MBA (Bharathiar University) - First Year, Accounting & Finance for Managers - Theory for quick revision

1. UNIT - I
Accounting is the language of the business. It records all monetary transaction of a business enterprise during a period. There are three different activities in Accounting. They are
a. Recording – It includes Identification of business transaction, preparation and Recording of business transaction.
b. Classifying – It includes Creating, Maintaining and Posting of Journal transaction in various Ledger Accounts.
c. Summarizing – It includes Preparation of Trial balance, Trading & Profit and Loss Account and Balance Sheet
Accounting- Definition
American Institute of Certified Public Accountants Association defines the term Accounting as follows “ Accounting is the process of recording, classifying, summarizing in a significant manner of transactions which are in financial character and finally results are interpreted “
Users of the Financial Statements
1. Management
2. Shareholders, Security Analyst and Investors
3. Lenders or Financiers of Fund/Capital
4. Suppliers
5. Customers
6. Government and different Regulatory Authorities
7. Research Scholars for Research and Development purpose
Generally Accepted Accounting Principles (GAAP)
1. Assumptions or Concepts
Accounting concepts include certain basic assumptions, principles or conditions on which the accounting system is based. These assumptions are most natural and are not forced ones. These are general notions and hence they are called Concepts.
i. Accounting entity or Separate Entity
ii. Going Concern
iii. Money Measurement – transactions in terms of money or money worth
iv. Accounting period- a stop and see approach for to see the financial position of the concern.

2. 2. Accounting Principles or Conventions
Accounting Principles are the body of doctrines commonly associated with the theory and procedure of accounting. It is a general law or rule adopted as a guide to action. Accounting is also based on usage and custom, for universal acceptance and uniformality.
i. Revenue Realization
- When to realize revenue or at which point of time
ii. Verifiable Objective
- Financial Statements must be capable to verify. It is also known as „Objective Evidence Concept‟
iii. Matching Principle
- Record corresponding expense in accordance with the declared revenue for the year.
iv. Full Disclosure
- Relevant details regarding a vital transaction or event must be disclosed
v. Dual Aspect
- Two aspect of accounting ( Debit and Credit )- for every debt, there is corresponding credit
vi. Historical Cost
- All cost must be record according to their actual cost acquisition
3. Modifying Principles
The above mentioned are all related to the theoretical aspect of accounting. Modifying principles are the practical side of accounting. They are as follows:-
i. Materiality
- An item may be regarded as material if there is sufficient reason to believe that acknowledgement would influence the decision of investors.
ii. Consistency
- A firm must follow some principles in its entire life time, unless there is inadequacy in that accounting principle, it is as per Going Concern Assumption.
iii. Conservatism ( Prudence)
- Playing Safe. It must record all the expected losses and ignore the expected gain.
iv. Timeliness
- The financial statement must be produced in time , otherwise it will not facilitate rational decision making.

3. v. Substance over legal form
- Accounting gives importance to actual situation rather than the legal position. Example, In Hire purchase it‟s possession will be with the hire purchaser, but it‟s title will be with the Vendor company.
vi. Practice in Industry
- Practice and methods prevailing in industry has to kept in mind and follow that. It helps in inter-firm comparison and increase in reliability in accounting information.
4. Accounting Standards
In India the Accounting Standards are issued by The Institute of Chartered Accountants of India (ICAI). These are the accounting standards to be followed in India.
Financial Statements
To find the results of a business they prepare Trading and Profit and Loss Account (Income Statement ). To ascertain the financial position of the business a Balance Sheet is prepared. Both these statements are collectively known as Statements of Final Accounts.
I. Profit and Loss Account ( Income Statement )
Income Statement or Profit and Loss Account is prepared to ascertain the profit/Loss of a business during a period of time. Gross Profit, Net Profit and Operating Profit are ascertained from this account.
Need/Purpose and importance of Profit & Loss Account
1. To ascertain net profit or net loss.
2. To compare actual performance with the desired performance
3. To calculate different ratios such as net profit ratio, ratio of operating expenses to sales etc
4. To determine the future line of action
II. Balance Sheet
A Balance sheet is a statement of assets and liabilities of a business prepared with a view to ascertain the financial position of the business as on a particular date.

4. Characteristics of Balance Sheet
1. Balance sheet is a statement and not an Account
2. It is prepared on a particular date to show the assets and liabilities on that date
3. It gives the financial position of the business
4. Its agreement is a clear proof of the arithmetic accuracy of the adjustments made while preparing final accounts
5. It shows the nature and cost of assets and the nature and the amount of liabilities as on a particular date
Need for Balance Sheet
1. To ascertain the financial position of the firm
2. To ascertain the nature and value of the assets owned
3. To determine the nature and amount of the liabilities to the outsiders
4. To ascertain the capital owned by the business to the proprietor
5. To find out the solvency of the business
6. To make assessment of the progress of the business by making comparison with different accounting ratios
7. To know the sources and application of funds
8. To ascertain the working capital of the business
Depreciation
According to Dickens “ Depreciation is the permanent and continuous diminution in the quality/quantity/value of the asset.”
In simple words, it is the terminology to show a permanent decrease in the value of the fixed assets. Through depreciation apportion of fixed asset is charged to total expense of the business in every year. Through this the Matching Principle of Accounting is satisfied and the Profit and Loss Accounts shows a much realistic figure.
Reasons for Charging Depreciation
1. Continuous wear and tear of assets
2. Exhaustion – through continuous extraction of Fixed Assets like Oil Fields, Quarries etc.
3. To face technological obsolescence like Change in taste, preference, trends, production capacity etc
4. Accidents
5. To recover Cost- by charging a smaller amount each year to Profit and Loss Account
6. To makeup funds for replacement of asset.
7. To find out correct Profit and Loss Account balance
8. To know the actual position of the business.

5. Methods for Charging Depreciation
1. Straight Line Method
2. Diminishing Balance Method or Written Down Value Method
3. Depletion or Output Method
4. Machine Hour Rate Method
5. Sum of Digit Method
6. Annuity Method
7. Sinking Fund Method
8. Insurance Policy Method
Concentrate on first two methods only
Straight Line Method (SLM)
In Straight Line Method, depreciation is calculated as a fixed proportion on the original value of the asset. The depreciation is charged as fixed in volume on the original value of the asset at which it was purchased.
Depreciation = (Cost of Machine-Scrap Value)/ Economic Life of the asset
Diminishing Value Method or WDV
In WDV Method, the depreciation is charged as a fixed percentage on the opening balance of the asset every year. So depreciation charging in each year will vary and the same amount will be deducted from the opening of asset also.
Difference between SLM and WDV Method of Depreciation
1. Amount of Depreciation: The amount of depreciation remains the same all the years under straight-line method, while it goes on decreasing every year under the written down value method.
2. Computation of Depreciation: Under straight line method of depreciation, depreciation is charged on the original cost of the asset, while it is charged on the reducing balance every year under written down value method.
3. Value of Asset: Under the straight line method the value of the asset become nil at the end of its working life but it never becomes nil under the written down value method.
4. Rate of Depreciation: Normally, the rate of depreciation is lower under straight-line method whereas it is higher under the diminishing balance method.
5. Recognition: The straight line method of depreciation is not recognized by the income tax authorities while the later method is well recognized by them.

6. UNIT – II
Financial Statement Analysis
The analysis of financial statement provides valuable information for managerial decisions. Financial analysis is commonly called analysis and interpretation of financial statements. In the words of Metcaff and Titard, “ Analyzing financial statement is a process of evaluating the relationship between component parts of financial statements to contain a better understanding of a firm‟s position and performance “
Purposes of Financial Statement Analysis
1. To help in economic decision making
2. To estimate the earning capacity of the business
3. To assess the financial position and financial performance of the business
4. To ascertain the operating performance of the business
5. To determine the solvency and liquidity of the business
6. To determine the debt capacity of the firm
7. To decide about the future prospects of the firm
8. To make inter-firm comparison
9. To measure managerial efficiency of the firm
Tools or Techniques of Financial Statement Analysis
A number of techniques or devices are used to undertake financial analysis. The fundamental objective of any analytical method is to simplify the data to more understandable terms. The following are the important tools of financial analysis
I. Comparative Financial Statements
The changes in the financial statement data over a period can be best understood if the statements of two or more years are placed side by side to facilitate comparison. Such statements are called Comparative financial statements. Thus comparative financial statements are those statements that summaries and present accounting data for a number of years, showing therein changes in individual items of financial statements. Comparative financial statement consist of comparative balance sheet and comparative profit and loss account or income statement.
Objectives of Comparative Financial Statements
1. To make the data simpler and more understandable
2. To ascertain the changes occurring year by year in financial position and performance of the enterprise
3. To find out the strength and weakness of liquidity, solvency and profitability
4. To help the management in forecasting and planning

7. II. Common Size Statements
Common size statement is another technique of financial analysis. Common size financial statements are those statements in which items are converted into percentage taking some common base. These statements are also “100 percentage statements” or “component percentage” because each statement is reduced to the total 100 and each individual item is expressed as a percentage of this total. Common size statements include common size balance sheet and common size profit and loss account. These can be prepared for two or more years.
Objectives of Common Size Statement
1. To present the change in various items in relation to net sales, total assets or total liabilities
2. To establish a relationship between various items of the financial statements
3. To provide for a common base for comparison
III. Trend Analysis
Trend simply means general tendency. Analysis of these general tendencies is called Trend Analysis. In the context of financial analysis, trend analysis means analyzing general tendencies in each item of the financial statements on the basis of the data of the base year. In short, comparing the past data over a period of time with a base year is called Trend Analysis.
Objectives of Trend Analysis
1. To find the trend or direction of movement over a period of time.
2. To make a comprehensive and comparative study of financial statements.
3. To have a better understanding of financial and profitability position
Ratio Analysis
Ratio simply refers to one number expressed in terms of another number. It shows numerical relationship between two figures. Accounting ratio refers to relationship between two accounting figures expressed mathematically. Accordingly to J. Batty, “the term accounting ratio is used to describe the significant relationship which exists between figures shown in a Balance Sheet, Profit and Loss Account, in a budgetary control system or in any other part of the accounting organization”. In short, ratios calculated on the basis of accounting information are called Accounting Ratios.
Ratio Analysis is a widely used technique of analyzing financial statements. An analysis of financial statement with the help of ratios is termed as ratio analysis. Ratio analysis may be defined as the process of computing and interpreting relationship between the items of the financial statements for arriving at conclusions about the financial position and performance of an enterprise.

8. Uses or Utilities of Ratio Analysis
1. Helps management in formulating policies, forecasting and planning, decision making, knowing trends of business, measuring efficiency, communicating and controlling purpose.
2. Helps the shareholders and investors to invest their money in safe, secure and profitable ventures.
3. Helps to know the liquidity position of the firm for the creditors
4. Helpful for employees for arguing for more wages, fringe benefits, working conditions according to the profitability
5. Useful for Government for to understand about the cost structure in a particular industry and for to formulate policies according to that.
Limitations of Accounting Ratios
1. Inherent limitation of accounting
2. Non-monetary factors are ignored
3. Qualitative factors are ignored
4. Need for comparative Analysis
5. Lack of adequate standards
6. Window dressing
7. Price level changes
Fund Flow Analysis
The fund flow statement is a statement which shows the movement of funds and is a report of the financial operations of the business undertaking. It indicates various means by which funds were obtained during a particular period and the ways in which these funds were employed. In simple words, it is a statement of sources and applications of funds.
Uses, Significance & Importance of Fund Flow Statement
1. It helps in the analysis of financial operations
2. It throws light on many complex questions of general interest
3. It helps in the formulation of a realistic dividend policy
4. It helps in the proper allocation of resources
5. It acts as a future guide
6. It helps in appraising the use of working capital
7. It helps knowing the overall creditworthiness of a firm
Limitations of Fund Flow Statement
1. It should be remember that a fund flow statement is not a substitute of an income statement or a Balance Sheet. It provides only some additional information as regards changes in working capital

9. 2. It cannot reveal continuous changes
3. It is not an original statement but simply an arrangement of data given in the financial statements
4. It is essentially historic in nature and projected funds flow statement cannot be prepared with much accuracy
5. Changes in cash are more important and relevant for financial management than the working capital
Cash Flow Statements
A Statement of charges in the financial position of firm on cash basis is called a cash flow statement. Such a statement enumerates net effects of the various business transactions on cash and takes into account receipts and disbursement of cash. Cash Flow Statement summaries the causes of changes in cash position of a business enterprise between two balance sheets.
Difference between Cash Flow Statement and Fund Flow Statement
Basis of Difference
Fund Flow Statement
Cash Flow Statement
1
Basic Concept
Wider Concept; Working Capital
Narrow Concept; Cash Only
2
Basis of Accounting
Accrual Basis
Cash Basis
3
Schedule of Changes in Working Capital
Used for to show the changes in current assets and current liabilities
No Schedule of Changes in Working Capital
4
Method of preparing
Schedule of Changes in Working Capital, Fund from Operation and Fund Flow Statement
Opening Balance of Cash ; Add Cash Inflows; Less Cash Outflows and we get Closing balance of cash
5
Basis of Usefulness
Used for planning intermediate and Long term financing
Used for Short Term analysis and cash Planning of the business

10. Limitations of Cash Flow Statement
1. It is difficult to precisely define the term „Cash‟. There are controversies over a number of items like Cheques, Stamps, Postal Orders etc to be included in cash
2. A Cash flow statement reveals the inflow and outflow of cash, but the exclusion of near cash items from cash observes the true reporting of the firm‟s liquidity position.
3. Working Capital being a wider concept of funds, a Fund Flow Statement presents a more complete picture than Cash Flow Statement.

11. UNIT – III
Cost : According to ICMA London Cost as “ the amount of expenditure (actual or notional) incurred on or attributable to a specified thing or activity”. In short, the term cost refers to the total expenses incurred on the production and sale of articles.
Costing : Costing means ascertaining actual cost. ICMA, London defines costing as, “the technique and process of ascertaining the cost”. The technique of costing refers to principles and rules for ascertaining the cost.
Cost Accounting : Cost Accounting can be defined as the process of accounting for costs which begins with recording of income and expenditure and ends with the preparation of periodical statements and reports for ascertaining and controlling costs. It includes techniques of ascertaining cost, application of cost control methods and ascertainment of profitability.
Cost Accounting Vs Management Accounting Vs Financial Accounting
Point of difference
Cost Accounting
Management Accounting
Financial Accounting
Objectives
Its main purpose is to ascertain the cost and control
Its major objective is to take decision through supplement presentation of accounting information
The main object of financial accounting is to ascertain correct profit/loss of the business and to show a true and fair view of the state of affairs of business
Scope
It deals only with the cost and related aspects
It not only deals with the cost but also revenue. It is wider than the cost accounting
Financial accounts are the accounts of the whole business and deals with external transactions (between business and outsiders)
Utilisation of data
It uses only quantitative information pertaining to the transactions
It uses both qualitative and quantitative information for decision making
It uses only quantitative information for recording transactions
Utility
It ends only at the presentation of information
But it starts from where the cost accounting ends; means that the cost information are major inputs for decision making
Financial Accounting provide information once in a year and fulfills the legal requirements of Income Tax Act, Companies Act etc.
Nature
It deals with the past and present data
But it deals with future policies and course of actions
Financial accounts record only actual (historical) costs

12. Cost Classification
Cost Classification is the process of grouping costs according to their common characteristics. The following are the various bases of cost classification.
i. By Nature or Element or Analytical Segmentation
The costs are classified into three major categories i.e; Materials, Labour and Expenses. Materials include the cost of acquisition of raw materials and valuation of Work in Progress and Finished Products. Labour includes all kinds of payments made to employees for both direct and indirect labours. Expenses are overheads attributable to production process.
ii. By Functions
On the basis of function, costs are classified into five categories.
Manufacturing Cost – These are the costs associated with the production of goods.
Administrative Cost – These are the costs associated with the firm‟s general management.
Selling Cost – These are the costs of creating and stimulating demand and of securing orders.
Distribution Cost – These are the costs incurred in moving the goods from the factory to the consumers.
Financing Cost – These are costs incurred for raising and using capital.
iii. Direct and Indirect Cost
Direct Cost – All costs which can be conveniently identified with a particular cost centre or cost unit are known as direct costs. These are directly chargeable to a product, activity or department. Example, Material used and labour employed in production process.
Indirect Cost – Those costs which cannot conveniently be identified with a particular cost unit or cost centre are known as indirect costs. These are common to a number of cost units or cost centres. They are to be apportioned on a suitable basis. Example, manager‟s salary, factory rent, depreciation of machinery etc.
iv. By Variability
Fixed Cost – It is cost which does not vary irrespective of an activity or production. Example, Rent of the factory, Salary to the manager etc.
Variable Cost – It is a cost which varies in along with the level of an activity or production. Example, material consumed in production.
Semi Variable Cost – It is a cost which is fixed up to certain level of an activity, then later it fluctuates or varies in line with the level of production. It is known in other words as Step Cost. Example, Electricity Charges

13. v. By Controllability
Controllable Costs – Cost which can be controlled through some measures known as controllable costs. All variable cost are considered to be controllable in segment to some extent.
Uncontrollable Costs – Costs which cannot be controlled are known as uncontrollable costs. All fixed costs are very difficult to control or bring down; they rigid or fixed irrespective to the level of production.
vi. By Normality
Normal Cost – It is the cost which is normally incurred at a given level of output in the conditions in which that level of output is normally achieved.
Abnormal Cost – It is the cost which is not normally incurred at a given level of output in the conditions in which that level of output is normally attained.
vii. By time
Historical Cost – The costs are accumulated or ascertained only after the occurrence known as Past Cost or Historical Cost.
Predetermined Cost – These costs are determined or estimated in advance to any activity by considering the past events which are normally affecting the costs.
viii. For Planning and Controlling
Standard Cost – It is the cost scientifically determined by way of assuming a particular level of efficiency in utilization of material, labour and indirect expenses.
Budget – A budget is detailed plan for some specific future period. It is an estimate prepared in advance of the period to which it applies. It acts as a business barometer as it is complete programme of activities of the business for the period covered.
ix. For Managerial Decisions
Sunk Cost – Sunk Cost are historical cost or past cost. These are cost incurred as a result of a decision made in past. Example, Investment in Plant and Machinery.
Marginal Cost – It is the amount at any given volume of output by which aggregate costs are changed if the volume of output is decreased or increased by one unit.

14. Cost Sheet
Cost Sheet simply refers to statement of cost of goods manufactured and sold. It is a statement prepared to analyse the total cost of production and cost of sales. It shows the various elements and divisions of cost. According to ICMA, London, cost sheet is “a statement which provides for the assembly of the detailed cost of a cost centre or cost unit”
Divisions or Components of Costs
By grouping the various elements of cost, we get the following divisions or components of cost:
1. Prime Cost : Prime Cost refers to the total of three important elements of cost – direct material, direct labour and direct expenses. Thus it is the aggregate of all direct elements of cost.
Prime Cost = Direct Materials + Direct Labour + Direct Expenses
2. Factory Cost : This is the total of prime cost and factory overheads. It is the actual expenses that are incurred in converting raw materials into finished products. It is also known as Works Cost.
Factory Cost = Prime Cost + Factory Overheads
3. Cost of Production : This is the aggregate of factory cost and office and administrative overheads. It is also known as Office Cost.
Cost of Production = Factory Cost + Office and Administration Overheads
4. Total Cost : When Selling and Distribution Overheads are added to Cost of Production, it is called Total Cost or Cost of Sales. It serves the purpose of fixing the selling price by adding a margin of profit to the total cost.
Total Cost = Cost of Production + Selling and Distribution Overheads
Budgetary Control
The term „budget‟ has been derived from the French word ‟Bougette‟. It means a leather bag into which funds are appropriated to meet the anticipated expenses. According to ICMA London, “Budgeted is a financial and/or quantitative statement, prepared and approved prior to a defined period of time, of the policy to be pursued during that period for the purpose of attaining a given objective”
Budgeting simply means preparing budgets. It is a process of preparation, implementation and the operation of budget. It is the formulation of plans in numerical terms for a given future period. Budgetary control is a system of using budgets for planning and controlling costs. “It is a system of controlling costs which includes the preparation of budgets, co-ordinating the departments and establishing responsibilities, comparing actual performance with that budgeted and acting upon the results to achieve maximum profitability.”

15. Steps involved in Budgeting and Budgetary Control
1. Establishing budgets for each section of the organization.
2. Recording the actual performance
3. Comparing continuously the actual performance with that budgeted
4. Calculating the difference or variances between budgeted performance and actual performance
5. Analyzing the causes for such differences or variances
6. Furnishing budget reports to top management
7. Taking corrective action where necessary
8. Revising budget, if necessary
Essential of Effective Budgetary Control
1. Support of top management is essential
2. Must be clear and realistic goals
3. Sound organizational structure is essential
4. Adequate accounting system is required
5. It must be at minimum cost of operation
6. Effective communication
7. Timely reporting is essential
8. Flexibility
9. Sound organization
Advantages of Budgets and Budgetary Control
1. Budgeting compels the management to plan for the future. It makes planning precise and purposeful
2. It minimizes wastage of all kinds and promotes efficiency, productivity and profitability
3. It is a tool for measuring the managerial performance
4. It ensures optimum utilization of both human and non-human resources
5. It ensures co-ordination of activities of various departments and facilitates smooth running of the business enterprise
6. It is an important tool of managerial control; the management can find out the deviation from the plan and take remedial actions.
7. It improves communication throughout the organization.
8. It motivates executives to attain the given goals.
9. It facilitates management by exception. In this way, it saves management‟s time and energy
10. It assists in delegation of authority and assignment of responsibility. It permits participation of employees at all levels in the preparation of budgets
11. The integration of budgets make possible cash and working capital management
12. It ensures effective use of firm‟s resources

16. Disadvantages of Budgets and Budgetary Control
1. Budget deals with future periods and therefore depends upon forecasts. Estimates and forecasts can never be accurate
2. It trends to bring about rigidity in control. Revision must be made in time in the light of changing conditions
3. A budgetary system cannot be successful unless it is understood and supported by the managers and subordinates
4. Budgeting is merely a tool of management and not a substitute for management. It just helps the management in carrying out the decisions.
5. The installation and operation of budgetary control system is expensive because it requires the employment of specialized staff. Therefore, a small concern cannot afford it
6. There should be continuous evaluation of the actual performance. Otherwise budgeting will hide inefficiencies
7. The preparation of a budget under inflationary conditions and changing government policies is really difficult. Thus the accurate position of the business cannot be estimated
8. Inefficient executives and workers may oppose the introduction of budgetary control system
Classification of Budgets
Budgets can be classified in many ways. The following are the most important among them.
A. Classification according to time factor
1. Long-term budgets – These budget are related to planning the operation of a firm for a period of 5 to 10 years. For example, capital expenditure budget, research & development budget etc.
2. Short term budgets – These budgets are drawn usually for a period of one or two years. For example, Cash Budget, Material Budget etc
3. Current budgets – These budgets cover a period of one month or so. These are related to current conditions
B. Classification according to function
1. Functional Budgets – Functional budgets are those while prepared by heads of functional departments for their respective departments. Functional budgets are prepared for each function and are subsidiary to the master budget.
2. Master Budget – The managers of various departments prepare their budgets (functional budgets) and submit them to the budget committee. The committee will make necessary adjustments, incorporate all the functional budgets and prepare a

17. master budget. The master budget is the heart and soul of the budget. It brings all the pieces together, incorporating all the functional budgets and the financial budget of an organization into one comprehensive picture.
C. Classification according to flexibility factor
1. Flexible Budget – Flexible budget is a dynamic budget. CIMA defined flexible budget as “a budget designed to change in accordance with the level of activity actually attained “. It shows estimated costs and profits at different levels of output.
2. Fixed Budget – Fixed budget is a budget which is designed to remain unchanged irrespective of the level of activity attained. It doesn‟t change with the change in the level of activity. It is prepared for one level of activity for a definite time period. This type of budget is most suited for fixed expenses.
TYPES OF FUNCTIONAL BUDGETS
1. Cash Budget – Cash budget is the most important of all functional budgets. It is prepared only after all the other functional budgets are prepared. Cash Budget is also called the financial budget or the ways and means budget. It is the device to plan for and control the use of cash. It is a statement showing estimated cash inflows and ash outflows over the budget period. Thus it shows the periodical cash position. It is prepared to ensure that there will be just sufficient cash in hand adequately with budgeted activities.
2. Sale Budget – Sales budget is a forecast of total sales expressed in quantities and money. It is the sales manager who prepares the sales budget. In almost all organizations, it is sales budget which holds the key for the success of all other budget.
3. Selling and Distribution Cost Budget – This is the forecast of selling and distribution expense during the budget period. This is inter-related with sales budget because it is based on the quantity of sales estimated as per the sales budget.
4. Production Budget – Production Budget is usually based on the sales budget and the desired inventory levels. It is the forecast of the quantity of production for the budget period.
5. Production Cost Budget – It is a forecast of the cost of production as per the production budget. It expresses the physical quantity of the production budget in terms of money.

18. 6. Material Budget – A Material Budget shows the estimated quantities as well as cost of raw material required for the production of different products during the budget period.
7. Purchase Budget – This shows the quantity of different type of materials to be purchased during the budget period taking into consideration the level of activity and the inventory levels.
8. Labour Budget – It is the forecast of the labour requirements during the budget period. Generally, the labour budget shows the requirements of direct labour. Labour budget enable the personnel department to plan in recruitment, selection and training process of labourers.
9. Production Overhead Budget – It represent the forecast of all production overheads to be incurred during the budget period. This budget includes the cost of indirect material, indirect labour and indirect work expenses. It may be classified into fixed cost, variable cost and semi variable cost.
Marginal Costing and Break Even Analysis
According to ICAM, London Marginal Cost represents “the amount of any given volume of output by which aggregate costs are changed if the volume of output is increased by one unit.”
Marginal Costing- “the ascertainment of marginal costs and their effect on changes in volume or type of output by differentiating between fixed costs and variable costs “
Features of Marginal Costing
1. It is technique of analysis and presentation of cost helps the management to take decision
2. All the costs are classified into variable, semi-variable and fixed
3. Variable costs are regarded as the cost of the product
4. Fixed costs are periodic cost and charged to profit and loss account for the period, which is relevant
5. Stock of finished goods and Work in Progress are valued at marginal costs
6. Price determined on the basis of contribution

19. Assumptions of Marginal Costing
1. All the elements of costs are segregates into fixed and variable components
2. Variable cost remains constant per unit of output irrespective of level of output
3. Selling price per unit remains unchanged or constant at all levels of activity
4. Fixed cost remains unchanged for the entire volume of production
5. The volume of production or output is the only factor which influences the costs
Advantages of Marginal Costing
1. Easy and simple
2. Simple valuation of stock
3. Better cost control
4. No problem of under or over absorption of overhead
5. Helps in decision making
6. Helps in fixing selling price
7. Helps in ascertaining profitability
Limitations of Marginal Costing
1. Difficulty in separating cost into fixed and variable
2. Difficulty at the time of application of theory into practice
3. Undervaluation of stock due to lack of consideration to fixed cost
4. Short run Analysis- only for a short period of time
5. Time factor is ignored-No consideration for interest rate and time value of money
6. More emphasis on sales
Contribution
Contribution is the difference between sales and variable cost or Marginal Cost of sales. It may also be defined as the excess of selling price over variable cost per unit. Contribution is also known as Contribution Margin or Gross Margin.
Contribution = Sales – Variable Cost
Or
Contribution = Fixed cost + Profit
CVP Analysis
Cost-Volume-Profit Analysis is a technique for studying the relationship between cost, volume and profit. In CVP Analysis an attempt is made to analyze the relationship between variations in cost with variation in volume.

20. Break Even Analysis
The study of Cost-Volume-Profit Analysis is often referred to as „Break Even Analysis‟ and the two terms are used interchangeably by many of them. It refers to the study of relationship between costs, volume and profit at different levels of sales or production.
Advantages of BEP Analysis or CVP Analysis
1. Forecasting sale or profit
2. Helps in determining the selling price which gives desired profit
3. Determine the volume of output, which gives a desired profit
4. Helps in determining cost and revenue at various levels of activity
5. Helps in profit planning
6. Helps in understanding about Margin of Safety
7. Helps in formulating Pricing policies
8. Effective cost control is possible
Margin of Safety
Margin of safety is the extra sales achieved by the firm in excess of Break Even Sales
Margin of Safety = Present Sales – BEP Sales
PV Ratio
PV Ratio is the ratio shows relationship between sales and contribution. It is prime tools used in Marginal Costing for decision making. It also show relationship between sales and variable costs
PV Ratio = Contribution/Sales *100
Uses of PV Ratio
1. Helps in comparing profitability of the products
2. Helps in estimating sales, profit and variable cost
3. Helps in decision making
4. Helps in formulation of pricing policies
5. Helps in determining sales volume to earn a desired profit
6. Helps in calculating profits at various level of sales

21. How can we improve Margin of Safety?
1. Increasing sales
2. Increasing selling price
3. Reducing variable cost
4. Reducing fixed cost
5. Switch over to other profitable products
Application of Marginal Costing in Decision Making
1. Profit planning
2. Selection of suitable sales mix
3. Key factor problems – limiting factor problems
4. Make/ Buy Decisions
5. Decision regarding dropping a product line
6. Alternative methods of production
7. Shut down decision – only when it has negative contribution
8. Accepting bulk order/Export Order, Additional Orders etc
9. Introduction of a new product

22. UNIT – IV
Sources of Finance
Finance is the life-blood of business. Finance is required for starting and operating a business enterprise. Without finance, no organization can achieve its objectives. The following are some of the long term finance for an organization.
1. Equity Shares
Equity Shares represent shares of ownership in a company. Equity shares do not carry any preferential right in respect of dividend or repayment of capital. That is why these are known as ordinary shares. Equity shares are also known as Ordinary Shares. Equity shares are also known as common stock or equity stock. Dividend is paid on equity shares only after paying a fixed rate of dividend on preference shares. The rate of dividend on equity shares is not fixed. It varies according to the amount of profit the company earns. In the event of winding up, the equity capital is repaid last. However, equity shareholders get full voting power.
Sweat Equity : A sweat Equity share is an equity share issued by the company to employees or directors at a discount or for consideration other than cash for providing know-how or making available rights in the nature of intellectual property rights or value additions.
2. Preference Shares
Preference shares are those which carry a preferential right over equity shares as regards payment of dividends and repayment of capital in the event of winding up. A fixed rate of dividend is paid on preference shares before any dividend is paid on equity shares. Similarly, on winding up, preference capital is repaid before equity capital is repaid. The important types of Preference shares are Cumulative Preference Shares, Convertible Preference Shares, Redeemable Preference Shares, and Participating Preference Shares.
Equity Shares
Preference Shares
Bonds
Debentures
Warrants
Sources of Long Term Finance

23. 3. Debentures
Long term debt mainly includes debentures and long term loans. A company can borrow money by issuing debentures. Debenture is an instrument of acknowledgement of debt. It is an acknowledgement of debt, issued by a company under its common seal. According to Section 2(12) of the Companies Act, Debentures includes debentures, stock, bonds and any other securities of a company whether constituting a charge on the assets of the company or not. Debenture represents loan or borrowed capital of a company. It is common to put the rate of interest before debentures. Suppose, debentures are issued carrying interest @ 8%. Then such debentures will be known as 8% Debentures. Some types of Debentures are Mortgage/Naked Debentures, Bearer/Registered Debentures, Redeemable/Irredeemable Debentures, Fully/Non/Partly Convertible Debentures
4. Bonds
It is a long-term debt instrument issued by the company to raise the financial resources from the market, for a specific period and it carries fixed rate of interest which has its own salient features,
- Issued at face value
- Rate of interest is fixed or flexible
- Maturity date is specified but not in the case of perpetual bonds.
- Redemption Value-in the bond certificate-may be par or premium-terms of the issue.
- Bonds are traded in the market
Some new generation bonds are Zero Coupon Bonds, Deep Discount Bonds, Pay in Kind Bonds etc.
5. Warrants
These are nothing but Bearer documents which are title to buy the specified number of equity shares at specified price during the future period. The life period of the warrants is normally too long. The warrants are normally issued by the company only in order to attract the issue of fixed bearing securities viz preference shares and debentures.
Capital Budgeting
Capital Budgeting simply refers to investments decisions. It is a decision about capital expenditure. Capital expenditure simply refers to investment in fixed assets and other development projects. It refers to that expenditure which is incurred at one point of time whereas the benefits of the expenditure are realized at different points of time in future.
An important step in capital budgeting is to determine which investment opportunity is most profitable. The procedure adopted for this is known as Project Appraisal. Project Appraisal is a tool to examine as to whether in the given situation, it would be most reliable and reasonable to invest resources or not. The most important and important techniques of Capital Budgeting or Project Appraisal:

24. 1. Pay Back Period Method
This is one of the commonly used techniques of evaluating capital expenditure proposals. It is a cash based technique. Payback period is the length of time or period required to recover the initial cost ( investment) of the project. It is the expected number of years during which the original investment is recovered. It is the breakeven point of the project, where the accumulated returns (cash inflows) equal investment (cash outflow). Pay back method is also called „pay-out‟ or „pay-off period‟ or „recoupment period‟ or „replacement period‟.
2. Accounting Rate of Return Method (ARR)
Accounting Rate of Return method is a simple technique of averaging returns over investments. The ARR represents the ratio of the average annual profits to the average investment in the project. It is based on accounting profits and not cash flows. This method is also known as Average Rate of Return method or Return on Investment method or Unadjusted Rate of Return method. Under this method average annual profit (after tax) is expressed as percentage of investment.
3. Net Present Value Method (NPV)
NPV method involves discounting future cash flows to present values. Under this method, the present value of all cash inflows (stream of benefits) is compared against the present value of all cash outflows (cash outlays or cost of investment). The difference between the present value of cash inflows and present value of cash outflows is called the net present value. This net present value may be either positive or negative. If the NPV is positive, it means that the actual rate of return is more than the discount rate. A negative NPV indicates that the project is not even covering the cost of capital. It means that the actual rate of return is less than the discount rate.
4. Internal Rate of Return (IRR)
In IRR we try to discount at different discount rates until we reach the discount rate at which the present value of cash inflows is equal to the present value of cash outflows(investments). Thus, internal rate of return is the rate of return at which total present value of future cash inflow is equal to initial investment. In other words, it is the rate at which NPV is zero. This rate is called the internal rate because it exclusively depends on the initial outlay and cash proceeds associated with the project and not by any other rate outside the investment.
5. Present Value Index Method
The profitability index method is more useful in the case of more number of investments, having uneven investment outlays, but this problem comes with only one investment proposal. It is much easier to assess even in the case of Net Present Value Method.
Profitability Index = PV of Cash Inflows / PV of Cash Outflows

25. 6. Discounted Pay Back Period
A major shortcoming of the conventional payback period method is that it does not take into account the time value of money. To overcome this limitation, the discounted payback period method is suggested. In this modified method, cash flows are first converted into their present values (by applying suitable discounting factors) and then added to ascertain the period of time required to recover the initial outlay on the project.
Risk & Return
Risk refers to the possibility that the expected return may not materialize. There may be loss of capital, i.e. investment has to be sold for an amount less than paid for it. There may be no income from investment or the income may be less than the expected. The natural query is “why the investors go for risky investment?” The answer is that the desire for higher return entitles them to go for risky investments. Return comprises the income, which is in the form of dividends or interest, and the capital gain (loss).
Different types of Risk
It is known as macro level risk. It is concerned with the economy as a whole. The factors causing this type of risk affect all the investments in a similar fashion(and not in a similar dagree). All investors (particularly equity investors) have to bear this risk.
The most serious systematic risks are:
i. Interest rate risk: Increase in interest rates generally have adverse effects on the financial position and earnings of the companies.
i. Inflation risk: Inflation disturbs business plans of the most of the organizations. Input costs may go up, all the increase in input costs may not been passed on to the customers.
ii. Political risk: This risk involves change in government policies and political instability
iii. Level of economic activities(recession and boom)
The unsystematic risk is also known as micro level risk. It is concerned with the company or industry. This type of risk arises from such factors which are concerned with the firm. This risk is unique to a particular security. The two serious unsystematic risks are :
i. Business risk: Business risk is the possibility of adverse change in EBIT. Example, reduction in demand for company‟s products, increase in costs of inputs etc
ii. Financial risk: It is the possibility of bankruptcy. It arises because of dependence on borrowed funds and that two at high interest rates.
Capital Asset Pricing model (CAPM)
CAPM explains about the required return on investment. The required return has some relation with the minimum return and risk premium. Risk premium is the additional return expected by the investor for bearing the additional risk associated with a particular investment. And through CAPM, it tries to measure the quantum of risk through a factor

26. called beta(β). In nutshell, CAPM quantifies the rate of return as any addition or reduction from minimum return according to the risk in that investment.
Assumptions of CAPM
The CAPM is based on the following eight assumptions:
1. The investor‟s objective is to maximize the utility of terminal wealth
2. Investor‟s make choices on the basis of risk and return
3. Investors have homogenous expectations of risk and return
4. Investors have identical time horizon
5. Information is freely and simultaneously available to investors
6. There is a risk free asset and investors can borrow and lend unlimited amount at the risk free rate
7. There are no taxes, transaction costs, restrictions on short term rates or other market imperfections
8. Total assets quantity is fixed and all assets are marketable and divisible

27. UNIT – V
Cost of Capital
Cost of Capital simply refers to cost of obtaining funds. Cost of Capital is the rate a firm pays to its investors for the use of their money. In the words of John. J. Hampton, “the cost of capital is the rate of return, the firm requires from investment in order to increase the value of the firm in the market place”
To conclude, cost of capital is the minimum rate of return that must be earned to maintain the market value per share. It is the rate of return required by those who supply the capital. In short, it is the payment for the use of capital.
1. Cost of Debt
The cost of the prepectual debt is nothing but the cost of raising the debt financial resource, in which the time period of repayment of the principal is not known. This particular specific source has two different classifications viz, cost of interest and cost of debt.
Cost of Interest (Ki) = Interest/ Sales Value
Cost of Debt (Kd) = Tax Adjusted Interest/ Sales Value
2. Cost of Preference Share Capital
Preference shares carry a fixed rate of dividend. It is paid before equity dividend is paid. The rate of dividend is determined at the time of issue. The cost of preference capital is the dividend expected by the preference shareholders. It is found by dividing annual preference dividend by the net proceeds from the issue of preference shares.
Kp = Dp / NP *100
Where, Kp = Cost of Preference Share Capital
Dp = Preference Share Dividend
NP = Net Proceeds from the issue of preference shares. Floatation cost, if any
should be deducted.
3. Cost of Retained Earnings
The cost of retained earnings is to be computed on the basis of opportunity cost. It does not have any direct cost, instead, the amount of retained earnings loses the opportunity of the investors to earn in the form of dividends due to retained earnings; which are foregone by them one side and on the other side the earnings which are invested in some other investments, would be in a position to yield the return, is the cost of retained earnings.

28. 4. Cost of Equity
Under this method the cost of equity is divided into two components – (i) the near risk free return available on investing in government bonds, and (ii) an additional risk premium for investing in a particular share or investment. This risk premium in turn comprises the average return on the overall market portfolio and the beta factor (or risk) of the particular investment. The formula to calculate cost of equity is as follows:
Ke = Rf + β (Rm – Rf)
Weighted Average Cost of Capital (WACC)
Weighted Average Cost of Capital (WACC) refers to the average cost of the various sources of finance. It is an average of the costs of all sources of funds in the capital structure, properly weighted by the proportion of each source in the total capital structure. It is also known as composite cost of capital or overall cost of capital.
Leverage Analysis- Introduction
The term „leverage‟ comes from physics. In physics the term „leverage‟ means „to lever‟ or „to rise‟. Generally the term leverage means the relationship between two inter-related variables. It refers to the percentage change in one variable corresponding to percentage change in other variable.
There are two major components of capital structure of a company. They are debt and equity. Whenever there is a change in debt equity mix, there is an impact on the shareholders‟ return and risk. The effect on the shareholders‟ return of change in the debt-equity mix is known as leverage.
There are mainly three types of leverage. They are explaining as follows:
I. Financial Leverage
Debentures, long term loans (debt) and preference shares are fixed charge securities. The rate of interest on debt is fixed. It has to be paid irrespective of the amount of earnings. Similarly, the rate of dividend on preference shares is also fixed. However, it is paid when the company earns profit. The rate of dividend on equity shares is not fixed. Only the residual profit is paid as equity dividend. Residual profit means profit left after interest, tax and preference dividend. When the rate of earning is higher than the rate of interest and preference dividend, there is increase in earnings per equity share. This impact of fixed charge securities on earnings per share is the result of financial leverage.
The financial leverage arises when a firm employs a combination of equity capital and fixed charge securities (debt and preference shares) in its capital structure. In short, using fixed cost capital with the equity share capital is known as Financial Leverage.

29. Financial Leverage may be favorable or unfavorable. If the earnings by the use of fixed cost bearing securities (debt and preference capital) is more than their fixed costs ( interest and preference dividend), it is known as favorable financial leverage. Favorable financial leverage is also known as Trading on Equity. If the firm‟s earnings are less than the cost of borrowed funds (including preference dividend), it is called unfavorable financial leverage. The unfavorable financial leverage cannot be termed as trading on equity.
Financial Leverage = EBIT/EBT
Degree of Financial Leverage = % change in EPS/ % change in EBIT
II. Operating Leverage
Operating Leverage refers to the amount of fixed cost in the cost structure. In simple words, presence of fixed cost is known as Operating Leverage. It measures the extent to which fixed cost is used in operating the firm. If the fixed costs are more as compared to variable costs, the operating leverage will be high. It is calculated by,
Operating Leverage = Contribution/EBIT
Where, Contribution = Sales – Variable Cost
EBIT = Contribution – Fixed Cost
Degree of Operating Leverage (DOL) measures how much is the effect of change in sales on change in operating profit. The Degree of Operating Leverage (DOL) at any level of output is expressed as the ratio of the percentage change in operating profit (EBIT) to percentage change in sales. It is calculated by using the following formula:
DOL = % change in EBIT/ % change in Sales
Capital Structure - Introduction
Capital Structure simply refers to the makeup of the capitalization (long term capital) of a firm. It is the mix of debt and equity which a company uses to finance its long term operations. Deb capital is the company‟s long term borrowings. Equity capital is the long term funds provided by the shareholders or owners of the company (i. e, capital collected through the issue of shares).
R. H. Wessel says,“ The term capital structure is frequently used to indicate the long term sources of funds employed in a business.”
The importance of study of capital structure is because of, to achieve optimal capital structure. Optimal Capital Structure is a point of capital structure in which the overall cost of debt is minimum and the overall value of the firm is the maximum. Where, overall cost of debt is the average cost of capital for total long term fund of the business and the value of the firm is aggregate value of debt and value of equity.

30. Capital Structure Theories
Basic Assumptions
1. There are only two resources in the capital structure viz. Debt and Equity share capital
2. The dividend payout ratio 100% which means that there is no space for the retained earnings.
3. The life of the firm is perpetual.
4. The total assets of the firm do not change
5. The total financing remains constant through balancing taking place in between the debt and share capital.
6. No corporate taxes, this was removed later.
I. Net income Approach
This theory was developed by David Durand. According to this theory, a company can increase the value of the firm and reduce the overall cost of capital by increasing the proportion of debt in its capital structure to the maximum possible extent. Debt is generally a cheaper source of fund because of two reasons:
i. Interest rate is lower than dividend rate
ii. Interest is deductible expense for expense for income tax purpose.
When the firm increases the proportion of debt(cheaper source of fund) in its capital structure, its overall cost of capital decreases. The optimal capital structure of such a firm is the point at which the overall cost of capital is the minimum and the value of the firm is maximum. Thus there is a relationship between cost of capital and value of the firm.
II. Net operating Income Approach
This theory was propounded br Durand. According to Net Operating Income Approach, the market value of the firm depends upon the net operating profit (EBIT) and the overall cost of capital. The capital structure is irrelevant and it does not affect the value of the firm. In short, the theory states that the value of the firm is not affected by the change in the capital structure. i. e; capital structure is irrelevant. Thus this theory is quite opposite to the Net Income Approach.
The main argument of this approach is that an increase in the use of debt would lead to increase in the financial risk of shareholders. Because of the increase in the risk, the equity shareholders start expecting higher return. This would result in an increase in the cost of equity capital.

31. III. Traditional Approach
Traditional approach was suggested by Soloman Ezra. This lies midway between the Net Income Approach and Net Operating Income Approach. It is, in fact, a compromise between the two. Hence it is known as intermediate approach. According to this approach, a firm can reduce the overall cost of capital or increase the total value of the firm by increasing the proportion of debt in the capital structure to a certain limit. Beyond this limit the additional does of debt may result in a decrease in the total value of the firm. Hence, by mixing the debt and equity judiciously, it is possible to minimize the overall cost of capital and maximizing the total value of the firm. Thus there is an optimum capital structure. The optimum capital structure is one at which the value of the firm is maximum and cost of capital is minimum.
IV. Modigliani- Miller Theory
Franco Modiglianni and Merton Miller (both Nobel Prize winners in financial economics) developed a capital structure theory in 1958. According to this theory, a firm‟s total value and its overall cost of capital will be same at all degrees of financial leverage. By arbitrage process. Modigliani and Miller have proved under a given set of assumptions, the capital structure and its composition have no effect on the value of the firm. The assumptions are as follows:
i. There is perfect capital market
ii. Investors are allowed to buy and sell securities.
iii. Investors are rational to access the information.
iv. No transaction costs involved in the process of the buying and selling of securities.
Arbitrage Process: Arbitrage process refers to buying a security which has low risk and selling it in a high risk market. The investors will develop a tendency to sell the shares of the overvalued firm (whose prices are higher) and to buy the shares of the undervalued firm (whose prices are lower). This buying and selling will continue till the two firms have same market values. It happens so because the increased demand for undervalued securities raises their prices and the increased supply of overvalued securities reduces their prices. Thus arbitrage process restores equilibrium (i.e. the prices become the same). Arbitrage process ensures that a security cannot sell at different prices for long time.
Dividend Policy
The dividend policy is the policy that facilitates the firm to decide how much should be declared as dividend. It is a crucial decision of every company, because it affects the current cash position, current share prices and future appropriation of profit. So each and every dividend decision must be judicial and logical.
Following are the types of dividend Policies:
i. Cash Dividend – dividend paid in the form of cash

32. ii. Bond Dividend Policy – Instead of cash as dividend company issue Bonds as dividend. It help the company to maintain the cash position and the shareholders will get interest on bonds also. This is not popular in India.
iii. Property Dividend Policy – Instead of paying dividends in cash, some assets are given to the shareholders as dividend payments. This does also not exist in India.
iv. Stock Dividend Policy – Paying stock as dividend, instead of cash. It is also known as Stock Dividend.
Working Capital Management
Working Capital is the capital required for the day-to-day working of an enterprise. It is required for the purchase of raw materials and for meeting the day-to-day expenditure on salaries, wages, rents, advertising etc. it is needed for holding some convertible assets (current assets) such as stock, book debts, bill receivable and cash.
The Working Capital means the funds available for day to day operations of the operations of the enterprise. It also represents the excess of current assets over the current liabilities which include the short term loans.
Determinants of Working Capital
1. General nature of business, whether it deals with cash/credit, goods/service etc
2. Length of production cycle
3. Impact of business cycle
4. Production policies and purchase patterns of purchasing department
5. Credit policy of the business
6. Price level changes in the economy and availability of raw materials
7. Size of business
8. Quantum of turnover and terms of trade
Working Capital Polices
1. Hedging Approach – A balanced approach which maintains a balance between current assets and current liabilities
2. Conservative Approach – Maintains a higher amount of current assets than current liabilities as a precautionary measure.
3. Aggressive Approach – Maintains much lesser amount of current assets when compared to current liabilities
4. Zero Working Capital Approach – A latest trend in working capital management, here nil amount of working capital is maintained almost all the times. And excess amount of working capital quickly used for investment purpose.

33. Cash Management
Cash management simply refers to management of cash, i.e. cash inflows and cash outflows. It is the process of forecasting, collecting, disbursing, investing and planning for the cash a company needs to operate its business smoothly.
Objectives and basic problems of cash management refer p.no.309 and 310
Management of Inventories
Management of inventories is another major area in management of working capital. Because of inventories are the basic matter in production, it is a crucial factor in working capital management. In broader terms inventories are classified into three. They are Raw Materials, Work in Progress and Finished Goods.
Raw Materials are the unprocessed inventory stock used for production for further processing and transformations. Finished Goods are the final product after the entire production process and they are ready for sale. And Work in Progress is those inventories in the process of production. They are in mid way in between raw material and finished goods.
There are a lot of traditional and modern methods for inventory control in management. Some of the inventory controls can be placed by proper positioning of stores department in organization. The arrangement of stores department can be Centralised or Decentralised or Central and Sub stores. In Centralised stores all the materials, stores and consumables will be supplied from a centralized stores department in that organization and in case of decentralized stores, we have individual stores department for each department. And in the case of central and sub stores, it is combination of centralized and decentralized store system which tries to eliminate the deficiencies of both the centralized and decentralized system.
Levels of Inventories
1. Reorder Level : This is the level at which order is placed for fresh supply of materials. When the stock of material reaches this level, the storekeeper must reorder for this material. Reorder level is fixed somewhere between minimum level and maximum level. It must be fixed in such a way that the stock representing the difference between reorder level and minimum level should be sufficient to meet demands of production till new materials arrive.
Reorder Level = Maximum consumption * Maximum reorder period
2. Minimum Level : Minimum stock level is the minimum quantity of stock that should be held at all times. It is that level below which stock should not normally be allowed to fall. Minimum stock is also called safety or buffer stock. The main purpose of this level is to ensure that production is not stopped due to non availability of materials.
Minimum Level = Reorder Level – (Normal consumption * Normal reorder period)

34. 3. Maximum Level : Maximum stock level is the upper level of inventory. This is the level above which stock should not be maintained. The main purpose of this level is to avoid overstocking of materials and unnecessary blocking of capital in inventories.
Maximum level = Reorder level + Reorder quantity – (minimum consumption *
Minimum reorder period)
4. Danger Level : This is the level of stock below which the stock should never be allowed to fall. If the stock level falls below the minimum level is called the danger level. When stock reaches danger level, urgent and emergency action should be taken to replenish the stock so that production is not stopped. Danger level is rightly described as danger warning level.
Danger Level : Average consumption * Maximum reorder period for emergency
Purchases
5. Average Stock Level : This is the average stock held by an organization
Average Stock Level = Minimum Level + ½ Reorder Quantity
Economic Order Quantity (EOQ)
While purchasing the materials an important question arises as to what quantity should be purchased or ordered. Neither too larger quantity nor too smaller quantity should be ordered. Only optimum or most favorable or economic quantity should be purchased at a time. This quantity is called Economic Order Quantity. Thus economic order quantity can be defined as the quantity which is most economical to order at a time.
EOQ = √(2AO/I)
Where A = Annual requirement in units
O = Ordering cost
I = Annual carrying or storing cost per unit