SECURITY ANALYSIS AND PORTFOIO MANAGEMENT

SECURITY ANALYSIS AND PORTFOIO MANAGEMENT

MODULE-1

INTRODUCTION TO CONCEPTS OF INVESTMENTS:
In its broadest sense, an investment is a sacrifice of current money or other resources for future benefits. There are many avenues of investment available today, viz deposit in bank account, purchase of long term government bond, buy equity shares of a company…, contribute to provident fund account, purchase of a plot of land etc.,
An investment is a commitment of funds made in expectation of some positive return. If the investment is properly undertaken the return will commensurate with the risk the investor assumes.
Financial and non-financial assets Investments generally involve real assets and financial assets. Real assets are tangible material things such as buildings, automobiles, text books etc, financial assets are pieces of paper representing an indirect claim to real assets held by someone else. These pieces of paper represent debt or equity commitments in the form of IOUs or stock certificates. Among the many properties that distinguish real from financial assets are of special interest to investor is liquidity. Liquidity refers to the ease of converting an asset into money quickly, conveniently and bit little exchange cost. Real assets are generally less liquid than financial assets, largely because real assets are more heterogeneous, often peculiarly adapted to a specific use and yield benefit only in cooperation with other productive factors. In addition, return on real assets are frequently more difficult to measure accurately owing to the absence of broad, ready ad active markets. Many of the concepts techniques and decision rules applicable to financial assets are applicable to real assets. However focus of the subject is on financial assets.










Investment activity
Financial assets (ACQUISION OF ASSETS) Physical assets


In brief real assets produce goods and service, whereas financial assets define allocation of income or wealth among investors. Real assets opera only on asset side of balance sheet. Financial assets appear on both sides. Financial assets are created and destroyed in the course of business. Real assets are destroyed due to wear out or accident.
Security: Investment in capital market is in various financial instruments which are all claims on money. These instruments are called securities in the market parlance. Securities Contract Regulations act (1956) has defined security as inclusive of shares, scrips, stocks, bonds, debentures stock or any other marketable securities of a like nature in or any debentures of a company or body corporate, the government and semi government body etc.,. it includes all rights and interests in them including warrants and loyalty coupons etc., issued by any of the bodies organizations or govt. Portfolios are combinations of assets held by investors.

The two key aspects of any investment are time and risk. While sacrifice for making an investment is certain, the expected benefits in the future tends to be uncertain. In some investments like government bonds, the time element is dominant. In stock options investment in a company risk element is dominant. Finally in investments in equity shares both time and risk are important.

Objectives of financial investment use funds or savings for further creation of assets or acquisitions of existing assets.

Investment methods The various avenues for investment ranging from risk less to high risk investment opportunities consist of both security and non security forms of investment.
All securitized forms given below are marketable.

A. Security forms of investment
a. Corporate bonds* / Debentures
i. Convertible
ii. Non-convertible
b. Public sector Bonds
i. Taxable
ii. Tax free
c. Preference shares
d. Equity shares
i. New issue
ii. Rights issue
iii. Bonus issue
B. Non- security forms of Investment (non-marketable)
a. National Savings scheme
b. National savings Certificates
c. Provident fund
i. Statutory Provident Fund
ii. Recognised P F
iii. Un recognized P F
iv. Public Provident Fund
d. Corporate Fixed Deposits
i. Public sector
ii. Private sector
e. Life Insurance Policies (LIC & other private sector)
i. Whole life policies
ii. Limited payment life policy
iii. Convertible whole life assurance policy
iv. Endowment assurance policy
v. Jeevan mitra
vi. Special endowment plan with profits
vii. Jeevan sathi
viii. The new money back plan etc.,
f. Schemes of Unit Trust of India (some ar marketable among these)
i. Unit schemes of UTIMF(UTI-II)
ii. Unit schemes of UTI-I
iii. Unit linked insurance plan, 1971capial gains unit scheme 1983
iv. Children’s gift growth funds 1986
v. Parent’s gift growth funds 1986
vi. Monthly income unit scheme with extra bonus plus growth
vii. Master shares
viii. Master gains
ix. Equity linked savings scheme
x. Growing monthly income unit scheme
xi. Master plus etc.,
More than 60 UTI schemes and mutual funds of banks

g. Post office savings bank account
i. Recurring deposit
ii. Time deposit
iii. Monthly income scheme
iv. Social security certificates
h. others such as
i. Rahat patras or relief bonds
ii. Kissan vikas patra
iii. Deposits in co-operative banks
1. Recurring deposits
2. time deposits

Sources of information Sources of information or information on stock market activity is reported in various media. It is covered in news papers, business periodicals, other publications, radio and television. For most of the investors the coverage in Economic Times or the Financial Express is adequate. For greater details the most comprehensive source of information is ‘Daily Official Quotation list of BSE’. In addition prospectus of the public issue can be referred.

Just as securities and financial institutions come into existence as natural responses to investor demand, so too do markets evolve to meet needs. There are four types of markets. Viz. Direct search market, brokered markets, dealer markets and auction markets.

A direct search market is least organized market. Here buyers & sellers meet seek each other out directly. One example is of a transaction taking place in such a market would be the sale of a used refrigerator in which the seller advertises in the local newspaper. Such markets are characterized by sporadic participation and low priced and non standard goods. It does not pay most people or firms seek profits by specializing in such an environment.
Brokered market In brokered markets where trading in a good, is sufficiently active, brokers can find it profitable to offer search services to buyers and sellers. An example is real estate market, where economies of scale in search of available homes and prospective buyers make it worth while for participants to pay brokers to conduct searches for them. Brokers develop specialized knowledge on valuing asset traded in a given market. An important brokered investment market is primary market, where new issues of securities are offered to public. In primary market investment brokers act as brokers. They seek out investors to purchase securities directly from the issuing corporation. Another brokered market is that for large block of shares (> 10000 shares), are so large that brokers or ‘block houses’ are often engaged to search directly for other large traders rather than bringing the trade directly to the stock exchange where relatively smaller investors trade.

When trading activity in a particular type of assets increases dealer markets arise. Here dealers specialize in various assets, purchasing them for their inventory and selling them for a profit from their inventory. Dealers unlike traders, trade assets from their own account . The profit margin is ‘bid – asked’ spread, the difference between buying and selling from the inventory. Dealer market save traders search costs because market participants can easily look up prices at which they can buy from or sell to dealers. The over the counter (OTC) securities is a market is an example of dealer market. Fair amount of market activity is required before dealing in a market become an attractive source of income. Trading among investors of already issued securities is said to take place in ‘secondary market’. OTC market is an example of secondary market. Trading in secondary market does not affect the outstanding amount of securities; ownership is simply transferred from one investor to another.

The most integrated market is an ‘auction market’ in which all transactors in a good converge at one place to bid on or offer a good. Both Mumbai Stock Exchange (BSE) and National Stock Exchange of India (NSE) are examples of an auction market. An advantage of auction market over dealer markets is that one need not search for a best price to buy a good. If all the participants converge they can arrive upon a mutually agreeable price and thus make ‘bid-asked’ spread.

Continuous auction market requires very heavy and frequent trading to cover the expense of maintaining the market. For this reason BSE, NSE, NYSE and other exchanges set up listing, requirement which limits the share traded on exchange to those firms in which sufficient trading interest is likely to exist. The organized stock exchanges are also secondary market.

Investment instruments : Treasury Bills , Certificates of Deposits , Commercial Paper , Euro dollar , Repos and reverse Repos , Call Money Market , LIBOR Market , Government Securities , International Bonds.

Treasury Bills are the most marketable of all the money market instruments. T-Bills represent simplest form of borrowing. The government raises money by selling bills to the public. Investors buy the bill at discount from the stated maturity value. At the bills maturity the holder receives from the government a payment equal to the face value of the bill. The difference between the purchase price and ultimate maturity value constitutes the investor’s earnings.

T-Bills are issued with initial maturities of 91 or 364 days (introduced in 1992). Till 1998 the yield on the 91 day T-Bills remained unchanged at 4.5%. banks and primary dealers, provident funds and other investors can purchase T-Bills directly at an auction or in the secondary market from a primary dealer. T-Bills are highly liquid : that is they are easily converted in to cash and sold at low transaction cost and with not much price risk. The face value of T-Bill is Rs. 100 and they are available for a minimum amount of Rs. 25000 and in multiples of Rs. 25000 after that.

Certificate of Deposit : CD is a time deposit with a bank. As per RBI guidelines are issued at a discount to the face value. CDs are issued in denominations of Rs. one lakh and are negotiable : that is they can be sold to another investor if the owner needs cash before its maturity date. CDs are issued with maturity period ranging between 14 days to 1 year. Short term CDs are highly marketable, although market significantly thin out for maturities of three months or more. The liquidity of the market improved significantly in October 2000 after the RBI reduced the minimum tenure of the CD from 90 days to 14 days. The financial institutions can issue CDs with maturity days ranging between one year to three years.

Commercial Paper: highly rated companies in India (with a CRISIL rating of P2 and above or an equivalent rating from another rating agency) can issue (in a private placement) there own short term unsecured debt notes. These notes are called Commercial Paper. Now financial institutions (apart from primary dealers and satellite dealers) can also raise short term funds by issuing Commercial Papers.

Commercial Paper maturity range between 15 days to one year. CPs are issued in denominations of Rs 5 lakhs or multiples there of. Like CDs CPs are also issued at a discount to the face value. In march 1997, Indian companies were allowed to issue CPs upto 100% of the maximum permissible bank finance. In India CPs attract stamp duty and stamp duties are biased. Thus for example when that tenor of the CP is less than 90 days, the stamp duty for the bank 0.05% as against 0.125% for non banking entities. Therefore banks are major players in the primary market for CPs in India. However secondary market transactions in CPs do not attract any stamp duty and hence non banks find it cost effective to operate in the secondary market. Of late the money market mutual funds in India have become large players in secondary market for CPs.
Eurodollars Eurodollar denominated deposits at foreign banks or foreign branches of American banks. By locating outside the United States , these banks escape regulation by the Federal Reserve Board. Despite the tag Euro, these accounts need not be in European banks, although that is where the practice of accepting dollar denominated deposits outside the United States began.
Most Eurodollar deposits are for large sums and most are time deposits less than 6 months. A variation on the Eurodollar time deposit is the Eurodollar Certificate of Deposit. A Eurodollar CD resembles a domestic bank CD except that it is the liability of non-US branch of a bank, typically a London branch. The advantage of Eurodollar CD over Eurodollar time deposit is that the holder can sell the asset to realize its cash value before maturity. Eurodollar CDs are considered less liquid and riskier than domestic CDs, however they offer high yields. Firms also issue Eurodollar bonds, which are dollar denominated bonds outside the US, although bonds are not a money market investment because of their long maturities.
Repos and reverse Repos: one can use repurchase agreement also calle ‘Repos’, as a form of short term, usually, overnight borrowing. The minimum period for repos transaction was three days at one point of time, now it has been brought down to one day. In a repo transaction, one transfers government securities (now state govt. securities and bonds issued by public sector undertakings and Private Corporate Sector (provided they are in demat form) are eligible for repo transaction) to an investor or an (usually) overnight basis, with an agreement to buy back those securities after the repo period at a slightly higher price. The increase in price is the interest for the repo period (adjusted for coupon).
A reverse repo is the mirror image of a repo. Here securities are purchased with a commitment to sell them back after the repo period. Since June 2000, the RBI is conducting repo transactions every working day.
Call Money Market Call money market refers to the market for short term funds with maturity period ranging between one day and 14 days. In India banks and primary dealers are allowed to both borrow and lend money in the call money market. However financial institutions, mutual funds (in 1997 all SEBI registered mutual fund were also allowed to lend money in the call market) and a select group of Corporates are allowed only to lend money in call money market. From different mid term reviews the monetary and credit policy, the RBI is sending clear signal that it wants to convert the call market in India into pure inter-bank call money market. The non-bank entities are encouraged to participate in the repo market now.

LIBOR Market: the London inter-bank offered (LIBOR) is the rate at which large banks are willing to lend money among themselves. This rate which is quoted dollar denominated loans has become the premier short term interest rate quoted in the European money market and it serves at a reference rate for a wide range of transaction. For example a corporate might borrow at a floating rate of LIBOR+2%.

Bond Market: Bond Market is composed of longer-term borrowing or debt instrument than those traded in the money market. This market includes Government Securities (G-Secs), bonds issued by State Governments, Corporate Bonds, Public Sector Undertaking and Financial Institutions.

These instruments are sometimes said to comprise the ‘fixed income capital market’, because most of them promise either a fixed stream of income or a stream of income that is determined according to a specific formula. In practice these formulae can result in a flow of income that is far from fixed. Therefore the term ‘fixed income’ is probably not fully appropriate. It is simpler and more straight forward to call these securities either debt instruments or bonds.

G-Secs: the Government of India borrows funds in large part by selling dated G-Secs. G-Secs maturities range up to 30 years. The face value of G-Secs is Rs 100. The G-Secs make semi-annual payments called coupon payments, a name derived from pre-computer days, when investors would literally clip coupons attached to the bond and present a coupon to receive the interest payment.

Federal Agency Debt in U.S. : some government agencies in U.S. their own securities to finance their activities. These agencies are usually formed to channel credit top a particular sector of the economy that congress believes might not receive adequate credit through normal private sources. Example Federal Farm Credit Loan, Home Loan, Tennessy Valley Authority Loan, etc.

International Bonds : many firms borrow from abroad and many investors buy bonds from foreign issues. In addition national capital market there is a thriving International capital market, largely centered in London.
A Euro Bond is a bond denominated in a currency other than that of country in which it is issued for example a dollar denominated bond sold in Britain would be called a Euro dollar bond. Similarly investors might speak of Euro-Yen Bonds, Yen denominated bonds sold outside Japan. Since the new European currency is called the euro the term Euro Bond may be confusing. It is best to think of them as international bonds.

Municipal Bonds in the U.S. : in the U.S. the bonds are issued by state and the local government which are similar to treasury and corporate bonds except that their interest income is exempt from federal income taxation.

Corporate Bonds : are the means by which private firms borrow money directly from public they are similar to treasury issues . They pay semi annual coupons over their lives and return the face value to the bond holder during maturity. They differ most importantly from treasury bonds in degree of risk. Mortgage and mortagaged backed securities generally home loan is 15-30 years time etc.

Equity Securities : Common stocks or ownership shares common stocks also known as equity securities or equities represent ownership shares in a corporation. Each share of common stock entitles its owner to one vote. Characteristic of common stock as an investment is residual claim and limited liability. Preferred stock it has a feature similar to both equity and debt. Like bond it promises to pay a fixed amount of income each year. In this sense preferred stock is similar to an in finite maturity bond that is a perpetuity.

Derivative Market: are the most significant developments in the financial market. In the recent years there has been growth of futures, options, and related derivatives market. These instruments provide pay-offs that depend on the value of the other assets such as commodity prices, bond and stock prices, or market index values. The call option gives it holder the right to purchase an asset to a specified price called the exercise or strike price on or before a specified expiration date. Put option gives its holder the right to sell an asset for a specified exercise price on or before a specified expiration date.
Futures contract calls for delivery of an asset (in some cases its cash value) at a specified delivery or maturity date for an agreed upon price called future price to be paid at contract maturity. The long position is held by the traders who commits purchasing the asset on the delivery date. The trader who takes the short position commits to deliver the asset at contract maturity.

SAPM (MODULE-3)



Financial markets: primary and secondary markets

Securities market is the market for equity, debt & derivatives. The debt market may be devided into three parts viz. govt. securities market, corporate debt market and money market. The derivatives can be divided into two parts viz. options market and future market.





















Fig -1


Except derivative market each of the above has two components viz. the primary and secondary market. Market where new securities are issued is called primary market and where outstanding securities are traded is called the secondary market.

Major players and instruments in secondary market:
The Indian securities market has following participants:
Regulators: The key agencies that have a significant regulatory influence, direct and indirect one of securities market are:
1. The company law board (CLB) responsible for the administration of the Companies Act 1956.
2. The RBI responsible for the supervision of the banks, money market and govt. securities market.
3. The securities and Exchange Board of India (SEBI) responsible for regulation of the capital market.
4. The Dept. of Economic Affairs (DEA) a govt. arm, concerned with orderly functioning of the financial markets as a whole.
5. The Dept. of Company Affairs (DCA) a govt. arm responsible for the administration of corporate bodies.

Stock exchanges:
A stock exchange is an institution where securities that have already been issued are brought and sold. Presently there are 23 stock exchanges in India. Important ones are NSE and BSE.

Listed securities:
Securities listed on various stock exchanges and hence being eligible for trading are called listed securities. Presently 10,000 securities are listed on all the stock exchanges in India put together.

Depositories:
A depository is an institution which dematerialize physical certificates and effects transfer of ownership electronic book entries. Presently there are two depositories in India viz. National Securities Depository Limited and the Central Securities Depository Limited.

Brokers:
Brokers are registered members of the stock exchanges through whom investors transact. There are about 10,000 brokers in India.

Foreign institutional investors:
Institutional investors from abroad who are registered with SEBI to operate in Indian capital market are called foreign institutional investors. There are about 500 of them and they have emerged as a major force in the Indian market.

Merchant bankers:
Firms that specializes in managing the issue of securities are called merchant bankers they have to be registered with SEBI.

Primary dealers:
Appointed by the RBI, primary dealers serve as underwriters in the primary market and as the market makers in the secondary market for govt. securities.

Mutual funds:
A mutual fund is a vehicle for collective investment. It pools and manages the funds for investors. There are about 30 mutual funds in India.

Custodians:
A custodian looks after the investment back office of a mutual fund. It receives and delivers securities, collects income, distributor dividends and segregates the asset between schemes.


Registrar:
Also known as a transfer agent, a registrar is employed by a company or a mutual fund to handle all investor’s related services.

Underwriters:
An underwriter agree to subscribe to a given number of shares (or any other security) in the event the public subscription is inadequate. The underwriter in essence, stands guarantee for the public subscription.

Bankers to an issue:
The bankers to an issue collect money on behalf of the company from the applicants.

Debenture trustees:
When debentures are issued by a company, a debenture trustee has to be appointed to ensure that the borrowing firms fulfill its contractual obligations.

Venture capital funds:
A venture capital fund is a pool of capital which is essentially invested is equity shares or equity linked instruments of unlisted companies.

Credit rating agencies:
It assigns ratings primarily to debt securities.

FUNCTIONING OF STOCK EXCHANGES:

The most important development in the Indian stock market was the establishment of the National Stock Exchange (NSE) in 1994, with is a short period it emerged on the largest stock exchange is the countries surging ahead of the Bombay Stock Exchange(BSE) which was historically the dominant stock exchange in India. The NSE has cast its shadow over the most of regional stock exchanges, jeopardizing their very existence. In a bid to service the regional stock exchanges have set up subsidiaries which in turn have become institutional member of NSE as well as BSE. For example Bangalore Stock Exchange has set up a subsidiary called the BGSE Financial Service Limited which is an institutional member of NSE as well as BSE. Members of the Bangalore Stock Exchange can trade as NSE as well as BSE through BGSE Financial Services Limited.

NATIONAL STOCK EXCHANGE:

Inaugurated in 1994, the NSE seeks to,
a) Establish a nationwide trading facility for equities, debt and hybrids.
b) Facilitate equal access to investors across the country
c) Impart fairness, efficiency & transparency to securities
d) Shorter settlement cycle
e) Meet international securities market standard. The distinctive features of NSE functions are as follows,

1) the NSE is a ringless, national, computerized exchange
2) NSE has two segments: the capital market segment and the wholesale debt market segment. The capital market segment covers equities, convertible debentures, and retail trade in non convertible debentures. The wholesale debt market is a market for high value transactions in govt. securities, PSU bonds, commercial papers and other debt instruments.
3) The trading members in the capital market segment are connected to the central computer in Mumbai through a satellite link up, using VSATs (very small aperture terminals). The trading members in the wholesale debt market segment are linked through dedicated high speed lines to the central computer at Mumbai.
4) The NSE has opted for an order driven systems. When an order is placed by a trading member the computer automatically generates a unique order number and the member can take a print of order confirmation slip containing this number.
5) When a trade takes place, a trade confirmation slip is printed at the trading members workstation. It gives detail like quantity, price, code number of counter party and so on.
6) The identity of trading member is not revealed to others when he places an order or when his pending orders are displayed. Hence large orders can be placed on the NSE.
7) Members are required to deliver securities and cash by certain day. The payment day is the following day.
8) All trader on NSE are guaranteed by the national securities clearing corporation (NSCC). This means that when A buys from B, NSCC becomes the counter party to both legs of the transaction. In effect, NSCC becomes the seller to A and the buyer from B. This eliminates counter party risk.


The Bombay Stock Exchange (BSE):

Established in 1875, BSE is one of the oldest organized exchange is the world with long, colorful and chequered history. Its distinctive features are as follows,

1. the BSE switched from the open outcry system to screen based systems in 1995. It accelerated its computerization programme in response to the threat from the NSE.

2. Jobbers play an important role on the BSE. A jobber is a broker who trades his account and hence offers a two way quote or a bid-ask quote. The bid price reflects the price at which the jobber is willing to buy and the ask price represents the price at which the jobber is willing to sell.

3. Investors have to transact via. a jobber/ broker. The jobber/ broker feeds his buy/ sell quotes in his computer terminal, which is linked to the main server at the BSE. Since both jobber and brokers feed their orders, the BSE has adopted a ‘quote- drivers’ systems and an order- driven system.


Trading and Settlement:

Trading:
Each stock exchange has certain listed securities and permitted securities which are traded on it. Members of the exchange alone are entitled to the trading privileges. Investors interested in buying or selling should place their orders with the members (also called brokers) of the exchange. There are two ways of organizing the trading activity. The open outcry system and the screen based system.

Open outcry system:

Under the open cry system, traders should shout and resort to signals or trading floor of the exchange which consists of several ‘national’ trading posts for different securities. A member or his representative wishing to buy or sell a certain security reaches the trading post where security is traded. Here he comes in contact with others interested in transacting in that security. Buyers make their bids and sellers make their offers and bargains are closed at mutually agreed upon prices. In stocks where jobbing is done, the jobber plays an important role. He stands ready to buy or sell on his account. He quotes his bid (buying) and ask (selling) prices. He provides some and continuity to the market.

Screen based system:

In the screen based system, the trading ring is replaced by the computer screen and distant participants can trade with each other through the computer- network. A large number of participants, geographically separated can trade simultaneously at high speeds. The screen based trading system:

a) Enhances the informational efficiency of the market as more participants trade at a faster speed.
b) Permits the market participants to get full view of the market which increases their confidence in the market.
c) Establishes transparent audit trails. While computerised trading is more efficient, it decidedly lacks the vibrancy and vitality of the traditional floor trading. Technology seems to have its own way of pushing colorful traditions and policies into obvious.

Till 1994 trading in the stock market in India was based on the open outcry system. With establishment of National Stock Exchange in 1994, India entered the era of screen based trading. With in a short span of time, screen based trading has supplanted the open outcry system on all the stock exchanges in the country, thanks to the SEBI’s initiative in this respect . No country has achieved such a transformation so rapidly. The kind of screen based trading system adopted in India is referred to as the open Electronic Limit Order Book (ELOB) market system. The key features of this system are as follows:
1. Buyers and sellers place and their orders on the computer, these orders may be limited orders or market orders. A ‘ limit order’ pre specifies the price limit. For ex. A limit order to buy at a price of Rs. 90 means that the trader wants to buy at a price not greater than Rs. 90. Likewise a limit order to sell at a price of Rs. 95 means that the trader wants to sell at a price not less than Rs. 95. A ‘market order’ is an order to buy or sell at the best prevailing price. A market order to sell will be executed at the highest bid price whereas a market order to buy will be executed as the lowest ask price.
2. The computer constantly tries to match mutually compatiable orders. The matching is done on a price time priority, implying that price is given preference overtime in the process of matching.
A buy order at a higher limit price is accorded precedence over a buy order at a lower limit price. By the same token a sell order at a lower limit price is given priority over a sell order at a higher limit price. Between two limit orders placed at the same price, the limit order placed earlier is accorded priority over the limit order placed later.
3. The limit order book ie. the list of unmatched limit orders is displayed on the screen. Put differently it is open for inspection to all traders.






Fig 2

Settlement
Traditionally, trades in India were settled by physical delivery. This means that the securities had to physically move from seller to seller’s broker, from the seller’s broker to the buyer’s broker (through the clearing house of the exchange or directly) and from buyer’s broker to the buyer. Further the buyer had to lodge the securities with the transfer agents of the company and the process of transfer took on to three months. This led high paperwork cost and created bad paper risk. To mitigate the cost and risks associated with physical delivery, security transactions, in developed markets are settled mainly through electronic delivery facilitated by depositories. A depository is an institution which dematerializes physical certificates and effects transfer of ownership by electronic book entries.
To enable the creation of depositories, to facilitate dematerialized trading in India, the central government promulgated the Depository Ordinance 1995 which was followed by Depositories Act 1996. The high lights of the depositories act are as follows.
1) every depository will be required to be registered with the SEBI.
2) Investors will have the choice of continuing with the equity share certificates or opt for the depository mode.
3) Investors opting to join the depository mode are required to register with the agents for the depositories. These will be custodial agencies like banks, financial institutions and large brokerage firms.
4) While the depository will be registered owner in the register of the company, the investors will enjoy the economic benefits as well as the voting rights or the shares concerned.
5) Shares in the depository mode will be fungible. This means that they will cease to have distinctive nos.
6) Investors having entered the depository mode can leave the systems and get share certificates from the company as registered owners in the books of the company.
7) Ownership changes in the depository system will be made automatically on the basis of delivery against payment. Further there will be no stamp duty on transfer of ownership.
8) Any loss caused to the beneficial owners due to the negligence of the depository or the participant will be indemnified by the depository.

The National Securities Depository Limited (NSDL) India’s first depository, was set up in 1996.It was followed by the Central Securities Depository Limited (CSDL). Both the depositories, the NSDL in particular have recorded a significant growth in their operations.

SEBI has made dematerialized trading compulsory for all the stock exchanges in the country. This means that if you want to buy or sell shares in any exchange you have to do it only in that dematerialized form, of course the two parties can engage in an off-market spot transaction that can be settled through the delivery of shares in physical form. There is a transfer duty of .50% on physical transfer.


Shift to rolling settlement:
Till recently share transaction in India was settled on the basis of a weekly period (on the Bombay Stock Exchange the account period was Monday to Friday and on the NSE the account period as Wednesday to Tuesday). This meant that purchases and sales during an account period could be squared up and, at the end of the account period, transactions could be settled on a net basis. For example if you bought 100 shares of Infosys on BSE on Monday at Rs 5000 a share and sold 95 shares of Infosys at Rs 5050 on Friday of that week, you are required to take delivery for only 5 shares by paying Rs 20250/- (purchase consideration Rs. 500000 - sale consideration of Rs. 479750) at the end of account period.
The weekly settlement system along with badla system of carrying forward transactions from one account period to the next, according to many informed observers of the Indian stock market, led to unbridled speculative activity and periodic market crisis. So, SEBI decided to introduce rolling settlement in a phased manner from 2002. Under the compulsory rolling system now in vogue, every day represents a new settlement period. This means you have to square an open position the same day, otherwise you have to take delivery or give delivery depending on your position.

SEBI and future challenges:

Before the establishment of SEBI the principal legislators governing securities market in India were the Capital Issue Contol Act 1956 (governing primary market) and the Securities Contracts (Regulations) Act 1956 (governing secondary market). The regulatory powers were vested with the Controller of the Capital Issues (for the primary market) and Stock Exchange Division (for the secondary market) in the Ministry of Finance, GOI.
In 1989 SEBI was created by an administrative fiat of the Ministry of Finance. Since, then SEBI has been gradually been granted more and more powers. With the repeal of the Capital Issues Control Act and the enactment of the SEBI act in 1992, the regulation of the primary market has become the preserve of SEBI. Further the ministry of finance, GOI has transferred most of the powers under Securities Contracts (Regulations) Act 1956 to SEBI.

SEBI’s principal tasks are to:
1. Regulate the business in the stock exchanges and any other securities market.
2. Register and regulate the working of capital market intermediaries (broker, merchant bankers, portfolio managers and so on).
3. Register and regulate the working of mutual funds.
4. Promote and regulate self regulatory organizations.
5. Prohibit fraudulent and unfair trade practices in securities market.
6. Promote investors education and training of intermediaries of securities markets.
7. Prohibit insiders trading in securities.
8. Regulate substantial acquisition of shares and takeovers of companies.
9. Perform such other functions as may be prescribed.

INITIATIVE OF SEBI:

It has covered the entire gamut of capital market activities through nearly 30 legislations. Important ones are:-

1) Freedom in designing and pricing instruments:
Companies now enjoy substantial freedom in designing the instruments of financing a long as they fully disclose the character of the same. More important they enjoy considerable latitude in pricing the same.

2) Introduction of stock invest:
To save investors from the loss of interest on the subscription money located with the company, SEBI has introduced the stock invest scheme as an additional facility to the investors.

3) Ban of badla:
The financial regulations of 1992high lighted the deficiencies of the badla system which permitted excessive leveraging. To rectify the defects in trading practices the badla system has been banned.

4) Screen based trading:
Thanks to the competition posed by the NSE and the insistence or prodding done by SEBI, all the exchanges have switched to screen based trading.

5) Electronic transfer:
The traditional method of transfer by endorsement on security and registration by issuer has been supplanted by electronic transfer in book entry form by depositories.
6) Risk management:
A comprehensive risk management system that covers capital adequacy, limits on exposure and turnover, margins based on VAR (value at risk) level, gross margining and online monitoring of positions has been introduced.

7) Rolling settlement:
The trading cycle, which was previously one week, has been reduced to one day and the systems rolling settlement has been introduced.

8) Corporate governance code:
A new code of corporate governance, based on the recommendations of Kumaramangalam Birla committee report, has been defined. It has been operationalised by inserting a new clause (clause 49) in the listings agreement- The agreement that a listed company enters the stock exchange where its securities are listed. (exam question)

9) Change in management structure:
stock exchanges earlier were broker dominated. SEBI now requires 50% non broker Directors. Further it has mandated that a non-broker professional be appointed as the Executive Director.

10) Registration and regulation of intermediaries:
capital market intermediaries such as merchant brokers, underwriters, bankers to the issue, registrar, transfer agents brokers and sub brokers are required to be registered with SEBI. Regulation for these intermediaries has been prescribed.

11) Redressal of investor grievances:
Investor grievances have been on the rise, thanks to the steps taken by SEBI.

12) Regulation of mutual funds:
Mutual funds have been brought under the purview of SEBI and SEBI has issued the regulatory guidelines for this purpose.

13) Regulation of foreign portfolio investment: The govt. welcomes foreign portfolio investment in the Indian capital market. SEBI has formulated guidelines to permit this investment through board based funds (such as mutual funds, pension funds, and country funds) referred to as foreign institutional investors.


14) Development of a code for takeover:
Takeovers are gaining importance in India. SEBI has developed a code for regulating them.

15) Introduction of equity derivatives:
SEBI has allowed the introduction of equity derivatives like stock index futures, stock index options, individual stock options, and individual stock futures.






Thrust of SEBIs’ regulation

Primary market




Access Restricted

Instruments Multiplied
Pricing Relaxed
Disclosure Norms Tightened

Responsibility of merchant banker Enhanced
Method Book building



Secondary Market

Trading Computerized
Settlement Electronic model
Transaction costs Lowered
Transparency Enhanced
Markets Integrated
Globalization Encouraged
Risk management Strengthened
Exchange management Improved




Future Challenges:
While SEBI has done a great deal, it has a long way to go in accomplishing its mission. It has to address several challenges such as the following:

Prepondance of speculative trading and skewed distribution of turnover:
There is a predominance of speculative trading where the primary motive is to derive benefit from short term fluctuations. Only a small fraction of traders results in delivery. Earlier when the account period was one week and the facility of badla was allowed, nearly 90% of the trades were squared with in the account period or carried forward. After the introduction of rolling settlement intra day squareing has become common. After the ban of badla, individual stock futures , which are cash settled, have become very popular. An allied problem is that the distribution of trading is highly skewed. About 10 scrips account for nearly 80% of the turnover on the stock market. Thanks to such skewed distribution of trading, most shares are traded infrequently and hence lack liquidity.
L.C. Gupta argues that the over speculation charter of the Indian market is evident from the following:
1) There is an extremely high concentration of trading in a small no. of shares to the neglect of the remaining shares.
2) The trading velocity is absurdly high for ‘speculation counters’. The trading velocity of share is defined as: Total trading volume in the share during a year divided by its market capitalization.
3) Hardly 10-15% of the transactions are genuine investment transaction, the balance being speculative transaction.
To mitigate excessive speculation is the cash market and promote liquidity across the board, the following steps may be taken.
a) Introduce margin trading wherein investors put up a certain amount for purchase securities. The balance being lent by brokerage firms.
b) encourage market making by jobbers
c) Provide lines of credit to brokerage firms.


Market Abuses:

Insider trading, market manipulation, and price rigging, continue to impair the quality of the market. Insiders who are privy to price sensitive information, use such information to their advantage. Often companies issuing securities in domestic market or international capital market artificially rig up prices. Cartels of powerful brokers tend to play manipulation games on the market.
It is virtually impossible to eliminate market abuses because of the ingenuity of manipulators manifests itself in unanticipated ways. Nevertheless a vigilant regulatory body, well-managed exchanges, and severe penalties can go a long way in mitigating market abuses. Though some progress has been made in that directions a lot more has to be done.





Financial Services

Meaning:
All types of activities which are of a financial nature could be brought under the term ‘financial services’.

The term “Financial Services” in a broad sense means “mobilizing and allocating savings”. Thus, it includes all activities involved in the transformation of saving into investment.

The ‘financial service’ can also be called ‘financial intermediation’.

Financial intermediation is a process by which funds are mobilized from a large number of savers and make them available to all those who are in need of it and particularly to corporate customers.

A well developed financial services industry is absolutely necessary to mobilize the savings and to allocate them to various investable channels and thereby to promote industrial development in a country.

Classification of financial services industry
The financial intermediaries in India can be traditionally classified into two:
i. Capital market intermediaries
ii. Money market intermediaries


The capital market intermediaries consist of term lending institutions and investing institutions which mainly provide long term funds.

On the other hand, money market consists of commercial banks, co-operative banks and other agencies which supply only short term funds.

Scope of financial services
Financial services cover a wide range of activities. They can be broadly classified into two namely:
i. Traditional activities
ii. Modern activities

Traditional activities
Traditionally, the financial intermediaries have been rendering a wide range of services encompassing both capital and money market activities. They can be grouped under two heads viz;

i. Fund based activities and
ii. Non-fund based activities

Fund based activities
The traditional services which come under fund based activities are the following:
i. Underwriting of or investment in shares, debentures, bonds etc. of new issues (primary market activities)
ii. Dealing in secondary market activities
iii. Participating in money market instruments like commercial papers, certificate of deposits, treasury bills, discounting of bills etc.
iv. Involving in equipment leasing, hire purchase, venture capital, seed capital etc.
v. Dealing in foreign exchange market activities.


Non-fund based activities
Financial intermediaries provide services on the basis of non-fund activities also. This can also be called “fee based” activity. A wide variety of services, are being provided under this head. They include the following:
i. Managing the capital issues, i.e., management of pre-issue and post-issue activities relating to the capital issue in accordance with the SEBI guidelines and thus enabling the promoters to market their issues.
ii. Making arrangements for the placement of capital and debt instruments with investment institutions.
iii. Arrangement of funds from financial institutions for the clients project cost or his working capital requirements.
iv. Assisting in the process of getting all government and other clearances.

Modern activities
Besides the above traditional services, the financial intermediaries render innumerable services in recent times. Most of them are in the nature of non-fund based activity.

i. Rendering project advisory services right from the preparation of the project report till the raising of funds for starting the project with necessary government approval.
ii. Planning for mergers and acquisitions and assisting for their smooth carry out.
iii. Guiding corporate customers in capital restructuring.
iv. Acting as Trustees to the debenture holders
v. Structuring the financial collaboration/joint ventures by identifying suitable joint venture partner and preparing joint venture agreement.
vi. Rehabilitating and reconstructing sick companies through appropriate scheme of reconstruction and facilitating the implementation of the scheme.
vii. Hedging risks due to exchange rate risk, interest rate risk, economic risk and political risk by using swaps and other derivative products.
viii. Managing the portfolio of large public sector corporations.
ix. Undertaking risk management services like insurance services, buy back options, capital market etc.
x. Promoting credit rating agencies for the purpose of rating companies which want to go public by the issue of debt instruments.
Financial products and services

• Today, the importance of financial services is gaining momentum all over the world.

• In these days of complex finance, people expect a financial service company to play a very dynamic role not only as provider of finance but also as a departmental store of finance.

• As a result, the clients both corporates and individuals are exposed to the phenomena of volatility and uncertainty and hence they expect the financial service company to innovate new products and services so as to meet their varied requirements.


1. Merchant Banking:
A merchant banker is a financial intermediary who helps to transfer capital from those who possess it to those who need it. Merchant banking includes a wide range of activities such as management of customer’s securities, portfolio management, project counseling and appraisal, underwriting of shares and debentures, loan syndication, acting as banker for the refund orders, handling interest and dividend warrants etc. Thus merchant banker renders a host of services to corporates and thus promotes industrial development in the country.

2. Loan Syndication
This is more or less similar to ‘consortium financing’. But, this work is taken up by the merchant banker as a lead manager. It refers to a loan arranged by a bank called lead manager for a borrower who is usually a large corporate customer or a government department. The other banks who are willing to lend can participate in the loan by contributing a amount suitable to their own lending policies. Since a single bank cannot provide such a huge sum as loan, a number of banks join together and form a syndicate. It also enables the members of the syndicate to share the credit risk associated with a particular loan among themselves.

3. Leasing
A lease is an agreement under which a company or a firm, acquires a right to make use of a capital asset like machinery, on acquire any ownership to the asset, but he can use it and have full control over it. He is expected to pay for all maintenance charges and repairing and operating costs.

4. Mutual Funds
A mutual fund refers to a fund raised by a financial services company by pooling the savings of the public. It is invested in a diversified portfolio with a view to spreading and minimizing risk. The fund provides Investment Avenue for small investors who cannot participate in the equities of big companies. It ensures low risks, steady returns, high liquidity and better capital appreciation the long run.
5. Factoring
Factoring refers to the process of managing the sales ledger of a client by a financial service company. In other words, it is an arrangement under which a financial intermediary assumes the credit risk in the collection of book debts for its clients. The entire responsibility of collecting the book debts passes on to the factor. His services can be compared to a del credre agent who undertakes to collect debts. But, a factor provides credit information, collects debts, monitors the sales ledger and provides finance against debts. Thus, he provides a number of services apart from financing.


6. Forfaiting
Forfaiting is a technique by which a forfaitor (financing agency) discounts an export bill and pay ready cash to the exporter who can concentrate on the export front without bothering about collection of export bills. The forfeiter does so without any recourse to the exporter and the exporter is protected against the risk of non-payment of debts by the importers.

7. Venture capital
A venture capital is another method of financing in the form of equity participation. A venture capitalist finances a project based on the potentialities of a new innovative project. It is in contrast to the conventional ‘security based financing’. Much thrust is given to new ideas or technological innovations. Finance is being provided not only for ‘start-up capital’ but also for ‘development capital’ by the financial intermediary.

8. Custodial services
It is yet another line of activity which has gained importance, of late. Under this, a financial intermediary mainly provides services to clients, particularly to foreign investors, for a prescribed fee. Custodial services provide agency services like safe keeping of shares and debentures, collection of interest and dividend and reporting of matters on corporate developments and corporate securities to foreign investors.

9. Corporate advisory services
Financial intermediaries particularly banks have set up corporate advisory services branches to render services exclusively to their corporate customers. For instance, some banks have extended computer terminals to their corporate customers so that they can transact some of their important banking transactions by sitting in their own office. As new avenues of finance like Euro loans, GDRs etc. are available to corporate customers; this service is immense help to the customers.

10. Securitization
Securitization is a technique whereby a financial company converts its ill-liquid, non-negotiable and high value financial assets into securities of small value which are made tradable and transferable. A financial institution might have a lot of its assets blocked up in assets like real estate, machinery etc., which are long term in nature and which are non-negotiable? In such cases, securitization would help the financial institution to raise cash against such assets by means of issuing securities of small values to the public. Like any other security, they can be traded in the market.

11. Derivative security
A derivative security is a security whose value depends upon the values of other basic variables backing the security. In most cases, these variables are nothing but the prices of traded securities. A derivative security is basically used as a risk management tool and it is restored to cover the risks due to price fluctuations by the investments manager. Derivative helps to break the risk into various components such as credit risk, interest rate risk, exchange rates risk and so on. It enables the various risk components to be identified precisely and priced them and even traded them if necessary.

12. New products in forex market
New products have also emerged in the forex markets of developed countries. Some of these products are yet to make full entry in Indian markets. Among them the following are the important ones:
a) Forward contracts
b) Options
c) Swaps

13. Letter of credit (LOC)
LOC is an arrangement of a financing institution/bank of one country with another institutions / bank / agent to support the export of goods and services so as to enable the importers to import no deferred payment terms. This may be backed by a guarantee furnished by the institution / bank in the importing country. The LOC helps the exporters to get payment immediately as soon as the goods are shipped. The greatest advantage is that it saves a lot of time and money on mutual verification of bonafides, source of finance etc. It serves as a source of forex.






SEBI Guidelines
Debenture issue
• The amount of working capital debenture should exceed 20% of the gross current assets.
• Rate of interest should be decided by the company
• Credit rating is compulsory for all debentures excepting debentures issued by public sector companies, private placement of NCD with financial institutions and banks.
• Debentures are redeemed after the expiry of seven years from the date of allotment. NCD is permitted to be redeemed @ 5% premium.
• FCD/ PCD/ NCD issued for a period of more than 18 months are to be compulsorily credit rated
• Converted debentures are treated as equity (18)
• FCDs having more than 36 months of conversion will not be permitted
• Issue should be stated in the prospectus & interest rate should be determined by the issuer
• Conversion after 18 months from the date of allotment but before 36 months will be optional @ the hand of debenture holders

Guidelines for the protection of debenture holders

Servicing of debentures

DRR shall be created by the companies issuing debentures on the following
• Existing companies need create DRR up to the date of commercial production. It shall be created in equal installments for the remaining period
• For new companies, creation of DRR will commence from the year the company earns profit
• In case of PCDs, DRR should be created only for NCD portion
• DRR should be created upto 50% of the amount before redemption commences
• Withdrawal will be permitted only after 10% liability actually redeemed
• DRR should be treated as a part of general reserve for the purpose of bonus issue
• In case of new companies, distribution of dividend shall require approval of trustees to the debenture issue and the lead institution, if any
• In case of existing companies, prior permission of the lead institution for declaring dividend exceeding 20% or as per the loan covenants is necessary if the company does not comply with institutional conditions regarding interest and debt service coverage ratio


Protection of interest of debenture holders

• Trustees to the debenture issue shall be vested with the requisite powers for protecting the interest of debenture holders
• Lead/ investment institutions will monitor the progress in respect of debentures for project finance, modernisation, diversification etc. the lead bank will monitor the debenture raised for working capital of the company.
• Company shall file with SEBI, a certificate from their bankers that the assets on which security is to be created are free from encumbrances and necessary permissions
• Security should be created within 6 months from date the issue of debentures.
• Can be created within 12 months provided 2% penal interest is paid to debenture holders
• If security is not created even after 18 month, a meeting shall be called within21 days to explain the reasons thereof & the date by which it should be created

• Trustees of the debenture holders will supervise the implementation of the conditions regarding creation of security for the debenture & DRR
• Trustees & institutional debentures should obtain the certificate from the company’s auditors


SEBI Guidelines on Book Building

• The option of 100% book building shall be available only to issuer companies which propose to make an issue of capital of above Rs.100 crores
• Book-building shall be for the portion other than the promoters & to permanent employees of issuer company & share holders of promoting companies in case new company& shareholders of group companies in case of existing companies
• The draft prospectus shall be filed with SEBI by the lead merchant banker
• The issuer company after receiving final observations, if any, on the offer document from SEBI make an advertisement in newspaper.
• Book runner’s & the company shall determine the issue price based on the bids received through syndicate members
• Once price is fixed all those bidders whose bids have found to be successful shall entitled for allotment of securities
• On this basis the information regarding same will be intimated immediately to the investors

FINANCIAL SERVICES

Financial Services

Meaning:
All types of activities which are of a financial nature could be brought under the term ‘financial services’.

The term “Financial Services” in a broad sense means “mobilizing and allocating savings”. Thus, it includes all activities involved in the transformation of saving into investment.

The ‘financial service’ can also be called ‘financial intermediation’.

Financial intermediation is a process by which funds are mobilized from a large number of savers and make them available to all those who are in need of it and particularly to corporate customers.

A well developed financial services industry is absolutely necessary to mobilize the savings and to allocate them to various investable channels and thereby to promote industrial development in a country.

Classification of financial services industry
The financial intermediaries in India can be traditionally classified into two:
i. Capital market intermediaries
ii. Money market intermediaries


The capital market intermediaries consist of term lending institutions and investing institutions which mainly provide long term funds.

On the other hand, money market consists of commercial banks, co-operative banks and other agencies which supply only short term funds.

Scope of financial services
Financial services cover a wide range of activities. They can be broadly classified into two namely:
i. Traditional activities
ii. Modern activities

Traditional activities
Traditionally, the financial intermediaries have been rendering a wide range of services encompassing both capital and money market activities. They can be grouped under two heads viz;

i. Fund based activities and
ii. Non-fund based activities

Fund based activities
The traditional services which come under fund based activities are the following:
i. Underwriting of or investment in shares, debentures, bonds etc. of new issues (primary market activities)
ii. Dealing in secondary market activities
iii. Participating in money market instruments like commercial papers, certificate of deposits, treasury bills, discounting of bills etc.
iv. Involving in equipment leasing, hire purchase, venture capital, seed capital etc.
v. Dealing in foreign exchange market activities.


Non-fund based activities
Financial intermediaries provide services on the basis of non-fund activities also. This can also be called “fee based” activity. A wide variety of services, are being provided under this head. They include the following:
i. Managing the capital issues, i.e., management of pre-issue and post-issue activities relating to the capital issue in accordance with the SEBI guidelines and thus enabling the promoters to market their issues.
ii. Making arrangements for the placement of capital and debt instruments with investment institutions.
iii. Arrangement of funds from financial institutions for the clients project cost or his working capital requirements.
iv. Assisting in the process of getting all government and other clearances.

Modern activities
Besides the above traditional services, the financial intermediaries render innumerable services in recent times. Most of them are in the nature of non-fund based activity.

i. Rendering project advisory services right from the preparation of the project report till the raising of funds for starting the project with necessary government approval.
ii. Planning for mergers and acquisitions and assisting for their smooth carry out.
iii. Guiding corporate customers in capital restructuring.
iv. Acting as Trustees to the debenture holders
v. Structuring the financial collaboration/joint ventures by identifying suitable joint venture partner and preparing joint venture agreement.
vi. Rehabilitating and reconstructing sick companies through appropriate scheme of reconstruction and facilitating the implementation of the scheme.
vii. Hedging risks due to exchange rate risk, interest rate risk, economic risk and political risk by using swaps and other derivative products.
viii. Managing the portfolio of large public sector corporations.
ix. Undertaking risk management services like insurance services, buy back options, capital market etc.
x. Promoting credit rating agencies for the purpose of rating companies which want to go public by the issue of debt instruments.
Financial products and services

• Today, the importance of financial services is gaining momentum all over the world.

• In these days of complex finance, people expect a financial service company to play a very dynamic role not only as provider of finance but also as a departmental store of finance.

• As a result, the clients both corporates and individuals are exposed to the phenomena of volatility and uncertainty and hence they expect the financial service company to innovate new products and services so as to meet their varied requirements.


1. Merchant Banking:
A merchant banker is a financial intermediary who helps to transfer capital from those who possess it to those who need it. Merchant banking includes a wide range of activities such as management of customer’s securities, portfolio management, project counseling and appraisal, underwriting of shares and debentures, loan syndication, acting as banker for the refund orders, handling interest and dividend warrants etc. Thus merchant banker renders a host of services to corporates and thus promotes industrial development in the country.

2. Loan Syndication
This is more or less similar to ‘consortium financing’. But, this work is taken up by the merchant banker as a lead manager. It refers to a loan arranged by a bank called lead manager for a borrower who is usually a large corporate customer or a government department. The other banks who are willing to lend can participate in the loan by contributing a amount suitable to their own lending policies. Since a single bank cannot provide such a huge sum as loan, a number of banks join together and form a syndicate. It also enables the members of the syndicate to share the credit risk associated with a particular loan among themselves.

3. Leasing
A lease is an agreement under which a company or a firm, acquires a right to make use of a capital asset like machinery, on acquire any ownership to the asset, but he can use it and have full control over it. He is expected to pay for all maintenance charges and repairing and operating costs.

4. Mutual Funds
A mutual fund refers to a fund raised by a financial services company by pooling the savings of the public. It is invested in a diversified portfolio with a view to spreading and minimizing risk. The fund provides Investment Avenue for small investors who cannot participate in the equities of big companies. It ensures low risks, steady returns, high liquidity and better capital appreciation the long run.
5. Factoring
Factoring refers to the process of managing the sales ledger of a client by a financial service company. In other words, it is an arrangement under which a financial intermediary assumes the credit risk in the collection of book debts for its clients. The entire responsibility of collecting the book debts passes on to the factor. His services can be compared to a del credre agent who undertakes to collect debts. But, a factor provides credit information, collects debts, monitors the sales ledger and provides finance against debts. Thus, he provides a number of services apart from financing.


6. Forfaiting
Forfaiting is a technique by which a forfaitor (financing agency) discounts an export bill and pay ready cash to the exporter who can concentrate on the export front without bothering about collection of export bills. The forfeiter does so without any recourse to the exporter and the exporter is protected against the risk of non-payment of debts by the importers.

7. Venture capital
A venture capital is another method of financing in the form of equity participation. A venture capitalist finances a project based on the potentialities of a new innovative project. It is in contrast to the conventional ‘security based financing’. Much thrust is given to new ideas or technological innovations. Finance is being provided not only for ‘start-up capital’ but also for ‘development capital’ by the financial intermediary.

8. Custodial services
It is yet another line of activity which has gained importance, of late. Under this, a financial intermediary mainly provides services to clients, particularly to foreign investors, for a prescribed fee. Custodial services provide agency services like safe keeping of shares and debentures, collection of interest and dividend and reporting of matters on corporate developments and corporate securities to foreign investors.

9. Corporate advisory services
Financial intermediaries particularly banks have set up corporate advisory services branches to render services exclusively to their corporate customers. For instance, some banks have extended computer terminals to their corporate customers so that they can transact some of their important banking transactions by sitting in their own office. As new avenues of finance like Euro loans, GDRs etc. are available to corporate customers; this service is immense help to the customers.

10. Securitization
Securitization is a technique whereby a financial company converts its ill-liquid, non-negotiable and high value financial assets into securities of small value which are made tradable and transferable. A financial institution might have a lot of its assets blocked up in assets like real estate, machinery etc., which are long term in nature and which are non-negotiable? In such cases, securitization would help the financial institution to raise cash against such assets by means of issuing securities of small values to the public. Like any other security, they can be traded in the market.

11. Derivative security
A derivative security is a security whose value depends upon the values of other basic variables backing the security. In most cases, these variables are nothing but the prices of traded securities. A derivative security is basically used as a risk management tool and it is restored to cover the risks due to price fluctuations by the investments manager. Derivative helps to break the risk into various components such as credit risk, interest rate risk, exchange rates risk and so on. It enables the various risk components to be identified precisely and priced them and even traded them if necessary.

12. New products in forex market
New products have also emerged in the forex markets of developed countries. Some of these products are yet to make full entry in Indian markets. Among them the following are the important ones:
a) Forward contracts
b) Options
c) Swaps

13. Letter of credit (LOC)
LOC is an arrangement of a financing institution/bank of one country with another institutions / bank / agent to support the export of goods and services so as to enable the importers to import no deferred payment terms. This may be backed by a guarantee furnished by the institution / bank in the importing country. The LOC helps the exporters to get payment immediately as soon as the goods are shipped. The greatest advantage is that it saves a lot of time and money on mutual verification of bonafides, source of finance etc. It serves as a source of forex.

Financial Services

Meaning:
All types of activities which are of a financial nature could be brought under the term ‘financial services’.

The term “Financial Services” in a broad sense means “mobilizing and allocating savings”. Thus, it includes all activities involved in the transformation of saving into investment.

The ‘financial service’ can also be called ‘financial intermediation’.

Financial intermediation is a process by which funds are mobilized from a large number of savers and make them available to all those who are in need of it and particularly to corporate customers.

A well developed financial services industry is absolutely necessary to mobilize the savings and to allocate them to various investable channels and thereby to promote industrial development in a country.

Classification of financial services industry
The financial intermediaries in India can be traditionally classified into two:
iii. Capital market intermediaries
iv. Money market intermediaries


The capital market intermediaries consist of term lending institutions and investing institutions which mainly provide long term funds.

On the other hand, money market consists of commercial banks, co-operative banks and other agencies which supply only short term funds.

Scope of financial services
Financial services cover a wide range of activities. They can be broadly classified into two namely:
iii. Traditional activities
iv. Modern activities

Traditional activities
Traditionally, the financial intermediaries have been rendering a wide range of services encompassing both capital and money market activities. They can be grouped under two heads viz;

iii. Fund based activities and
iv. Non-fund based activities

Fund based activities
The traditional services which come under fund based activities are the following:
vi. Underwriting of or investment in shares, debentures, bonds etc. of new issues (primary market activities)
vii. Dealing in secondary market activities
viii. Participating in money market instruments like commercial papers, certificate of deposits, treasury bills, discounting of bills etc.
ix. Involving in equipment leasing, hire purchase, venture capital, seed capital etc.
x. Dealing in foreign exchange market activities.


Non-fund based activities
Financial intermediaries provide services on the basis of non-fund activities also. This can also be called “fee based” activity. A wide variety of services, are being provided under this head. They include the following:
v. Managing the capital issues, i.e., management of pre-issue and post-issue activities relating to the capital issue in accordance with the SEBI guidelines and thus enabling the promoters to market their issues.
vi. Making arrangements for the placement of capital and debt instruments with investment institutions.
vii. Arrangement of funds from financial institutions for the clients project cost or his working capital requirements.
viii. Assisting in the process of getting all government and other clearances.

Modern activities
Besides the above traditional services, the financial intermediaries render innumerable services in recent times. Most of them are in the nature of non-fund based activity.

xi. Rendering project advisory services right from the preparation of the project report till the raising of funds for starting the project with necessary government approval.
xii. Planning for mergers and acquisitions and assisting for their smooth carry out.
xiii. Guiding corporate customers in capital restructuring.
xiv. Acting as Trustees to the debenture holders
xv. Structuring the financial collaboration/joint ventures by identifying suitable joint venture partner and preparing joint venture agreement.
xvi. Rehabilitating and reconstructing sick companies through appropriate scheme of reconstruction and facilitating the implementation of the scheme.
xvii. Hedging risks due to exchange rate risk, interest rate risk, economic risk and political risk by using swaps and other derivative products.
xviii. Managing the portfolio of large public sector corporations.
xix. Undertaking risk management services like insurance services, buy back options, capital market etc.
xx. Promoting credit rating agencies for the purpose of rating companies which want to go public by the issue of debt instruments.
Financial products and services

• Today, the importance of financial services is gaining momentum all over the world.

• In these days of complex finance, people expect a financial service company to play a very dynamic role not only as provider of finance but also as a departmental store of finance.

• As a result, the clients both corporates and individuals are exposed to the phenomena of volatility and uncertainty and hence they expect the financial service company to innovate new products and services so as to meet their varied requirements.


14. Merchant Banking:
A merchant banker is a financial intermediary who helps to transfer capital from those who possess it to those who need it. Merchant banking includes a wide range of activities such as management of customer’s securities, portfolio management, project counseling and appraisal, underwriting of shares and debentures, loan syndication, acting as banker for the refund orders, handling interest and dividend warrants etc. Thus merchant banker renders a host of services to corporates and thus promotes industrial development in the country.

15. Loan Syndication
This is more or less similar to ‘consortium financing’. But, this work is taken up by the merchant banker as a lead manager. It refers to a loan arranged by a bank called lead manager for a borrower who is usually a large corporate customer or a government department. The other banks who are willing to lend can participate in the loan by contributing a amount suitable to their own lending policies. Since a single bank cannot provide such a huge sum as loan, a number of banks join together and form a syndicate. It also enables the members of the syndicate to share the credit risk associated with a particular loan among themselves.

16. Leasing
A lease is an agreement under which a company or a firm, acquires a right to make use of a capital asset like machinery, on acquire any ownership to the asset, but he can use it and have full control over it. He is expected to pay for all maintenance charges and repairing and operating costs.

17. Mutual Funds
A mutual fund refers to a fund raised by a financial services company by pooling the savings of the public. It is invested in a diversified portfolio with a view to spreading and minimizing risk. The fund provides Investment Avenue for small investors who cannot participate in the equities of big companies. It ensures low risks, steady returns, high liquidity and better capital appreciation the long run.
18. Factoring
Factoring refers to the process of managing the sales ledger of a client by a financial service company. In other words, it is an arrangement under which a financial intermediary assumes the credit risk in the collection of book debts for its clients. The entire responsibility of collecting the book debts passes on to the factor. His services can be compared to a del credre agent who undertakes to collect debts. But, a factor provides credit information, collects debts, monitors the sales ledger and provides finance against debts. Thus, he provides a number of services apart from financing.


19. Forfaiting
Forfaiting is a technique by which a forfaitor (financing agency) discounts an export bill and pay ready cash to the exporter who can concentrate on the export front without bothering about collection of export bills. The forfeiter does so without any recourse to the exporter and the exporter is protected against the risk of non-payment of debts by the importers.

20. Venture capital
A venture capital is another method of financing in the form of equity participation. A venture capitalist finances a project based on the potentialities of a new innovative project. It is in contrast to the conventional ‘security based financing’. Much thrust is given to new ideas or technological innovations. Finance is being provided not only for ‘start-up capital’ but also for ‘development capital’ by the financial intermediary.

21. Custodial services
It is yet another line of activity which has gained importance, of late. Under this, a financial intermediary mainly provides services to clients, particularly to foreign investors, for a prescribed fee. Custodial services provide agency services like safe keeping of shares and debentures, collection of interest and dividend and reporting of matters on corporate developments and corporate securities to foreign investors.

22. Corporate advisory services
Financial intermediaries particularly banks have set up corporate advisory services branches to render services exclusively to their corporate customers. For instance, some banks have extended computer terminals to their corporate customers so that they can transact some of their important banking transactions by sitting in their own office. As new avenues of finance like Euro loans, GDRs etc. are available to corporate customers; this service is immense help to the customers.

23. Securitization
Securitization is a technique whereby a financial company converts its ill-liquid, non-negotiable and high value financial assets into securities of small value which are made tradable and transferable. A financial institution might have a lot of its assets blocked up in assets like real estate, machinery etc., which are long term in nature and which are non-negotiable? In such cases, securitization would help the financial institution to raise cash against such assets by means of issuing securities of small values to the public. Like any other security, they can be traded in the market.

24. Derivative security
A derivative security is a security whose value depends upon the values of other basic variables backing the security. In most cases, these variables are nothing but the prices of traded securities. A derivative security is basically used as a risk management tool and it is restored to cover the risks due to price fluctuations by the investments manager. Derivative helps to break the risk into various components such as credit risk, interest rate risk, exchange rates risk and so on. It enables the various risk components to be identified precisely and priced them and even traded them if necessary.

25. New products in forex market
New products have also emerged in the forex markets of developed countries. Some of these products are yet to make full entry in Indian markets. Among them the following are the important ones:
d) Forward contracts
e) Options
f) Swaps

26. Letter of credit (LOC)
LOC is an arrangement of a financing institution/bank of one country with another institutions / bank / agent to support the export of goods and services so as to enable the importers to import no deferred payment terms. This may be backed by a guarantee furnished by the institution / bank in the importing country. The LOC helps the exporters to get payment immediately as soon as the goods are shipped. The greatest advantage is that it saves a lot of time and money on mutual verification of bonafides, source of finance etc. It serves as a source of forex.

Standard Cost

Standard Cost


Learning Objectives
• To understand the meaning of standard costing, its meaning and definition
• To learn its advantages and limitations
• To learn how to set of standards and determinations
• To learn how to revise standards
Introduction
You know that management accounting is managing a business through accounting information. In this process, management accounting is facilitating managerial control. It can also be applied to your own daily/monthly expenses, if necessary. These measures should be applied correctly so that performance takes place according to plans. Planning is the first tool for making the control effective. The vital aspect of managerial control is cost control. Hence, it is very important to plan and control costs. Standard costing is a technique which helps you to control costs and business operations. It aims at eliminating wastes and increasing efficiency in performance through setting up standards or formulating cost plans.
Meaning of Standard
When you want to measure some thing, you must take some parameter or yardstick for measuring. We can call this as standard. What are your daily expenses? An average of $50! If you have been spending this much for so many days, then this is your daily standard expense.
The word standard means a benchmark or yardstick. The standard cost is a predetermined cost which determines in advance what each product or service should cost under given circumstances.
In the words of Backer and Jacobsen, “Standard cost is the amount the firm thinks a product or the operation of the process for a period of time should cost, based upon certain assumed conditions of efficiency, economic conditions and other factors.”
Definition
The CIMA, London has defined standard cost as “a predetermined cost which is calculated from managements standards of efficient operations and the relevant necessary expenditure.” They are the predetermined costs on technical estimate of material labor and overhead for a selected period of time and for a prescribed set of working conditions. In other words, a standard cost is a planned cost for a unit of product or service rendered.
The technique of using standard costs for the purposes of cost control is known as standard costing. It is a system of cost accounting which is designed to find out how much should be the cost of a product under the existing conditions. The actual cost can be ascertained only when production is undertaken. The predetermined cost is compared to the actual cost and a variance between the two enables the management to take necessary corrective measures.
Advantages
Standard costing is a management control technique for every activity. It is not only useful for cost control purposes but is also helpful in production planning and policy formulation. It allows management by exception. In the light of various objectives of this system, some of the advantages of this tool are given below:
1. Efficiency measurement-- The comparison of actual costs with standard costs enables the management to evaluate performance of various cost centers. In the absence of standard costing system, actual costs of different period may be compared to measure efficiency. It is not proper to compare costs of different period because circumstance of both the periods may be different. Still, a decision about base period can be made with which actual performance can be compared.
2. Finding of variance-- The performance variances are determined by comparing actual costs with standard costs. Management is able to spot out the place of inefficiencies. It can fix responsibility for deviation in performance. It is possible to take corrective measures at the earliest. A regular check on various expenditures is also ensured by standard cost system.
3. Management by exception-- The targets of different individuals are fixed if the performance is according to predetermined standards. In this case, there is nothing to worry. The attention of the management is drawn only when actual performance is less than the budgeted performance. Management by exception means that everybody is given a target to be achieved and management need not supervise each and everything. The responsibilities are fixed and every body tries to achieve his/her targets.
4. Cost control-- Every costing system aims at cost control and cost reduction. The standards are being constantly analyzed and an effort is made to improve efficiency. Whenever a variance occurs, the reasons are studied and immediate corrective measures are undertaken. The action taken in spotting weak points enables cost control system.
5. Right decisions-- It enables and provides useful information to the management in taking important decisions. For example, the problem created by inflating, rising prices. It can also be used to provide incentive plans for employees etc.
6. Eliminating inefficiencies-- The setting of standards for different elements of cost requires a detailed study of different aspects. The standards are set differently for manufacturing, administrative and selling expenses. Improved methods are used for setting these standards. The determination of manufacturing expenses will require time and motion study for labor and effective material control devices for materials. Similar studies will be needed for finding other expenses. All these studies will make it possible to eliminate inefficiencies at different steps.
Limitations of Standard Costing
1. It cannot be used in those organizations where non-standard products are produced. If the production is undertaken according to the customer specifications, then each job will involve different amount of expenditures.
2. The process of setting standard is a difficult task, as it requires technical skills. The time and motion study is required to be undertaken for this purpose. These studies require a lot of time and money.
3. There are no inset circumstances to be considered for fixing standards. The conditions under which standards are fixed do not remain static. With the change in circumstances, if the standards are not revised the same become impracticable.
4. The fixing of responsibility is not an easy task. The variances are to be classified into controllable and uncontrollable variances. Standard costing is applicable only for controllable variances.
For instance, if the industry changed the technology then the system will not be suitable. In that case, we will have to change or revise the standards. A frequent revision of standards will become costly.
Setting Standards
Normally, setting up standards is based on the past experience. The total standard cost includes direct materials, direct labor and overheads. Normally, all these are fixed to some extent. The standards should be set up in a systematic way so that they are used as a tool for cost control.
Various Elements which Influence the Setting of Standards
Setting Standards for Direct Materials
There are several basic principles which ought to be appreciated in setting standards for direct materials. Generally, when you want to purchase some material what are the factors you consider. If material is used for a product, it is known as direct material. On the other hand, if the material cost cannot be assigned to the manufacturing of the product, it will be called indirect material. Therefore, it involves two things:
• Quality of material
• Price of the material
When you want to purchase material, the quality and size should be determined. The standard quality to be maintained should be decided. The quantity is determined by the production department. This department makes use of historical records, and an allowance for changing conditions will also be given for setting standards. A number of test runs may be undertaken on different days and under different situations, and an average of these results should be used for setting material quantity standards.
The second step in determining direct material cost will be a decision about the standard price. Material’s cost will be decided in consultation with the purchase department. The cost of purchasing and store keeping of materials should also be taken into consideration. The procedure for purchase of materials, minimum and maximum levels for various materials, discount policy and means of transport are the other factors which have bearing on the materials cost price. It includes the following:
• Cost of materials
• Ordering cost
• Carrying cost
The purpose should be to increase efficiency in procuring and store keeping of materials. The type of standard used-- ideal standard or expected standard-- also affects the choice of standard price.
Setting Direct Labor Cost
If you want to engage a labor force for manufacturing a product or a service for which you need to pay some amount, this is called wages. If the labor is engaged directly to produce the product, this is known as direct labor. The second largest amount of cost is of labor. The benefit derived from the workers can be assigned to a particular product or a process. If the wages paid to workers cannot be directly assigned to a particular product, these will be known as indirect wages. The time required for producing a product would be ascertained and labor should be properly graded. Different grades of workers will be paid different rates of wages. The times spent by different grades of workers for manufacturing a product should also be studied for deciding upon direct labor cost. The setting of standard for direct labor will be done basically on the following:
• Standard labor time for producing
• Labor rate per hour
Standard labor time indicates the time taken by different categories of labor force which are as under:
• Skilled labor
• Semi-skilled labor
• Unskilled labor
For setting a standard time for labor force, we normally take in to account previous experience, past performance records, test run result, work-study etc. The labor rate standard refers to the expected wage rates to be paid for different categories of workers. Past wage rates and demand and supply principle may not be a safe guide for determining standard labor rates. The anticipation of expected changes in labor rates will be an essential factor. In case there is an agreement with workers for payment of wages in the coming period, these rates should be used. If a premium or bonus scheme is in operation, then anticipated extra payments should also be included. Where a piece rate system is used, standard cost will be fixed per piece. The object of fixed standard labor time and labor rate is to device maximum efficiency in the use of labor.
Setting Standards of Overheads
The next important element comes under overheads. The very purpose of setting standard for overheads is to minimize the total cost. Standard overhead rates are computed by dividing overhead expenses by direct labor hours or units produced. The standard overhead cost is obtained by multiplying standard overhead rate by the labor hours spent or number of units produced. The determination of overhead rate involves three things:
• Determination of overheads
• Determination of labor hours or units manufactured
• Calculating overheads rate by dividing A by B
The overheads are classified into fixed overheads, variable overheads and semi-variable overheads. The fixed overheads remain the same irrespective of level of production, while variable overheads change in the proportion of production. The expenses increase or decrease with the increase or decrease in output. Semi-variable overheads are neither fixed nor variable. These overheads increase with the increase in production but the rate of increase will be less than the rate of increase in production. The division of overheads into fixed, variable and semi-variable categories will help in determining overheads.
Determination of Standard Costs
How should the ideal standards for better controlling be determined?
1. Determination of Cost Center
According to J. Betty, “A cost center is a department or part of a department or an item of equipment or machinery or a person or a group of persons in respect of which costs are accumulated, and one where control can be exercised.” Cost centers are necessary for determining the costs. If the whole factory is engaged in manufacturing a product, the factory will be a cost center. In fact, a cost center describes the product while cost is accumulated. Cost centers enable the determination of costs and fixation of responsibility. A cost center relating to a person is called personnel cost center, and a cost center relating to products and equipments is called impersonal cost center.
2. Current Standards
A current standard is a standard which is established for use over a short period of time and is related to current condition. It reflects the performance that should be attained during the current period. The period for current standard is normally one year. It is presumed that conditions of production will remain unchanged. In case there is any change in price or manufacturing condition, the standards are also revised. Current standard may be ideal standard and expected standard.
3. Ideal Standard
This is the standard which represents a high level of efficiency. Ideal standard is fixed on the assumption that favorable conditions will prevail and management will be at its best. The price paid for materials will be lowest and wastes etc. will be minimum possible. The labor time for making the production will be minimum and rates of wages will also be low. The overheads expenses are also set with maximum efficiency in mind. All the conditions, both internal and external, should be favorable and only then ideal standard will be achieved.
Ideal standard is fixed on the assumption of those conditions which may rarely exist. This standard is not practicable and may not be achieved. Though this standard may not be achieved, even then an effort is made. The deviation between targets and actual performance is ignorable. In practice, ideal standard has an adverse effect on the employees. They do not try to reach the standard because the standards are not considered realistic.
4. Basic Standards
A basic standard may be defined as a standard which is established for use for an indefinite period which may a long period. Basic standard is established for a long period and is not adjusted to the preset conations. The same standard remains in force for a long period. These standards are revised only on the changes in specification of material and technology productions. It is indeed just like a number against which subsequent process changes can be measured. Basic standard enables the measurement of changes in costs. For example, if the basic cost for material is Rs. 20 per unit and the current price is Rs. 25 per unit, it will show an increase of 25% in the cost of materials. The changes in manufacturing costs can be measured by taking basic standard, as a base standard cannot serve as a tool for cost control purpose because the standard is not revised for a long time. The deviation between standard cost and actual cost cannot be used as a yardstick for measuring efficiency.
5. Normal Standards
As per terminology, normal standard has been defined as a standard which, it is anticipated, can be attained over a future period of time, preferably long enough to cover one trade cycle. This standard is based on the conditions which will cover a future period of five years, concerning one trade cycle. If a normal cycle of ups and downs in sales and production is 10 years, then standard will be set on average sales and production which will cover all the years. The standard attempts to cover variance in the production from one time to another time. An average is taken from the periods of recession and depression. The normal standard concept is theoretical and cannot be used for cost control purpose. Normal standard can be properly applied for absorption of overhead cost over a long period of time.
6. Organization for Standard Costing
The success of standard costing system will depend upon the setting up of proper standards. For the purpose of setting standards, a person or a committee should be given this job. In a big concern, a standard costing committee is formed for this purpose. The committee includes production manager, purchase manager, sales manager, personnel manager, chief engineer and cost accountant. The cost accountant acts as a co-coordinator of this committee.
7. Accounting System
Classification of accounts is necessary to meet the required purpose, i.e. function, asset or revenue item. Codes can be used to have a speedy collection of accounts. A standard is a pre-determined measure of material, labor and overheads. It may be expressed in quality and its monetary measurements in standard costs.
Revision of Standards
For effective use of this technique, sometimes we need to revise the standards which follow for better control. Even standards are also subjected to change like the production method, environment, raw material, and technology.
Standards may need to be changed to accommodate changes in the organization or its environment. When there is a sudden change in economic circumstances, technology or production methods, the standard cost will no longer be accurate. Standards that are out of date will not act as effective feed forward or feedback control tools. They will not help us to predict the inputs required nor help us to evaluate the efficiency of a particular department. If standards are continually not being achieved and large deviations or variances from the standard are reported, they should be carefully reviewed. Also, changes in the physical productive capacity of the organization or in material prices and wage rates may indicate that standards need to be revised. In practice, changing standards frequently is an expensive operation and can cause confusion. For this reason, standard cost revisions are usually made only once a year. At times of rapid price inflation, many managers have felt that the high level of inflation forced them to change price and wage rate standards continually. This, however, leads to reduction in value of the standard as a yardstick. At the other extreme is the adoption of basic standard which will remain unchanged for many years. They provide a constant base for comparison, but this is hardly satisfactory when there is technological change in working procedures and conditions.
Summary
Basically, standard costing is a management tool for control. In the process, we have taken standards as parameters for measuring the performance. Cost analysis and cost control is essential for any activity. Cost includes material labor and overheads. Sometimes, we need to revise the standards due to change in uses, raw material, technology, method of production etc. For a proper organization, it is required to implement this under a committee for the activity. It is a continued activity for the optimum utilization of resources.



STANDARD COSTING
Standard : Predetermined measurable quantity set in defined conditions.
Standard cost: A scientifically predetermined cost which is arrived at assuming a particular level of efficiency in utilization of material ,labor,and indirect services.
It is like a model which provides basis for comparison with actual cost. This comparison provides a useful information for cost control.
It is also the cost plan for a single unit.
Uses:
Standard cost information is used for the following:
(1) Establishing budgets
(2) controlling cost and motivating and measuring efficiencies
(3) promoting possible cost reduction
(4) simplifying cost procedures
(5) forming basis for quotations.
Standard Costing : “is a control technique which compares standard costs and revenues with actual results to obtain variances which are used to stimulate improved performances”
Standard cost sheet: A cost sheet showing the total standard cost analysed in to standard material cost, standard labour cost and standard overheads.
Variances : Variances represent deviations of actual performance from standard performance. A variance can be favourable or unfavourable depending on its impact on the profit.
Variances Analysis: “ is an exercise to classify the variances according causes for highlighting the situations requiring managerial attention.

Advantages (Merits):
(1) Optimum utilization of resources such as material ,labor and services
(2) Helps comparison with actual costs
(3) Only major deviations are reported to management drawing its attention
(4) It helps planning,control,decision making and price fixation
(5) It creates an atmosphere of cost consciousness
(6) It motivates employees to achieve targets

Limitations (Demerits):
(1) Establishment of standard is difficult . For ex. Fixing standard for labor efficiency
(2) Standards are subject to frequent changes difficult to comply with
(3) Difficult to fix responsibility when it is a result of collective effort.
(4) It may create adverse psychological effects
(5) It is difficult to distinguish the controllable and uncontrollable elements of variances

Classification of variances:
Variances are classified as follows:
(1) Cost Variance : the difference between the actual cost and the standard cost
(2) Profit (sales margin) variance : the difference between the actual profit and the standard profit
(3) Sales value variance: the difference between the actual sales and the standard sales.
Cost Variances: A cost variance is adverse if the actual cost is more than the standard cost (denoted by A, bad performance ) . It is favourable if the actual cost is less than the standard cost (denoted by F, good performance)
Cost variance is divided in to:
(a) Direct Material cost variance
(b) Direct wages (Labor) variance
(c) Variable Overhead Variance
(d) Fixed overhead variance

Material cost variance is divided in to :
(a) Material Price Variance (b) Material Volume or Quantity or Usage Variance
Material Usage variance is further divided in to (i) Material Mix Variance and (ii) Material Yield Variance .
Material Cost variance : the difference between the actual cost of material used and the standard cost of material specified for the output achieved
Material Price variance: is that part of material cost variance which is due to difference between the actual price and the standard price
Material Quantity or Usage Variance: is that part of material cost variance which is due to actual quantity and standard quantity of material used.
Material Mix Variance : is that part of material quantity (usage) variance which is due to actual composition of mix and standard composition of mix.
Material Yield Variance: is that part of material usage variance which is due to difference between actual output (Yield) obtained and the standard yield specified.

Exercise:
(1) A product is manufactured by using a raw material. The details are as follows:
Standard quantity specified , 100 units at Rs 15/ unit. Actual quantity used , 90 units at Rs 20 /unit.
Determine : (a) Material Price Variance (b) Material Usage Variance (c) Material Cost Variance.

(2) Following data relate to a Product:
Standard Mix: 40 tons of Material A @Rs 10 /ton and 80 tons of Material B @ Rs 20/ton
Actual Mix: 50 tons of Material A @ 12 /ton and 70 tons of Material B @ Rs 16 /ton.
Determine the Material Cost variances.
(3) From the data given below , determine the cost variances:
Standard Mix for Production of A ---- X – 60 tons@ Rs5/ton; Y—40tons @ Rs10/ton
Actual Mix for production of A ----- X – 80 tons @ 4/ton ; Y --- 70tons @ Rs8/ton
(4) The standard cost of a Chemical mixture is as follows: 40% of Material A at Rs 20 per Unit ; 60% of Material B at Rs 30 per Unit.
Actual cost is as follows: 180 units of A @ Rs 18 /unit; 220 units of B @Rs 34 /unit.
A standard loss of 10% of input is expected in production. But the actual output was 364 units.
Required: Calculate, (1) Material Price variance (2) Material mix Variance (3) Material Yield Variance (4) Material Usage Variance (5) Material Cost Variance
5ANC ltd produces a product by blending two basic raw materials ,m and n. The following details are available:

Material Standard mix Standard price / kg
M 40% 4
N 60% 3
The standard loss in process is 15%.
During Nov.2004 the company produced 1,700 kgs of finished output.
The quantity details are as below:
Material Stock on Nov.1.(kgs) Stock on Nov.30 (kgs) Purchases during Nov.
kgs Cost
M 35@4/kg 5 800 3,400
N 40@3/kg 50 1,200 3,000
Calculate cost variances based on the materials used (assuming FIFO).
6.Determine the material cost variances under the following two situations:
(A) Purchased during the period 3,000 Kg ,cost 6,200
Standard 2 kg/unit @ 2 /kg
Original budget 2,000units
Production 1,400 units
(B) Purchased during the period 6,000 kgs , cost 2,400
Standard 3 kgs/ unit @ 0.50 /kg
Production 2,000 units
Ending stock 400 kgs.
Note: In case of(B) ,calculate price variance at (i) the time of purchase (ii) at the
time of use.
7.Details of a chemical product is as follows:

X Y
Qnty Value Qnty Value
Raw material purchased 2,000 4,000 5,000 6,250
Issued to production 2,150 ? 3,950 ?
Stocks : Beginning
Ending 300
200 ?
? 1,000
1,250 ?
?
Standard price : Material X – 1.90/kg,Material Y – 1.30/kg
Standard usage : Material X Material Y
Product A 1 kg 1 kg
Product B ½ kg 1 kg
Output during the period – Product A , 1,130 units, Product B, 2550 units.
Required : Determine the Material cost variances.
8. XYZ ltd is producing floor covers in roll of standard size measuring 3 meters wide and 30 meters long by feeding raw materials to a continuous process machine. Standard mix fixed for a batch of 900 sq.meters of floor cover is as follows:
2,000 kgs of A @ 1.00/kg, 800kgs of B @ 1.50/kg,20 gallons of C @ 30/gallon.
During the period , 1,505 standard size rolls were produced from the materials used for 150 batches. The actual usage and the cost of materials are as follows:
300,500 kgs of A @ 1.10/kg, 119,600 kgs of B @1.65/kg ,3,100 gallons of C @ 29.50 /kg
Required: Calculate Material cost variances.


Labour Cost Variance
Direct Wage Variance: Difference between Actual and Standard wages paid.
This is divided in to parts as below:

Wage Variance

Rate
Efficiency
Composition
Idle
Yield









L1 = Actual Hours x Actual Rate
L2 = Actual Hours x Standard Rate
L3 = Standard Composition x Standard Rate
L4 = Labour Hours Utilised x Standard Rate
L5 = Standard Labour Cost per unit x Actual Production

Direct Wage Variance : Difference between the actual wages paid & Standard wages specified for production.( L1- L5)
Direct Wage Rate Variance: Difference between wages for actual hours @actual rate and Standard Rate. (L1 – L2)
Direct Wage Efficiency Variance: Difference between wages paid for actual hours at standard rate & Standard Labour cost for actual production (L2- L5)
Direct Wage Composition Variance : Difference between wages paid at standard rate for actual composition & standard composition . (L2 – L3)
Direct Wage Idle Time Variance: Difference between Wages paid at standard rate for Labour hours applied & Labour hours utilized. (L3 – L4)
Labour Yield Variance : Difference between wages paid at standard rate for Actual & Standard Production. (L4 –L5 )
Note : If there is no idle time , then Yield variance = L3 – L5

Problem : 1
Following information relates to a factory :
Standard Composition Standard Hourly rate(Rs)
10 Men 62.5
5 Women 40.0
5 Boys 35.0
A week consists of 40 hours and the standard output for a week is 1,000 units.
But, in a particular week , the composition consisted of 13 Men , 4 Women, 3 Boys and actual wages were : Rs 60, 42.5 , 32.5 respectively.
Two hours were lost during the week and 960 units were produced.
Find: a.Labour Rate variance b. Labour Efficiency Variance c. Composiiton(Mix) Variance d.Idle Time Variance e. Yield variance f. Labour Cost Vairance

Answer :
L1 = 13 M x 40 x 60 = 31,200 + 4 W x 40 x 42.5 = 6800 + 3 B x 40 x 32.5 = 3900 = 41,900
L2= 13M x 40 x 62.5 = 32,500 + 4 W x 40 x 40 = 6400 + 3 B x 40 x 35 = 4200 =43,100
L3 = 10 M x 40 x 62.5 =25000+5Wx40x40=8000+5Bx40x35=7000 = 40,000
L4=10Mx38x62.5=23750+5 Wx38x40=7600+5Bx38x35=6650=38,000
L5= Std cost per unit i.e. 40000 /1000 x 960 units = 38,400
a.Labour Rate variance = L1 – L2 = 41,900-43,100 = 1,200 (F)
b. Labour Efficiency Variance: L2-L5 = 43,100- 38,400 = 4,700 (A)
c. Composiiton(Mix) Variance: L2 – L3 = 43,100-40,000 = 3,100 (A)
d.Idle Time Variance: L3 – L4 =40,000-38,000 = 2,000 (A)
e. Yield variance: L4 – L5=38,000-38,400 = 400 (F)
f.Labour Cost variance : L1-L5 = 41900-38400=3,500(A)

Problem 2
A mix of workers normally consists of 30 skilled ,15 Semi skilled & 10 Unskilled with Standard rate of Rs 80,60 & 40 respectively.Normal working week is 40 hours with a production of 2,000 units. During a specific week , the mix consisted of 40 Skilled, 10 Semiskilled and 5 Unskilled workers, with actual wages of Rs 70,65,30 respectively. 4 hours were lost in the week & 1,600 Units were produced.
Determine Labour Cost Variances.
Problem 3
Following data are available for Producing a product A: (Standard)
Hrs Rate per hr
Skilled 10 30
Semi Skilled 8 15
Unskilled 16 10
Actual production was 1,000 units of A for which actual data are as below:
Hrs Rate per hr
Skilled 9,000 40
Semi Skilled 8,400 15
Unskilled 20,000 9
Determine Labor Cost variances
Problem 4
Determining the standard cost of direct labor for the good output produced in January 2007:
Large Aprons Small Aprons Total
Actual aprons manufactured 100 60
Standard hours of direct labor per apron manufactured 0.3 hr. 0.2 hr.
Total standard hours of direct labor for actual aprons manufactured 30 hr. 12 hr. 42 hr.
Standard cost per direct labor hour incl. payroll taxes Rs10 Rs10 Rs10
Standard cost of direct labor in the good output Rs300 Rs120 Rs420


Assuming that the actual direct labor in January adds up to 50 hours and the actual hourly rate of pay (including payroll taxes) is Rs9 per hour, our analysis will look like this:

Direct Labor Variance Analysis for January 2007:



4. Credit Wages Payable for the actual direct labor cost.



5. Direct Labor Rate Variance
Act Hr x (Std Rate - Act Rate)
2. Actual hours of direct labor used x the standard hourly pay rate
3. Direct Labor Efficiency Variance (Std Hr - Act Hr) x Std Cost 1. Debit Inventory-FG for the standard hours of direct labor that should have been used to make the good output x the standard hourly pay rate
Act Hr x Act Rate Difference Act Hr x Std Rate Difference Std Hr x Std Rate
50 act hr x Rs9 50 hr x Rs1 50 act hr x Rs10 (8 hr) x Rs10 42 std hr x Rs10
Rs450 Rs500 Rs420
Rs50 Favorable Rs80 Unfavorable


In January, the direct labor efficiency variance (#3 above) is unfavorable because the company actually used 50 hours of direct labor—this is 8 hours more than the standard quantity of 42 hours allowed for the good output. The additional 8 hours is multiplied by the standard rate of Rs10 to give us an unfavorable direct labor efficiency variance of Rs80. (The direct labor efficiency variance could be called the direct labor quantity variance or usage variance.)

Note that DenimWorks paid Rs9 per hour for labor when the standard rate is Rs10 per hour. This Rs1 difference—multiplied by the 50 actual hours—results in a Rs50 favorable direct labor rate variance. (The direct labor rate variance could be called the direct labor price variance.)


Overhead Variances
Divided in to two: Variable & Fixed
Variable OH Variance: VOH remains constant per unit ,but varies in total
It is the difference between the Actual VOH incurred & the VOH at Standard Rate for Production.
It is divided in to two parts:
Variable OH Expenditure Variance: It is the difference between Actual VOH incurred & VOH of Actual hrs worked at Standard rate.
Variable OH Efficiency variance: It is the difference between VOH of Actual Hrs worked at standard rate & the VOH at standard rate for production (Std rate per unit x actual production )
Fixed OH variance: This remains constant in total ,but varies per unit as the production changes. It arises when absorption standard costing system is used. Under this, a standard fixed OH rate for a base is determined. Variances arise due to variation in the production, capacity utilization, in the base .
It is divided in to :
Expenditure / Budget variance: Difference between Actual FOH incurred & Budgeted FOH.
Volume variance: Difference between Budgeted FOH & Standard FOH for Actual Production.
Volume variance is further divided in to :
Calendar variance : This is due to difference in the number of working days.
Capacity variance : This is due to difference in the capacity utilized.
Efficiency Variance: This is due to efficiency in the production .