Annual audited accounts for government

requirements : financial accounting

± Business performance data with sufficient accuracy

for internal use : management accounting



financial accounting



The Balance sheet

1. A Financial snap shot of the organization

2. Generally prepared on last day of the financial year

3. The balance sheet is to be considered along with other

documents such as profit and loss account

4. It operates on the principle that if you have something it musthave been paid for somehow

5. To represent this on a balance sheet :

one side would show where money comes from

The other side shows what has done been with it

6. Assets equal the sources of the funds

Assets = Liabilities



The Balance sheet

Assets

1. Fixed assets

2. Current assets

Total assets

Liabilities

1. Long term liabilities

2. Current liabilities

Total liability3. Capital and reserves



Assets & Liabilities

Fixed assets:

a. Tangible assets: plant, machinery, building,(depreciation is allowed for and value of given asset

falls down with time), goodwill (loyal customerprepared to pay over market rates)

b. Investments : long term investments (more than 1financial year, such as loan made to other

companies, fixed deposits, mutual funds,debentures purchased),

Total fixed assets =a +b




Current assets:a. Cash on hand

b. Cash in bank

c. Stock (useful components , raw materials, work in progress)

d. Debtor (someone who is shortly to pay money)

e. short term investments (known as money market investments)




Liabilitiesa. Long term liabilities (due after more than 1 year)

Loan taken

Debenture sold (an agreement with lender to repay money at

fixed rate over a period of time in return for lump sump)b. Current liabilities (due in less than 1 year)

Creditor (people to whom organization owes money, normalperiod 30 days)

Tax

Unpaid bills to be paid within 1 year

Total liabilities =a +b



Capital and Reserves

1. Called-up share capital : money raised through sale of

shares at their nominal value.

2. Reserves : the reserve transferred out profit to at

discretion of the directors. Reserve may includebalancing amounts of money caused by revaluation of

property.

3. Share premium account : the amount of money raised

by issuing share at a price above their nominal value.



Profit and loss account

profit and loss

=total assets (total liabilities + total

capital and reserves)



Example: 1

Prepare a balance sheet for CNZ Limited as on

date with the help of given financial details

along with the entry of profit and loss account



Financial detailsDetails

1. Building

2. Cash in hands

3. Debentures purchased for 5 years

4. Debentures sold for 3 years

5. Equipment

6. Finished products7. Loan from ICICI

8. Loan given to XYZ for 10 years

9. Payment collected

10.Raw material

11.Reserve12.Share capital

13.Unpaid bills

14.WIP

Consider depreciation @10% for tangibleassets

Value in Lakh Rs.82.0

30.0

60.0

20.0

48.0

16.040.0

10.0

22.0

18.0

15300

25.0

12.0



Identify assetsDetails1. Building

2. Cash in hands



5. Equipment



9. Payment to be collected

10.Raw material

11.Reserve

12. Share capital13.Unpaid bills

14.WIP

Asset/ liabilities/surplus82.0 A

30.0 A

60.0 A

20.0

48.0 A

16.0 A40.0

10.0 A

22.0 A

18.0 A

15

30025.0

12.0 A



Identify Financial LiabilitiesDetails

1. Building

2. Cash in hands



5. Equipment




10.Raw material


13.Unpaid bills

14.WIP


30.0

60.0

20.0 L

48.0

16.040.0 L

10.0

22.0

18.0

15300

25.0 L

12.0



Identify capital and reservesDetails1. Building

2. Cash in hands



5. Equipment




10.Raw material


13.Unpaid bills

14.WIP


30.0

60.0

20.0

48.0

16.040.0

10.0

22.0

18.0

15 C300 C

25.0

12.0



Financial detailsDetailsBuilding

Equipment

Debentures purchased for 5 years

Loan given to XYZ for 10 years

Cash in hands

Raw materialWIP

Finished products

Payment collected

Loan from ICICI

Debentures sold for 3 years

Unpaid billsReserve

Share capital

CategoryA1

A2

A3

A4

A5

A6A7

A8

A9

L1

L2

L3C1

C2



Profit and loss and appropriation

1. It is the objective of the business is to make profit

Buying raw material / thingspvalue additionp selling at

sufficient high pricep pay labour, material cost and cost of

running business p the money left is Profit

2. The profit is disposed as per desire:� Payments to shareholders

� Purchase of new assets

� Bonuses to employees

3. Unlike the balance sheet , the profit and loss account applies toa period of time and shows the cumulative effect of all the

transactions over a period of time, usually a year



Profit and loss and appropriation

� Turn over

� Net operating cost

� Profit before tax

� Tax

� Profit after tax

� Dividends

� Profit retained

Year 5year 4

9070083800

7150066600

1920017200

6200 5800

1300011400

1900 1700

111009700



Cash flow projections

� Cash flow projections are covered to any

situation where the disbursement of cash is

important

Year sale cost profit loan repayment outstandingloan

5. - - - - 30

6. 105 80 19 2 28

7. 125 95 22 10 18

8. 130 89 33 12 6

9. 130 87 35 6 00

10. 139 87 35 0 00



Financial Ratios

The Use Of Financial Ratios

Analyzing Liquidity

Analyzing ActivityAnalyzing Debt

Analyzing Profitability

A Complete Ratio Analysis



Groups of Financial Ratios

1.Liquidity

2.Activity3.Debt

4.Profitability











Analyzing Liquidity

1. Liquidity refers to the solvency of thefirm's overall financial position, i.e. a

"liquid firm" is one that can easily meet its

short-term obligations as they come due.2. A second meaning includes the concept of

converting an asset into cash with little or

no loss in value.



Three Important Liquidity Measures

Net Working Capital (NWC)

NWC = Current Assets - Current Liabilities

Current Ratio (CR)

Current AssetsCR =Current Liabilities

Quick (Acid-Test) Ratio (QR)

Current Assets - Inventory QR =

Current Liabilities



Return on capital employed

(ROCE)

ROCE= (Pre tax Profit) / capital employed

The capital employed means the capital usedin creation of the profit, which is defined as

total asset less current liability

it indicates how much money was used in the

generation of the profit.



Profit margin

Profit margin=

(trading profit) / (total sales)

= (value of sales cost of sales) / sales value



(stock) Turnover (ST)

Inventory (stock) Turnover (ST)

(stock)

Cost of Goods Sold=

Inventory (stock)



Analyzing Debt

Debt is a true "double-edged" sword as it allows

for the generation of profits with the use of

other people's (creditors) money, but creates

claims on earnings with a higher priority thanthose of the firm's owners.

Financial Leverage is a term used to describe the

magnification of risk and return resulting fromthe use of fixed-cost financing such as debt and

preferred stock.



Four Important Debt Measures

Debt Ratio

(DR)

Debt-Equity Ratio

(DER)

Times Interest Earned

Ratio (T

IE

)

Fixed Payment Coverage Ratio (FPC)

T otal LiabilitiesDR=

T otal Assets

Long-T erm Debt DER=

Stockholders· Equity

Earnings Before Interest & T axes (EBIT )

T IE=Interest

Earnings Before Interest &T axes + Lease Payments

FPC=Interest + Lease Payments+{(Principal Payments +Preferred Stock Dividends)

X [1 / (1 -T )]}



Analyzing Profitability

± Profitability Measures assess the firm's ability to

operate efficiently and are of concern to owners,

creditors, and management

± A Common-Size Income Statement, whichexpresses each income statement item as a

percentage of sales, allows for easy evaluation of

the firms profitability relative to sales.



Seven Basic Profitability Measures

Gross Profit Margin (GPM)Operating Profit Margin

(OPM)

Net Profit Margin (NPM)

Return on Total Assets(ROA)

Return On Equity (ROE)

Earnings Per Share (EPS)Price/Earnings (P/E) Ratio

Gross ProfitsGPM=

Sales

Operating Profits (EBIT )OPM =

Sales

Net Profit After T axes

NPM= Sales

Net Profit After T axesROA=

T otal AssetsNet Profit After T axes

ROE=Stockholders· Equity

Earnings Available for Common Stockholder·s

EPS =Number of Shares of Common

Stock Outstanding

Market Price Per Share of Common Stock

P/E =Earnings Per Share





Other ratios

�Output per employee = (value of sales)/

Number of employees



Example : 1

Liquidity ratio

Quick (Acid-Test) Ratio (QR)

Current Assets - Inventory QR = Current Liabilities

= (98-18-12-16)/25 = 2.08

A measure of firms ability to pay off short-term

obligation without relying on the sales of its

inventories



management accounting



Costing

1. It is the process of calculating how much something costs tomake.

2. The most important use of information is in determining the

realistic selling price.

3. Helps to determine which product areas are worth investing4. Provides information for decisions relating to making or

buying-in parts

5. Allows to decide which product need further developments

for desired profit6. The term costing generally applies to existing products



Components of costing

1. Material

2. Labour

3. Lighting

4. Heating

5. Transportation

6. Professional services

7. Human resources development

8. Administration



Methods of costing

1. The first method is based on direct and

indirect costs.

2. The second is based on variable and fixed

cost.



Direct and indirect costs

1. Direct costs: can be directly attributed to the

product for which a cost is being prepared.

i. Direct labours for the particular product

ii. Direct material based on bill of material for a particular

product

iii. Direct expenses relates to the costs incurred in buying

services for the particular product



Direct and indirect costs

2. Indirect costs: are also called overheads, are the costsassociated with operating the business which can not be

directly assigned to product or services being provided.

i. Material used for other products also: e.g. soldering flux,

rags, cutting fluid etc.ii. Indirect Labour would include design engineers,

supervisors and administrative staff

iii. Indirect expenses would include heating, lighting and

rent of premises



Recovery of overheads

1. Apportionment (distribution) to cost centre

2. Absorption (inclusion) by product



Apportionment to cost centre

1. A Cost centre is part of business that can be

identified for the purpose of determining the costsi. Whole factory

ii. Particular departmentiii. Specific machine

iv. Particular product

v. Particular person

2. Each cost centre should bare a fair share of indirect

costs



Apportionment to cost centre

3. Typical bases for apportionment

i. Floor area for rent

ii. Number of employees for indirect labour and personnel

costsiii. Book value of assets for depreciation and insurance



Absorption of overhead by product

1. Indirect costs charged to a individual product

2. Calculated on the bases of :

i. Standard or expected rate , volume of production

ii. Units of output and machine hours

iii. Material rates is divided by the actual or

expected costs of direct materials



Full costing

1. The cost of product based on both direct and

overhead costs



fixed and variable costs

1. Sometimes the cost of a product is divided into: fixed andvariable costs

2. The variable costs are those that vary in proportion to the

amount of output and so would include:

i. Direct materialsii. Use of temporary labour

iii. Overtime charges

3. The fixed costs are paid irrespective of output

i. Cost of employing people

ii. Cost of having premises

iii. Cost of machinery available



Break-even point for

the manufacture of any product

� This the point at which the income from sales

is equal to the cost of manufacture, where no

profit or loss is made, and company breaks

even.





Example : 2

Following data is the cost incurred by amanufacturing company

Department Overhead in

Rs.

Direct material

cost in Rs.

Number of

employees

Personnel 52,000 - 4

Purchase 65,000 - 2

Machine shop 1,25,000 6,20,000 8

Assembly shop 1,00,000 1,75,000 6



Example : 2

Above mentioned job is manufactured in a

machine shop for which direct material cost is

Rs. 25; direct labour cost is Rs. 18 and direct

expenses is Rs. 10 per unit. The overhead

should be absorbed on the basis of direct

material rate. Find the total cost of the job.



Example : 2- solution

1.T

he problem is to be solved by apportion and absorption of overhead costs

2. Eliminate the cost of personnel department by distributing theoverhead of personnel department proportionately to otherdepartments.

Basis of distribution= number of employees in a particulardepartment

i. Total number of employees from other than personnel = 2+8+6 = 16

ii. Towards purchase department = (2/16)*52,000 = 6,500

iii. Towards m/c shop = (8/16)*52,000 = 26,000

iv. Towards assembly shop = (6/16)*52,000 = 19,5003. Total overhead purchase dept. =6,50,000+ 6,500

=71,500




3. Apportioning of purchase overheads to production shopsBasis of distribution= direct material cost in a particular department

TOTAL DIRECT MATERIAL COST= 6,200,00 + 1,75,000=

7,95,000

i. Towards machine shop =

(71,500* 6,20,000) / 7,95,000= 55,761

i. Towards assembly shop =

(71,500*1,75,000) / 7,95,000= 15,738

4. Total overhead of machine shop =

m/c shop overhead +personnel portion + purchase portion =

1,25,000+26,000+55,761=2,06,761




5. Total overhead of assembly shop =assembly shop overhead +personnel portion + purchase portion =

1,000,00 + 19,500 + 15,738

= 1,35,238

6. Total overheads of production shops = overhead of machine shop

+ overhead of assembly shop= 2,06,761 + 1,35,238 = 3,42,000

7. Material recover rate (MRR) :

for processing every Rupee of material in machine shop the

overhead = machine shop overhead / direct material cost =

2,06,761 / 6,20,000=

0.33, As the cost of direct material is Rs. 25 ,MRR = 25+25*0.33 = 33.25




8. Total cost of job which is manufactured in machine shop = 25+ 8.25 + 18 + 10 = 61.25



Example : 3

The running cost of a machine is as follows:

Values are in Rs.

1. Tooling cost 35,000

2. Maintenance 18,000

3. Spare parts 23,000

4. Power cost 4.5 per hour

� The machine is depreciated at the rate of Rs. 6,000 every

year

� The expected run time is 313 days with two shifts of 8 hours

each day i.e. 16 hours per day



Example : 3

� Find out overhead recovery rate and total cost of a job

manufactured on this machine with the following additional

information:

Direct material cost : Rs. 180

Direct labour cost: Rs. 250

Direct expenses : Rs. 120

Machine usage time : 6.5 hours



Example : 3 - solution

1. Total working hours = 313*16=5,008 per year

2. Power cost per year =5,008*4.5=22,536

3. Total overhead for the machine = Tooling cost

35,000+Maintenance 18,000 +Spare parts 23,000 +Depreciation 6,000 + Power cost 22,536 = 98,536

4. Machine hour rate = total overhead / number of working

hours = 98,536 / 5,008 =20.87 Rs. Per hour

5. Total cost = 180 + 250 + 120 + (6.5*20.87) = 685.67





Techniques of Investment appraisal

1. Payback period :i. It is the time that a project must run in order that the cash

generated will repay the initial investment.

ii. Payback is calculated on the basis of absolute values of

the expected income after tax.iii. This is simple a technique and therefore widely used

iv. The early returns are generally preferred to the longer

ones

v. It does not recognize that that money devalues withtime



Example : 4

1. Investment = Rs. 1,00,000

2. Annual return = Rs. 20,000

3. Payback =

(1,00,000 / 20,000) = 5 years



Techniques of Investment appraisal

2. Discounted cash flow:i. Looks at the earning the life of the project and the time

at which returns are received , and it allows for the fall in

value a period of time.

ii. It is a fact that Rs. 100 today is worth more than Rs. 100would be in a few years time. This comes about not

because of inflation, which evens out over a period of

time and also affects both costs and profit equality , but

because Rs. 100 invested today will attract interest at

some rate and therefore investment will increase in

value.



The present value

�If the interest rate is 10% and we invest Rs. 500 today and infive years of time the investment will be worth Rs. 805,

assuming that the interest is immediately reinvested at the

same rate and that capital is left untouched.

± 500*1.10*1.10*1.10*1.10*1.10 = 805

� In a similar way we can work backward and say that if the

interest rate is 10% then Rs.500 payable in fivers time will be

worth Rs. 310 today.

± 500/ (1.1)5 = 310

± 310*1.10*1.10*1.10*1.10*1.10 = 500

� This called the present value



The present value

P = S / (1+i)n

Where

P = Present valueS = Sum in future

i = interest rate (also called discount rate)

n = number of years



Net present value

1. An investor get 8% interest per annum by investing money ina building society . The investor is offered an alternative

investment by another company which will provide Rs.

3,88,000 at the end of each of three following years

2. In order to calculate the value of this second investment we

need to asses what it is worth today



Net present value

P = ((3,88,000) / 1.081) + ((3,88,000) / 1.082) +((3,88,000) / 1.083)

= 3,59,259.3 + 3,32,647.5 + 3,08,006.9 = 9,99,913.6

The present value of the investment is Rs. 9,99,913.6therefore if the capital cost of the second investment is less

than Rs. 9,99,913.6 then this investment will make more

money

Net Present Value =

present value of the return capital cost



Example : 5

� An investment of Rs. 13000 yields return of Rs. 4000

per year for first three years and Rs. 2000 per year

the next two years

� By calculating net present values determine whetherthis is a worth investment, if the money could

otherwise be invested at 5 % per annum or at 10 %

per annum



Example : 5 solution

1. Present value at 5 % interestP = (4000/1.051)+(4000/1.052) +(4000/1.053) +(2000/1.054)+

(2000/1.055)

= Rs. 14105

2. Net Present value at 5 % interest

= 14195 13000 = +1105

3. If the money could only be invested at 5 % then this is

worthwhile investment as it would bring a positivenet present value



Example : 5 solution

1. Present value at 10 % interestP = (4000/1.101)+(4000/1.102) +(4000/1.103) +(2000/1.104)+

(2000/1.105)

= Rs. 12555

2. Net Present value at 5 % interest

= 12555 13000 = - 445

3. If the money could be invested elsewhere at 10 %

then this is not profitable investment as it wouldbring a negative net present value



Internal rate of return

1. This is the discount rate, or rate of interest , atwhich net present value is zero

2. it is a point at which you break even.

3. Data of example : 5@ 5 % NPV = + Rs. 12555

@ 10 % NPV = - Rs. 445

IRR = 5 + ((1105/(1105+445)) = 8.56 %



1105

771

449

140

-158

-445

-600

-400

-200

0

200

400

600

800

1000

1200

0 1 2 3 4 5 6 7 8 9 10 11

N

P

V

i

n

R

s

.

interest rate %

DETERMINATION OF INTERNAL RATE OF RETURN



Depreciation

1. Investments in terms of cost to buy are considered as assetto the company in successive years with decreasing value

2. The term used to describe this reduction in value is

depreciation . The reduced vale is considered as book value

3.T

here are accounting techniques to calculate depreciation4. The factors for depreciation :

i. Wear and tear

ii. Shelf-life

iii. Damage due to misuse



Depreciation

5. Depreciation must be incorporated in balance sheetto show the reduction in asset value

6. Book value = cost of asset - depreciation

7. Stock is not to be depreciated because it is valuedannually

8. Methods for calculating depreciation

i. Straight-line method

ii. Reducing-balance methodiii. Production unit method



Straight-line method

1. Asset is depreciated by equal annual charges spreadover assets estimated life

2. D= (c-s)/n

D= depreciation charge, c= cost, s=scrap value,

n= estimated life

1. Example

i. Cost : Rs. 6,00,000

ii. Scrap value : Rs. 40,000

iii. Estimate life : 10 years

iv. Annual depreciation

= (6,00,000 40000) /10 = 56,000



Reducing-balance method

1. The depreciation charge is a constant proportion of balanceremaining at the end of each accounting period.

2. Example

i. Cost : Rs. 6,00,000


iii. Estimate life : 10 years

value year

Rs. 600000 0

Rs. 6,00,000 10% =54,0000 1Rs. 54,0000 10%=48,600 2



Production unit method

1. The depreciation charge is based on numberof units of work produced

2. D= (c-s)/ND= depreciation charge, c= cost, s=scrap value,

N= estimated production units

3. Examplei. Cost : Rs. 13,00,000


iii. Estimate production : 2,50,000 units

iv. Depreciation charge = (13,00,000- 50,000)/ 2,50,000

= Rs. 5 per unit



Example : 6

� A transport vehicle was purchased at a cost of

Rs.18,50,000 . The useful life in terms of

number of kilometer is 4,50,000 and scrap

value is Rs. 50,000 . Calculate the depreciationrate and find out deprecation for 1st and 2nd

year and also calculate the book value of

vehicle if it has travelled 13,000 km in 1st

yearand 18,500 km in 2nd year



Example : 6 - Solution

1st

year:� Cost C=18,50,000 Rs.

� Working units N=4,50,000 km

� Scarp value s = 50,000 Rs.

1. Depreciation rate =

(18,50,000 - 50,000)/ 4,50,000 = 4 Rs./km.

2. Depreciation for 13,000 km. = 4* 13,000

= 52,000 Rs.

3. Book value = cost of asset depreciation

=18,50,000 - 52,000 = 17,98,000 Rs.





Example : 7

The following data is given for a companyDepartment Direct

Material cost

Rs.

No. Of

employees

Floor

area m2

Dept

overhead

Rs.

M/c shop 5,00,000 14 500 90,000

Ass shop 2,50,000 20 1,000 74,000

Moulding

shop

2,00,000 14 1,000 82,000

Personnel 0 5 0 50,000

Purchase 0 6 0 70,000

Maintenance 0 3 0 30,000

Total 9,50,000 62 2,500 3,96,000



Example : 7

Apportion the overhead to 3 production

shops and calculate the cost of a job which is

manufactured a moulding shop where

material cost is Rs. 74 and labour cost is Rs. 50




1. The problem is to be solved by apportion and absorption of overhead costs

2. Eliminate the cost of personnel department by distributing the

overhead of personnel department proportionately to other

departments.

Basis of distribution= number of employees in a particular

department

3. Machine shop

i. Total number of employees from other than personnel = 62-5= 57

ii. Towards m/c shop = (14/57)*50,000 = 12,280.7

iii. Updated overhead of m/c shop =90,000+12,280=

1,02,280.7




4. Assembly shop :� personnel apportionment

= (20/57)*50,000 = 17,543

� Updated overhead of assembly shop

=74,000 + 17,543 = 91,5435. Moulding shop :

� personnel apportionment

= (14/57)*50,000 = 12,280

� Updated overhead of moulding shop

=83,000 + 12,280 = 94,280




6. Purchase department:� personnel apportionment

= (6/57)*50,000 = 5,263

� Updated overhead of Purchase department

=70,000 + 5,263 = 75,2637. Maintenance department:

� personnel apportionment

= (3/57)*50,000 = 2,631

� Updated overhead of Purchase department

=30,000 + 2,631 = 32,631



1. Eliminate the cost of purchase department by distributing

the overhead of personnel department proportionately to

other departments.

Basis of distribution= cost of direct material in a particular

department

2. Machine shop

i. Total cost of material= 5,00,000 +2,50,000 +2,00,000 = 9,50,000

ii. Towards m/c shop = (14/57)*50,000 = 12,280.7

iii. Updated overhead of m/c shop =90,000+12,280=

1,02,280

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Engineering Economy and Finance