PROJECT MANAGEMENT & ECONOMICS

Unit 5 – Fundamentals of Finance & Costing

 COST
• Cost is commonly defined as ‘sacrificed resource’ for a
particular thing.

• Cost can be of anything which is measurable in terms of

money.

• For example, the cost of preparing one pizza which in itself

include various other costs like the cost of flour, other
ingredients, labor, electricity, and other overheads. Just the
same way, the cost of production of any product or service can
be determined.
 Costing
• ‘Cost’ is a term whereas ‘Costing’ is a process for determining the
cost. It may be called a technique for ascertaining the cost of
production of any product or service in the business organization.

• The real scope of this term can best be understood in the context
of big manufacturing concerns who produce hundreds of
products and spend a lot of money on material, labor, and other
overheads.

• The cost of each product in those organizations requires

recording expenses with to each product or process, classifying
expenses like direct material, labor, overheads etc., allocating
direct expenses and suitable apportionment of overheads
to each product for most correct determination of per unit cost
of production of each product.
 Importance of Costing
• While it may sound trivial, knowing how much it costs to
make a product is extremely useful information about
your business. By understanding the importance of
costing before you run into trouble, you can use these
techniques to do more than just set a normal sales price;
costing can help you make other data-driven decisions
about your business process.

• Pricing Decisions
• Company Performance
• Financial Reporting
• Sell or Process Further
 Importance of Costing
In view of the complexity of businesses and increasing changes in
industry, trade and commerce, costing is becoming very
important :
• It assist management to make decision for example make or
buy, whether to accept a special order and others;
• It assist management in planning and control;
• Costing assists management to appreciate scarce resources in
the increasingly complex business operations;
• Understanding costing assist in cost awareness, cost control /
management;
• Is vital to an organization’s survival reusing marginal cost in
competitive tendering and others.
 Elements of Cost
• Cost of production/manufacturing consists of various expenses
incurred on production/manufacturing of goods or services.
These are the elements of cost which can be divided into three
groups :

Material

Cost
Expenses Labour
 Material
The substance from which the product is made is known as
material. It may be in a raw or manufactured state.
To produce or manufacture material is required.
For example to manufacture shirts, cloth is required and to
produce flour, wheat is required.
Material

Direct Material Indirect Material

is that material which can be easily is that material which cannot be easily
identified and related and conveniently identified and
with specific product, job, and process related with a particular product, job,
e.g. : Timber is a raw material for process, and activity.
making furniture, cloth for making e.g. : Consumable stores, oil and
garments, sugarcane for making sugar waste, printing and stationery
 Labour
Labour is the main factor of production. For conversion of raw
material into finished goods, human resource is needed, and such
human resource is termed as labour. Labour cost is the main
element of cost in a product or service.
Labour

Direct Labour
Indirect Labour
Direct labour is that labour which can be
Indirect labour is that labour which
easily identified and related with
can not be easily identified and
specific product, job, process, and
related with specific product, job,
activity. Direct labour cost is easily
process, and activity.
traceable to specific products.
e.g. : Wages of store-keepers, time-
e.g. : Cost of wages paid to carpenter
keepers, salary of works manager,
for making furniture, cost of a tailor in
producing readymade garments
 Expenses
All cost incurred in the production of finished goods other than
material cost and labour cost are termed as expenses.
e. g. : Rent, Insurance, building expenses, fees paid to architects
Expenses

Direct Expenses
These are expenses which are directly,
Indirect Expenses
easily, and wholly allocated to
These expenses cannot be directly,
specific cost center or cost units.
easily, and wholly allocated to specific
e.g. : hire of special machinery, cost of
cost center or cost units.
special designs, moulds or patterns,
e.g. : Rent, rates and taxes of
feed paid to architects, surveyors and
building, repair, insurance and
other consultants ,inward carriage and
depreciation on fixed assets,
freight charges on special material, Cost
of patents
 Overheads
The term overhead has a wider meaning than the term indirect expenses. Overheads
include the cost of indirect material, indirect labour and indirect expenses. This is the
aggregate sum of indirect material, indirect labour and indirect expenses.
Overhead = Indirect material + Indirect labour + Indirect expenses
Overheads are classified into following three categories:
• Factory/works/ production overheads
These include indirect material, indirect labour and indirect expenses incurred in the
factory. e. g. Grease, oil, lubricants, Salary of factory manager, foremen, EPF
contribution, Rent of factory buildings , Municipal taxes of factory building , etc.
• Office and administrative overheads
These represent the aggregate of the cost of indirect material, indirect
labour, and indirect expenses incurred by the office and administration
department of an organization. e.g. Office printing and stationery, Salaries of legal
adviser, accountants, clerks, Rent, insurance, rates and taxes of office etc.
• Selling and distribution overheads
Selling and distribution overheads are incurred for the marketing of a commodity, for
securing order for the articles, dispatching goods sold or for making efforts to find and
retain customers. These overheads have two aspects
(i) procuring orders (ii) executing the orders
e.g. Catalogues, price list , Salaries of sales managers, clerks , Advertising, Cost of
packing material, Packing expenses, Godown rent, insurance, etc
 Components of Cost
The four main components of costs are: (a) Prime Cost, (b) Works Cost, (c) Office Cost and
(d) Total Cost.

Prime Cost :
It consists of costs of direct material, direct labour and direct expense specifically
attributable to the job. This is also known as flat, direct or basic cost.

Works Cost :
It comprises of prime cost and factory overheads, (cost of indirect material, indirect labour
and indirect expenses related to factory works). This cost is also known as factory cost,
production or manufacturing cost.

Office Cost :
It is the sum total of works cost and office and administrative overheads (Cost of indirect
material, indirect labour and indirect expenses related to office works). This cost is known
as office cost.
Cost of Production = Works Cost + Office and Administrative Overheads

Total Cost :
It comprises of cost of production and selling and distribution overheads (Cost of indirect
material, indirect labour and indirect expenses for selling and distribution activities).
Total Cost = Cost of Production + Selling and Distribution Overheads
 Selling Price
• The selling price of a product or service is the seller’s final price, i.e., how much
the customer pays for something. The exchange can be for a product or service in
a certain quantity, weight, or measure.

• It is one of the most important factors for a company to determine. It is important

because it can define the success of its survival. A product’s price has a direct
effect on its sales.

• How much you sell something for must be enough so that you make a profit. It
must also secure a position in the market.

• We can set that price at a minimum, maximum, or the average of both. We can
establish prices according to the time of year or season, area, demand, and
market. It is also a good idea to look at what our competitors are doing.

• Regulations and national or local laws may affect selling prices.

 To determine the Selling Price
• There are several ways to determine the selling price. One way is by analyzing the
price sales history.
• This allows a business to understand demand better. It looks at different periods
or seasons and sets prices accordingly.
• Another way is through formula
• For example, the gross profit formula is selling price – cost price = gross profit. It
can help a business set the selling price according to the percentage of profit it
expects.
• Let’s suppose a product costs the company Rs. 10 and it wants to make a 20%
profit? What will be Its selling price ?
• See the calculation below.
• Selling Price – Cost Price = Gross Profit
SP – Rs. 10 = 20% of SP
1 SP – Rs. 10 = 0.2 SP
1 SP – 0.2 SP = Rs. 10
0.8 SP = Rs. 10
0.8SP/0.8 = Rs. 10/0.8
SP = Rs. 12.5
(Rs. 12.5- Rs. 10) / Rs. 12.5) to get the wanted gross profit (20%)
 Marginal Cost
• Marginal cost (MC) is the additional cost incurred for the production of an
additional unit of output. The formula is calculated by dividing the change in
the total cost by the change in the product output.

• MC indicates the rate at which the total cost of a product changes as the
production increases by one unit. However, because fixed costs do not change
based on the number of products produced, the marginal cost is influenced
only by the variations in the variable costs.

• MC is particularly important in the business decision-making process.

Management has to make decisions on where to best allocate resources in the
production process. For instance, when the management needs to decide whether
to increase production or not, they have to compare the marginal cost with the
marginal revenue that will be realized by an additional unit of output. Is it worth it
to the company to produce more goods on the whole?
 Marginal Cost
• Example :

• The total cost increases as the quantity of the product increases because larger
quantities of production factors are required.
• The MC is reduced up to a certain level of production and then, it keeps on
growing along with production.
Therefore Marginal cost is the extra expense associated with producing one
additional unit.
 Allocation of Costs
• Cost allocation is the distribution of one cost across multiple entities, business
units, or cost centers. An example is when health insurance premiums are
paid by the main corporate office but allocated to different branches or
departments.
• When cost allocations are carried out, a basis for the allocation must be
established, such as the headcount in each branch or department.
• The basis for allocating costs may include headcount, revenue, units
produced, direct labor hours, machine hours, activity hours, and square
footage.
• Companies will often implement a cost allocation methodology as a means to
control costs. Under an effective cost allocation methodology, business units
become directly accountable for the services they consume. As a result, both
the service provider and the respective consumers of that service become
aware of service requirements and usage, and how such usage influences the
costs incurred.
 Items excluded from Cost Sheet
• Financial Incomes : Capital profit, dividend received, brokerage &
commission received, share transfer fees, interest on
investments, rent received , bad debts recovery, interest on loan given.

• Financial charges :capital losses, cash discount , trade discount, penalties &
fines, share transfer fees paid, interest on debentures, preliminary
expenses, underwriting commission, discount on issue of shares
and debentures, loss on investment, capital expenses, interest on capital, salary
or commission paid to partner, income tax, wealth tax,
interest on debentures, reconstruction expenses, development expenses.

• Appropriations : Bad debts reserve, dividends paid, charitable donations,

transfer to reserve, sinking fund, debenture redemption fund, machinery
replacement fund, investment fluctuation fund.

• Abnormal items : Abnormal wastage, abnormal idle time,

loss by fire, loss by theft, loss of stock, insurance premium.
 Estimation
• Purpose of An Estimate
To know in advance the expected cost in varying
degree of accuracy, at different phases of the
project.

• Owner's Purpose of Estimate

1. Making investment decision in the conceptual
stage.
2. Negotiate and finalize the contract at the
implementation phase.
3. To implement cost control measures.
COST SHEET Particulars
Opening Stock of Raw Material

Add: Purchase of Raw materials

Add: Purchase Expenses

Amount Amount
***

***

***

FORMAT Less: Closing stock of Raw Materials

Consumed
Raw Materials
***

***

(Refer Separate file for clarity)

***
Direct Wages (Labour)

***
Direct Charges
Prime cost (1) ***
Add :- Factory Over Heads:

Factory Rent ***

Factory Power ***

Indirect Material ***

Indirect Wages ***

***
Supervisor Salary

***
Drawing Office Salary

***
Factory Insurance

***
Factory Asset
Depreciation
Works cost Incurred ***
Add: Opening Stock of WIP ***

Less: Closing Stock of WIP ***

Works cost (2) ***
Add:- Administration Over Heads:-

Office Rent ***

***

Asset Depreciation ***

General Charges ***

Audit Fees ***

Bank Charges ***

Counting house Salary ***

Other Office Expenses

Cost of Production (3) ***
Add: Opening stock of Finished Goods ***

Less: Closing stock of Finished Goods ***

Cost of Goods Sold ***
Add:- Selling and Distribution OH:-

Sales man Commission ***

Sales man salary ***

Traveling Expenses ***

Advertisement ***
 PROJECT MANAGEMENT & ECONOMICS

Unit 5 – Fundamentals of Finance

Statements of Financial Information:
Introduction, Source of financial
information, Financial statements,
Balance sheet, Profit and Loss account,
relation between Balance sheet and
Profit and Loss account.
 Why Accounting
• Informational requirement of a number of stakeholders in the business
– Internal Stakeholder
• Owners
• Management
• Employees
– External Stakeholders
• Government/ Tax department
• Investors
• Banks/Lenders
• Suppliers/Creditors
• NGOs/ Industry associations
• Researchers
• Accounting is the tool for providing financial information to various
stakeholders
 What is a Financial Statement?
A financial statement is a quantitative way of showing how a
company is doing.
Three different ways of representing the financial state of a
company:
1. Cash Management (can the company meet its obligations?)
2. Profitability (Is it making money?) - the income statement
3. Assets versus Liabilities (what is the value of the company?
Who owns what?) - the balance sheet
Each one of these questions is answered by our Financial
Statements.
The Balance Sheet measures what you
own and what you owe.

What you own is called your Assets.

What you owe is called your Liabilities.

 Assets
• Assets are probable future economic benefits
obtained or controlled by a particular entity as
a result of past transactions or events.
 Liabilities
• Liabilities are probable future sacrifices of
economic benefits arising from present
obligations of a particular entity to transfer
assets or provide services to other entities in
the future as a result of past transactions or
events.
The equity section is the difference
between the two.

Assets – Liabilities = Equity

The equity section is the difference
between the two.

Assets – Liabilities = Equity

Equity approximates
the net value of your
business.

Equity is sometimes called Net Worth.

 The Big Three

• Cash Flow Statements

– These answer the important managerial question “do I
have enough cash to run my business”
• Income Statements
– This is the financial sheet that tells you if your company is
profitable or not.
• Balance Sheets(statement of financial position)
– How much debt do I have? How large are my assets? This
sheet tells you the answer to these questions.
 Cash Flow Statements

• A report of all a firm’s transactions that involve cash

• The key elements are revenues (money flowing in)
and expenses (money flowing out).
• Cash flow statements compare the sum of the
revenues to the sum of the expenses on a regular
time basis – usually monthly.

“Manning Electronics” (Engineering 9) – Did Ms. Manning

have enough cash to buy that piece of equipment for her
boat business?
 What are Revenues?
• Sales
• Interest from firm’s investments (e.g., a
company savings account)
• Royalty and Licensing payments for
appropriate use of firm’s intellectual property

Another source of cash inflow, but not a

revenue is the cash the firm receives from
borrowing money.
What are Expenses?

There are two types of expenses:

FIXED COSTS
and
VARIABLE COSTS
 Fixed Costs

• Rent payments
• Salaried employees
• Capital Investments and (some) maintenance
• Utilities (phone, water, electric, etc)
• Insurance
• Taxes (on property, plant, and equipment)
• Advertising (*)
• Others things that do not depend on number
of units produced.
 Variable Costs
• Materials Cost
• Supplies
• Production Wages
• Outside / Contracted labor
• Advertising (*)
• Sales Commissions / Distribution Costs
• Equipment Maintenance
• Other things that depend on the number of units
produced (e.g. royalties paid)
 Putting it all together
So, placing the revenues at the “top” and the expenses below – you get the
following three month cash flow statement for a hypothetical startup:

Jan-00 Feb-00 Mar-00

REVENUES (inflow )
SALES $0.00 $0.00 $1,000.00
INTEREST $239.27 $167.04
RECEIPTS $0.00 $239.27 $1,167.04

EXPENDITURES (outflow )
MATERIALS COST AND MFG. LABOR $0.00 $0.00 $50.00
SALES COMMISSIONS $0.00 $0.00 $100.00
COST OF GOODS SOLD (COGS) $0.00 $0.00 $150.00

GROSS MARGIN $0.00 $239.27 $1,017.04

SALARY AND BENEFITS OF CEO $3,000.00 $3,000.00 $3,000.00

SALARY AND BENEFITS OF ASSISTANT $2,000.00 $2,000.00 $2,000.00
RENT $500.00 $500.00 $500.00
TELEPHONE AND OTHER $75.00 $75.00 $75.00
ADVERTISING $2,000.00 $2,000.00 $2,000.00
EQUIPMENT $20,000.00 $10,000.00 $10,000.00
TOTAL FIXED COSTS $27,575.00 $17,575.00 $17,575.00

MONTHLY CASH FLOW ($27,575.00) ($17,335.73) ($16,557.96)

 Cash Flow (cont.)
Jan-00 Feb-00 Mar-00
REVENUES (inflow)
“Receipts” is the sum of all the SALES $0.00 $0.00 $1,000.00
firm’s sales and interest it INTEREST $239.27 $167.04
RECEIPTS $0.00 $239.27 $1,167.04
collected that month
EXPENDITURES (outflow)
MATERIALS COST AND MFG. LABOR $0.00 $0.00 $50.00
SALES COMMISSIONS $0.00 $0.00 $100.00
Gross Margin is the Receipts minus COST OF GOODS SOLD (COGS) $0.00 $0.00 $150.00
the COGS GROSS MARGIN $0.00 $239.27 $1,017.04

SALARY AND BENEFITS OF CEO $3,000.00 $3,000.00 $3,000.00

SALARY AND BENEFITS OF ASSISTANT $2,000.00 $2,000.00 $2,000.00
RENT $500.00 $500.00 $500.00
Total Fixed Costs is the sum of all the TELEPHONE AND OTHER $75.00 $75.00 $75.00
ADVERTISING $2,000.00 $2,000.00 $2,000.00
fixed costs EQUIPMENT $20,000.00 $10,000.00 $10,000.00
TOTAL FIXED COSTS $27,575.00 $17,575.00 $17,575.00

MONTHLY CASH FLOW ($27,575.00) ($17,335.73) ($16,557.96)

Monthly Cash flow is the Gross Margin

minus the Total Fixed Costs
 Simple Example

• If a company has sales of $500/mo, COGS of

$200/mo, pays $50/mo in salary, and has no other
fixed costs, what is that firm’s three month cash
flow statement?

• Answer:
 Simple Example

• If a company has sales of $500/mo, COGS of

$200/mo, pays $50/mo in salary, and has no other
fixed costs, what is that firm’s three month cash flow
statement?
January February March
January February March
Revenues $500 $500 $500
Revenues $500 $500 $500
(Sales)
(Sales)
• Answer: COGS
COGS $200 $200 $200
$200 $200 $200
Salary $50 $50 $50
Salary $50 $50 $50
Monthly $250 $250 $250
Monthly
Cash Flow $250 $250 $250
Cash Flow
 What’s Missing?

• Cumulative Cash Flow numbers

• Taxes (… and accumulated depreciation)
• Net Earnings
 Cumulative Cash Flow -
Cash Balance
• Just like the average person keeps their checking
account balance – a firm also needs to know their
cumulative cash flow or cash balance.
• It is an easy calculation – simply take the
cumulative cash flow from this month and add it
to the previous month’s cash balance.
• Your very first month’s cumulative cash balance is
your first month’s monthly cash flow added to
your start-up capital (probably an initial loan or
first round financing).
 EBI ?
THE CHAIN OF EARNINGS

EBIDT (Earnings Before Interest, Depreciation and Tax)

EBIT (Earnings Before Interest and Tax)

( - accrued depreciation)
EBI
( - taxes paid once a year)
TOTAL EARNINGS

( - interest payments on your debt)

TOTAL EARNINGS
 EBIDT
Your EBIDT (Earnings Before Interest
Depreciation and Tax) is
Total Revenues – All Costs that are not
depreciable EXPENDITURES (outflow)
MATERIALS COST AND MFG. LABOR
Non-depreciable Costs SALES COMMISSIONS
COST OF GOODS SOLD (COGS)

GROSS MARGIN

SALARY AND BENEFITS OF CEO

SALARY AND BENEFITS OF ASSISTANT
RENT
TELEPHONE AND OTHER
ADVERTISING
Capital Equip. (Depreciable Costs) EQUIPMENT
TOTAL FIXED COSTS

EBITD = Revenues – (COGS + Salary + Rent + Phone + Advertising)

 Financial Reports
• Profit and loss statements
– Profit and Loss Statement (P&L) - A document
generated by the accounting department of an
organization that lists all the actual data
accumulated for the accounting period, including
both controllable as well as uncontrollable
revenues and expenses, as well as net profits or
losses.
Sample profit
and loss
statement

© 2006 Thomson-Wadsworth
 Financial Reports – Profit and Loss
Statements
• Inventory
– Manner chosen to value inventory affects P&L
– Higher inventory value = expenses appear lower = profit
appears higher
• Indirect labor costs
– May not appear in budget, but included in P&L
• Overhead
– May not appear in operating budget, but included in P&L
 Financial Reports
• Consolidated Profit and Loss Statement
– A report that merges all the data from the profit
and loss statements of an organization from
multiple years into one report.
– It can be used for identifying trends over time.
 Format for
consolidated
profit and loss
statement

© 2006 Thomson-Wadsworth
 Financial Reports – Profit and Loss
Statements
• Depreciation - An accounting technique that spreads
the expense of capital equipment or buildings over
their life spans, because value decreases gradually
with time.
– It is calculated by dividing the purchase price of an item by
its expected lifetime.
• Taxes
– Income taxes, not sales taxes
– Taxes on employee wages are reported as indirect labor
costs
 Balance sheet

• The Statement of Financial Position

– The balance sheet, also called the statement of
financial position, is the expanded expression of
the accounting equation.
• Remember that the basic accounting equation states that
assets equal the sum of liabilities and owners' equity.
Assets = Liabilities + Owners’ Equity
• Another way to state the equation:
Uses of resources = Sources of resource
.
 Financial Reports – Balance Sheet
• Assets - Items of value owned by a person or
business.
– ex: checking/ savings accounts, real estate,
inventories, equipment
• Liabilities - Debts or other financial obligations
of a business.
– ex: payroll, rent, invoices owed for goods and
services recently purchased, loan or interest
payments
 Financial Reports
• Balance Sheet
– A financial report that summarizes an
organization’s assets, liabilities, and owners’
equity. It provides the user with a snapshot of the
organization’s financial status at a specific point in
time.
 Financial Reports – Balance Sheet
• Current Assets - Cash and all assets that are readily
available and can be converted to cash within a short
period of time (usually one year).
– Cash on hand, money in checking/savings accounts
– Inventory
– Accounts Receivable - Money that is owed to a business
for products that have been delivered and invoiced.
– Prepaid Expenses - Expenses that are paid for in advance,
such as insurance.
 Financial Reports – Balance Sheet
• Fixed Assets - Non-liquid, tangible goods that have
been capitalized and are being depreciated over
time.
– ex: land, buildings, equipment, and any improvements like
new carpeting, paint jobs, and the installation of security
systems
– Liquid Assets - Items, like inventory, that can easily be
converted to cash (opposite of fixed assets).
 Financial Reports – Balance Sheet
• Other assets
– ex: bonds, securities, surplus real estate, funds
invested in ongoing product development,
intangible assets (name, reputation)
 Financial Reports – Balance Sheet
• Current Liabilities - Short-term debt that is due to be
paid in the near future.
– Accounts Payable - Money that is owed by a business to a
creditor for the purchase of products, rent, mortgage
payments, and other outstanding loans.
– Payroll Liability - Any salaries and wages that are owed to
employees on the day that the balance sheet is prepared.
 Financial Reports – Balance Sheet
• Current Liabilities
– Accrued Liability - Expenses for which payment
will be made in a future period, such as paid time
off and income taxes.
– Unearned Revenue - Liability incurred from the
advanced payments for products that have not yet
been delivered.
 Financial Reports – Balance Sheet
• Long-Term Debt - Any debt that becomes
payable after a year.
– ex: mortgages, long-term leases, and warranties
on goods sold.
• Other liabilities
– ex: post-retirement benefits for ex-employees,
potential liability from pending lawsuits
 Financial Reports – Balance Sheet
• Ownership Equity - An owner’s net
investment in a business after providing for
full payment of all creditors; the difference
between assets and liabilities.
– Assets are in excess of liabilities by a considerable
amount = equity is high
– Assets and liabilities are not significantly different
= equity is low
 Financial Reports – Balance Sheet
• Ownership Equity
– Owner’s Equity - The term used to describe the
ownership equity of a business with only one
owner.
– Stockholders’ Equity - The term used to describe
the ownership equity of a corporation for which
there is more than one owner.
Sample balance
sheet

© 2006 Thomson-Wadsworth
 Financial Reports
• Consolidated Balance Sheet
– A report that consolidates all the data from the
balance sheets of an organization from multiple
years into one statement.
– It is used to document financial conditions over
time for internal and external reporting purposes.
Conclusion

© 2006 Thomson-Wadsworth
Conclusion

© 2006 Thomson-Wadsworth
© 2006 Thomson-Wadsworth
© 2006 Thomson-Wadsworth
© 2006 Thomson-Wadsworth
© 2006 Thomson-Wadsworth
ECON 401: Engineering Economics 67
ECON 401: Engineering Economics 68
 Costing Vs Financial Accounting
Costing Financial Accounting

Purpose For Mgmt -Proper planning, Currency flow, P & L & financial
operation, control & position to stakeholders
decision making

Fixation of Selling Data For fixing SP -

Price
Profit Analysis Net Proft/Loss for each Net Proft/Loss for Whole
Product/service business

Reporting Periodicity As & when needed At the end of FY

Statutory Compulsion Voluntary for Prioritization Mandatory

Data status Estimated & actual costs Actual facts & figures

Project Life Cycle Initiation, Planning Execution, Closing

Phase