Friday, 30 January 2015

What is Costing and how it is done

Costing means evaluating or assessing the cost of a product or job in terms of money value.

Anything that you produce or create has its value in terms of money. Some of your resources have been utilised in producing that product and you need to evaluate those resources utilised in order to know the cost of your product.

For example, you are investing some money, time, energy, labour and other elements to produce that product. So value of all these items constitute the cost of your product. You will add up the monetary value of each of these inputs to arrive at the cost of your product.

So, costing can be defined as an accurate and systematic process of computing the cost of production of any product or the cost of running a business.

How Costing is done?
Costing is done by adding the value of all the factors of production to the cost. For example, take the simple case of your going to a movie. Here, your movie cost does not comprise only the movie ticket cost. To watch the movie, you have to go there by some transportation or your own vehicle. So, you incur the to and fro fare charges or the petrol charges of your vehicle. Then, if you have to eat there, the cost of food also is incurred. Then the value of your time spent for watching it may also be added if you are a very busy person and your other work is in loss due to your sparing time for the movie. Any other costs can also be added if they affect you financially or by way of health disturbance because of your watching the movie. So all these factors can add up to the cost of your movie and literally it will become a great price paid for watching that movie. This is how costing is to be done

  • First you will have to know and locate all the elements that affect the cost of your object.
  • Then you will have to bifurcate the actual quantum of those elements affecting your particular object.
  • If there are four elements used for making, say, 100 numbers of a particular product, then your cost per one unit will be the one hundredth part of the sum of value of those 4 elements.
  • When there are many stages of production, you can calculate the cost per each stage of production by considering the expenses incurred for each stage separately. This is known as process wise cost.
  • When there are many products with same elements of expenses or factors involving, you will calculate cost by identifying the quantum of proportionate expenses for each product. This is known as product wise cost.

Friday, 23 January 2015

Consumer Surplus and Producer Surplus

What is Consumer Surplus?
Consumers surplus is the difference between what the consumers are willing to pay for a product and the actual market price that they are paying for it. It is measured in monetary value in economics. It is the amount of extra utility derived by him for which he has not paid any money or value.

So, consumer surplus is a kind of extra advantage gained or money saved by the consumer. It is the measurement of the extra satisfaction that the consumer derives from that product. Here the consumer does not bother paying even an increased price to have that product, because he is getting much satisfaction from that product than he is actually paying to procure it.

For example, a consumer goes to the market to purchase sugar expecting the price to be Rs.50 per kg. But when he actually purchases it, he finds that he is charged with only Rs. 35 per kg. So, it is assumed that the consumer has derived a surplus satisfaction of Rs.15 which is his consumer surplus.

Buyers always think in terms of the extra satisfaction they derive when buying goods. They always look for products which give them most satisfaction and then bargain to pay much lesser amount than the actual utility that is derived by them. So, generally, consumers always enjoy some amount of consumer surplus from most of their purchases.

So,when the prices increase consumer surplus decreases and when the prices fall the consumer surplus increases.

Graphically, consumer's surplus can be described as the area below the demand curve and above the price line.

What is Producer Surplus?
Just like consumers enjoy surplus satisfaction from their purchases, the producers of product or the suppliers of it also enjoy extra benefits. It is the extra income that they get by selling goods at a price higher than what otherwise they would have been forced to sell. 

The producers may be willing to sell their products at a lower price than the present market price so as to carry on their business rather than wind up. So, by selling at present market price, they are enjoying extra income. This amount of income that they are receiving by selling the product at present market price (say 'x') instead of selling it otherwise at a lower price (say 'y') is their surplus. So they are enjoying a producer surplus of x-y amount multiplied by the quantity sold. This is their "producer surplus". 

The above is illustrated in the graph below.

The blue line indicates demand curve. The red line indicates the supply curve.
Both lines are intersecting at a point where the price level is Rs.500 at Price-3 point. This is the point where demand and supply are equal.

If you draw a line connecting the intersecting point to the Y-axis (vertical line), the consumer surplus will be equal to the volume of satisfaction that he enjoys from this line upto the tip of the demand curve at Rs.1000.

Similarly, the producer surplus will be equal to the volume of satisfaction in between the lines at price level 500 and price level 200 above the supply curve. ( I was unable to shade these portions with colour to be clear for you.)

(Click on the image to view it in larger size please).

I hope you are clear now about the concepts of Consumer Surplus and Producer Surplus. You may clear any doubts by asking in the comments section.

Saturday, 17 January 2015

Law of Diminishing Returns explained

When you are discussing about the "Law of diminishing marginal utility", you should not be got confused with the "Law of Diminishing Returns".

The law of diminishing returns is used for production and factors of production assessment whereas the law of diminishing utility is used for studying consumer needs and their satisfaction.

According to the law of diminishing returns, additions to a factor of production while other factors keep constant, will eventually result in diminishing returns after reaching a certain point of production.

This is because of the fact that production involves a mixture of all factors in a certain proportion. If anything gets increased out of proportion, it will result in negative performance. This law of diminishing returns is also known as the Law of Diminishing Marginal Returns.

The production will increase upto a certain point only when you go on increasing any factor of production with no corresponding changes in other factors. But, after that point, if you go on increasing the factor further more, then the additional yield or marginal return begins to fall and eventually on reaching a certain point, the marginal returns can be in minus figures.

Illustration of the Law of Diminishing Marginal Returns
Consider a factory employing new labour to increase the production while keeping other factors of production same. Upto some point, the production will increase. After a point is reached, if it goes on recruiting further labour, the efficiency of labourers will fall and the marginal increase in production falls and will begin decreasing the previous level of production. This is illustrated in the chart below.

Number of Labour
Production in MT
Marginal Production in MT
1000 (initial strength)

In the above example, you are able to notice that at labour strength of 1200, the factory is yielding a very good production of 6000 MT. But when you increase the strength to 1300, the marginal falls. When you employed 200 additional labour the increase in production was 1000 tonne. So, 200 labour contributed to an increase of 1000 ie. 500 tonnes per 100 labour. But the next recruitment of another 100 labour yielded only 300 tonnes of additional production. So, marginal return diminished here. Again, when an additional 100 labour was employed making total labour strength to 1400, the marginal return was only 200 tonnes which further more decreased than previous 300 tonnes. At 1500 strength, there is no increase in production at all. Then your manager went on employing further labour carelessly resulting in inefficiency of the existing labour making the production fall to 6300 MT.

The best marginal return you got in above case was by employing only a further labour of 200. After that recruitment, you should stop increasing the labour and concentrate on improving the other factors of production.

Friday, 16 January 2015

Law of Diminishing Marginal Utility as a Guide to Price fixation

In economics it is generally observed that if you go on consuming more of anything, the satisfaction or utility that you derive from extra unit is gradually decreased. If you go on consuming in spite of this diminishing utility,one point may arise where your satisfaction from one more extra unit is zero and then it will go in minus figures. So, ultimately, your total utility also gets decreasing by each extra unit of consumption. It can be harmful or even dangerous to you if you continue consuming those products.

For example, take a plate of meals. From the first plate of meals, suppose you get utmost satisfaction say 100 points. If you go for another round, you may get 60 points and from a third round you may get only 30 points. If you take one more round, then, it may not give you any more utility and it will become 0 points or in negative points from that round. You may even begin to vomit and get sick.

So, automatically, you will stop consuming more of that product even at a second or third round itself.

Hotels and Restaurants assume this law of diminishing utility as their safe point when they run full meal menus or buffer systems. Because, they are confident that nobody can eat excessively more than upto a certain limit. So, they can safely fix the prices of food according to that maximum limit calculated through this law of diminishing utility as follows:

In the above example of meals, the marginal utilities at each stage are as follows:
1st plate 100 points, 2nd round 60 points, 3rd 30 points and 4th 0 points. So, total utility you get from four rounds is (100+60+30+0) = 190 points.

Now, suppose each person has different capacities of eating. One person consumes only one round. The second takes two rounds and like that. So if there are 4 people, total rounds taken by them can amount to say 10. Now, you will have to calculate the price of food by calculating the average consumption per head which comes to 10/4 =2.5 times. The price per one person can be fixed at 2.5 times of the cost of one meal plate which can be a safer price from the point of view of the management of the restaurant. In this way the law of diminishing utility can be a very useful determining factor for fixing prices.

Wednesday, 14 January 2015

Scarcity, Utility, Marginal Utility and Total Utility

What is Scarcity?
Scarcity means lack of enough quantity of anything. It denotes to a situation where your requirements are for more quantities than those available to you. So, you experience shortage of items or resources to satisfy your demands.

In economics, this shortage or scarcity of resources makes you to take decisions and choose things carefully so as to get utmost satisfaction from the limited options available. The resources are either limited or they are not fully available for use thereby leading to scarcity because of the unlimited wants of human beings.

What is Utility?
Utility, in Economics, refers to the quantum of satisfaction derived by consumers while consuming goods or services. This consumer satisfaction is a major factor determining all the activities of demand and supply. Prices are fixed on this capability of goods to provide utility to consumers.

How Utility is measured?
  • Utility is measured or assessed by the degree of consumer's willingness to pay a certain amount of money to gain that utility.
  • It is rather some assumption that the product has certain amount of utility equal to the price paid the consumer to have it.
  • The consumer is ready to pay an increased amount of price to obtain that level of satisfaction as he wants to get it instead of changing to other products or services. This means that he is getting a good level of utility from that goods or service. So the product has that much amount of utility that he is willing to pay to have it.
What is Total Utility?
Total utility refers to the total quantity or measurement of satisfaction derived by a consumer by purchasing different number of units of the product. If you consume one unit, you will get certain level of satisfaction. If you get another unit, the level will increase. So the total satisfaction derived by you increases, as you go on adding more units. This total satisfaction derived is known as total utility of that product for you.

What is Marginal Utility?
Marginal utility refers to the extra amount of satisfaction derived by you when you consume one more unit of anything. 

Normally, a consumer will derive more satisfaction from the first unit that he consumes. As he goes on increasing his consumption, the extra unit that he purchases will not give him so much satisfaction that he experienced from the previous unit. So the extra satisfaction is decreased gradually as he increases his quantity. This quantum of extra satisfaction is known as the marginal utility of that product to him.

For example, take the case of your child eating choco bar candy. The first candy will give him utmost satisfaction. The second candy may not be so much appealing as he already got satisfied by the first candy. If you give him a third and a fourth one, he may not want to eat it any more. On the other hand, if you give only one candy and then a cup of ice cream or milkshake, he can derive same amount of satisfaction from both the candy and the ice cream or milkshake. So his total utility will be more than that he gets by eating 3 or 4 choco bars.

Example - 1
Chocó bar candy
Utility/ Marginal utility
Total Utility
First candy
Second candy
Third candy
Fourth candy

Example -2
Utility/ Marginal utility
Total Utility
Chocó bar candy
Ice cream

From the above two examples, you are able to see that in the first example you are getting 120 units of utility by consuming 4 candies whereas you are able to get same amount of 120 units utility by eating one choco bar and one ice cream only as per 2nd example.

Now, suppose one chocobar costs $1 and one cup of ice cream also costs $1.
So, in example 1, you are paying $4 to get 120 units of utility whereas in example 2, you will be paying only $2 to get same satisfaction of 120 utility.

Now, we come to know that additional units of consumption of same product will go on decreasing the satisfaction. This is known as diminishing marginal utility. The total satisfaction will increase upto certain extent and then it may cease to increase after a point. In the above example, if you take another candy, the marginal utility can be zero units and so total utility will remain same as 120 units only.

On the other hand, if you shift to other products, your utility will be greater because the utility from other product will be more than that got from consuming the same product in most cases.

So utility plays a major role in economics for fixing the prices of commodities.

Friday, 9 January 2015

Definition & classification of Wants, Needs, Comforts and Luxuries

Human beings have many desires. They can desire for the ownership of a good house, a car, luxurious furnitures and clothes and huge bank balances. But having a desire is different from the capacity of satisfying the desire. Here comes the difference between desires and wants.

Definition of Wants
Wants can be defined as those desires that are backed by the purchasing capacity of the people.
Desires can be satisfied when you have the purchasing power in terms of money or kind. So, wants are different from desires.

Even though you can not satisfy all desires, your purchasing capacity can convert a desire into a want. Consumers' actions are motivated by the desire or instinct to satisfy their wants and needs and the requirements to choose among different wants and needs.

In Economics, this activity of satisfying needs or wants governs the various business activities and business decisions of producers and manufacturers of goods. Markets also interact accordingly and they are completely controlled by these changing needs and wants of people.

Consumers act according to the urgency of wants. Most urgent wants are satisfied first, then lesser emergency wants are satisfied and lastly, superfluous wants are satisfied.

Let us briefly have a look at these economic terms of wants and needs.

Basically, all requirements of people are broadly classified into needs and wants.

Needs are those without which one can not survive. For example: food, clothes and shelter. These are the most basic requirements for anyone to survive. One may manage himself for one or two days without them. But ultimately, he needs these items to survive. So these items are called as needs.

Wants contain a wider choice of requirements made by human beings to satisfy their desires. Wants can include needs also. But needs can not include wants. You can survive without having or satisfying most of these wants desired by you. For example, a costly food, a bicycle or bike, a movie or TV set, mobile, etc. All these are wants. But they can not be needs. You can still survive without these items.

Now coming to another specific and more deep classification of human wants in economics (or desires), there are three types of wants in economics. They are classified as necessities comforts and luxuries.

Necessities or Necessaries
Necessaries are just like needs. You can't live without satisfying these necessities. Food is necessary to survive. Water is also very necessary for living. Similarly you need air to breathe and survive. So all these are known as necessities because you can't survive without them.

A comfort is something which gives you relief. A fan gives you comfort in breathing the air. An extra side dish of food gives you comfort in eating your food more enjoyingly. A bicycle provides you relief in travelling. All these items can be treated as comforts. They are not necessities as you can live without them. They are needed only to aid for your living conditions.

Luxuries are those which are even more superfluous than comforts. They provide you too much more comfort in your life and are very costly and are of very high standard lifestyle. A luxurious bungalow or a stay in five star hotel, very costly food with many varieties of dishes, a high definition LED TV, Air conditioner, Aeroplane travel, etc. all these can be examples of luxuries. These items give you a very superior standard of living which is not at all necessary under ordinary circumstances for your survival. So these are termed as luxuries.

Needs and Wants change according to circumstances
The above explanations of necessities comforts and luxuries are a view generally accepted by all economists under normal circumstances. But what is regarded as comfort or luxury may be at times considered as necessity under certain different circumstances.

For example, if you are burning with heat at a temperature of 50 degree celsius, then a cool breeze from an air conditioner can be of much need for you to survive yourself. So, in this case, the air conditioner may become a necessity for you.

So, comforts and luxuries can sometimes become necessities under specific circumstances.

With advancement of technology and changing habits of civilisation, this classification of human wants may also undergo variations. Many items of comforts and luxuries may tend to be regarded as necessities nowadays. A mobile phone, colour TV, coolers and even ACs have become normal lifestyles nowadays at every home. They became a part of necessities for most people.

Wednesday, 7 January 2015

Fund Flow Statements & How to prepare a Fund Flow Statement

What is Fund Flow Statement?
Fund Flow Statement is a financial document which depicts and explains the changes in the working capital and financial position of a company during a period as compared with another period.

Why it is prepared?
Fund Flow Statements are prepared to study and explain the changes in working capital and finances of the company during any period. It gives the reasons for increase or decrease of working capital and the finances of the company by revealing the various changes in different account heads for a better understanding and management of funds.

How to prepare Fund Flow Statement?
Fund flow statements are prepared by deriving the amounts of increase or decrease in figures of balance sheets comparing two accounting periods and putting those figures in a statement.

Fund flow statement contains two parts - Sources of Funds and Application of Funds. You can prepare it in a single columnar statement or in a double columnar one.

In a single column format, you will first mention all sources of funds and then mention the applications.

In a double columnar format, the left side will show sources of funds whereas application of funds are shown on the right side. Both totals will match as you will be describing the whole utilisation of resources.

Sources of Funds
Under this head, you will be showing the following figures.
  • Shares and debentures issued for cash (including bank cheques, drafts, money transfers,etc.) 
  • Amount received through long term loans. Short term loans are not taken as they are part of working capital.
  • Amount received through sale of fixed assets and investments, etc.
  • Gross Profit or funds generated from business operations during the year. This amount is calculated in a different way through indirect method by taking the net loss during the year and back calculating the gross funds in a format described below separately in worksheet
  • Decrease, if any, in the working capital. This figure is also calculated by deriving the changes between working capital of two years as per explanation given below separately in a worksheet.
Application of Funds 
Coming to application of funds, the following figures generally appear in a funds flow statement.

  • Purchase of Fixed Assets and Investments made during the year on actual payment basis.
  • Payments made against redemption of debentures, shares and loan repayments. 
  • Tax and dividend payments made during the year. (No provisions for dividend or tax should have been made in current liabilities in this case)
  • Increase in working capital, if any. (If there is decrease in working capital, it is taken as Source of Fund and increase in working capital is taken as Application of Fund).
So, the format for Fund Flow Statement will be something like this:

Fund Flow Statement of XYZ Company
Sources of Funds
Application of Funds
Issue of shares/debentures

Purchase of Fixed assets and Investments

Long term loan receipts during the year

Redemption of Debentures, Shares

Sale of fixed assets/investments

Repayment of Loans

Fund generated from business operations
 as per    worksheet
Tax and Dividend payments

Decrease in working capital  (* as per below  worksheet)

Increase in working capital   (* as per below work  sheet)



Now, coming to the Annexures of above statement, two work sheets are to be prepared for Funds generated from Business Operations and for Decrease or Increase in Working Capital. They are prepared as per below given worksheets. All other figures are taken direct from Balance Sheet in above columns

Work Sheet for funds generated from business operations (for above marked@)
You will proceed from Net Profit of the year and back calculate as follows:

Net Profit/ Income                                                
Add (Items shown as expense)
Loss on sale of Fixed assets
Loss on sale/ encashment of investments
Deferred Revenue Expenditure
Provision for Tax
Provision for Dividend
Other losses written off

Less: (Items shown as Income)
Profit on sale of assets
Profit on Investments
Reserves & Provisions written back, if any
Other fictitious income shown, if any

 Actual Fund generated from operations




Worksheet for Increase/ Decrease in Working Capital (marked * in fund flow)
Previous Year (2012-13)
Current Year
Increase / Decrease
A. Current Assets

(+) 300
      Sundry Debtors
(+) 150
      Cash & Bank Balances
(+)   25
      Loans & Advances
(+) 105
      Other Current Assets
(-)   10
(+) 570

B. Current Liabilities

     Liabilities (for expenses, creditors & customer advances)
(+) 150
     Provision for Tax
(+) 100
     Provision for Dividend
(+)   60
(-)    10
(+) 300
Net Working Capital (A – B)
(+) 270

Note: If net working capital increases, it is to be treated as application of funds as funds are utilized to add to the stocks. On the other hand, when there is decrease of working capital, it is a source of fund because you are saving money by spending less. 

Sunday, 4 January 2015

Cash Flow Statement and its importance

What is Cash Flow?
By Cash Flow  we mean the flow of cash in your hands or at your business. Cash always flows either into your purse from others or out of your purse to others.

Any business activity involves cash transaction- cash and cheque both are considered as cash for this purpose. Either cash comes to you or it goes out from you. This process of incoming and outgoing of cash is known as Cash Flow. Cash continuously flows either into your hands/business or out of your hands/business.

What is Cash Flow Statement?
A cash flow statement is a statement showing the details of inflows and outflows of cash in money value in a format. It depicts the funds generated and spent during a period of the business.

The need for Cash Flow Statement
The flow of cash needs to be tracked to have a better management of the funds of the business. You need to know where from your cash comes and how you are spending it so as to bifurcate and identify your spending habits. Once you can know the full details of your spending, you will be in a better position to manage your funds efficiently. For this purpose, you require the cash flow statements.

Types of Cash Flow Statements
Cash Flow statements are prepared in two methods

  • Direct method - this method takes the actual income and expenses received or paid during the period. These items are directly incorporated in this statement headwise. It can contain advance payments and advance receipts also. This will give you a real picture of increase or decrease in your cash balance and bank balances.
  • Indirect method - In this method, you will start from the net increase or decrease as found from your records and back calculate the expenses and incomes during that period to explain the net figure.

Further, a cash flow is nowadays prepared in three different stages in modern finance system.

  • Cash Flow from Operating Activities
  • Cash flow from Investing Activities
  • Cash flow from Financing Activities

How to prepare a Cash Flow Statement?
Here, I am going to explain the direct method of Cash Flow Statement.

A cash flow statement is prepared by keeping record of all payments and receipts during the period. All transactions are to be segregated into suitable account heads that you may consider fit for you or you can maintain the same account heads as in a trial balance or profit & loss account.
  • In this Cash Flow Statement, you will record income received on one side and expenses incurred on the other side just like a Trial Balance format. 
  • But the figures taken in this cash flow are actual receipts and actual payments during that period. 
  • You should have actually received the actual cash or cheque or draft during that period for showing it in your statement. 
  • Similarly, you should take only actual cash or bank payments made on the expenditure side and no accrued expenses or unpaid expenses should be taken into consideration for this statement. 
  • All figures that actually affect your cash or bank balance should be taken in this statement. No other figures should be included to get the correct picture.

The statement may be prepared either weekly, monthly or on annual basis. Sometimes, it is prepared daily also to track daily expenditure. You can have it prepared in all the four formats for a better understanding and control of your business.

The figures are taken in actual incurred basis. So the statements of Cash Flow and Profit & Loss does not tally for any period because profit & loss statement includes total expenditure whether it is paid or not.

The figures in the cash flow show you all the income you received into your cash box or bank account during a particular period under study and all the payments made by you during the same period whether it is by cash or bank. So, the net effect of these receipts and payments will give you the position of whether you are in plus or minus.

Benefits of Cash Flow Statement
  • Cash Flow statement gives you a picture of your receipts and expenditure during a period. It shows the spending nature of your business.
  • With the help of cash flow statement, you are able to locate where you are spending more and where it is too low and, thereby, you can adjust and control your activities suitably.
  • You can plan your project expansions and business growth with the help of this statement.
  • Sometimes, banks and financial institutions may require cash flow statements to judge your capability of repayments in case of applying for loans.