Time Value of Money and its importance

Time  value of money is one of the most important concepts in finance.  It means that the value of a rupee received one year from now is not the same as the value of a rupee received today. The concept of time value of money deals with the fact that can amount of money as seen in the future is not valuable as the same amount of money received at present. Continue reading

Elements of cost- Prime and Overheard Cost

Elements of cost:

There are three elements of cost: 1. Material cost 2. Labor cost and 3. Expenses

Material Cost: cost of raw materials, spare parts, consumable materials, packaging materials

Labor Cost: cost of skilled and unskilled labor employed in construction or production processes

Expenses: cost of special design, drawings or layouts, cost of purchase or hiring of tools and equipement for particular job and maintenance cost of such tools, advertisements

 

Prime and Overheard Cost:

Prime Cost: The direct cost that can be reasonably measured and allocated to an specific output or work activities. This is the aggregate of direct material cost.

Prime cost = direct material cost + direct labor cost + direct expenses

Components of Prime cost

  1. Direct Material cost
    • Materials including component parts, raw materials, specially purchased material for a specified job, order or processes
    • Materials passing from one operation or process to another
    • Primary packing materials such as cartoons, cardboard boxes
  2. Direct Labor Cost
    • Laborer engaged in altering the condition, confirmation and composition of the product
    • Inspector, analyst, designer, expert specially required for production
    • If specially identified, the wage of foreman, shop clerks, the wages of internal transport personnel
  3. Direct Expenses
    • Cost of special designs, drawings or layouts
    • Hire of special tools and equipment for a particular job
    • Maintenance cost of these special tools and equipments

Overhead Cost:

The indirect cost that can’t be reasonably measured and allocated to specific output or work activities is referred as overhead cost. This is the sum of indirect material cost, indirect labor cost and indirect expenses. Includes value increment, new office installation and premium insurance.

Overhead cost = indirect material cost + indirect labor cost + indirect expenses

Compounding and discounting

The process of calculating future values = compounding, ie the sum of beginning amount and the interest earned.

The process of finding out the present value = discounting ie the inverse of compounding.

Basically for a single cash flow:

F = P [F/P, i%, N]

F = P (1+i)N

!!! The following are the cases for discrete compounding and discrete cash flow.

Case 1. Finding F when A is given

F = A [F/A, i%, N]

 

The quantity inside the square brackets = Uniform series compound factor

 

Case 2. Finding P when A is given

P = A [P/A, i%, N]

 

The quantity inside the square brackets = Uniform series present worth factor

 

Case 3. Finding A when given F

A = F [A/F, i%, N]

 

The quantity inside the square brackets = Sinking fund factor

 

Case 4. Finding A when given P

A = P [A/P, i%, N]

 

The quantity inside the square brackets = Capital recovery factor

Benefit to Cost Ratio (B/C or BCR):

B/C ratio is defined as the ratio of equivalent worth of benefit to the equivalent worth of cost. Equivalent worth may be either Present worth (Pw), Annual worth (Aw) or Future worth (Fw).

Benefit to Cost ratio is also known as Profitability Index (PI) being the indicator of the profit.

Types of B/C Ratio:

  1. Conventional BCR
  2. Modified BCR

Decision:

The project is economically feasible only if

B/C ? 1

B/C Ratio formulae:

Methods Conventional B/C Modified B/C
Pw method    
Aw method    
Fw method    

Here,

I = investment

O/M = operation and maintenance cost

B = benefit

S = salvage value

CR = capital recovery

Break Even Analysis (BEA)

Break Even Analysis is a term given to the study of the inter-relationship between cost, volume and profits at various levels of activities. It is the most widely known form of the cost-volume-profit analysis. It is one of the most important techniques of profit planning and control.

Advantages of Break Even Analysis:

It is a simple device to understand the accounting data.
It provides basic info for further profit improvement studies.
It is a useful method for considering the risk implications of alternative actions.
It is a useful diagnostic tool.

Disadvantages of Break Even Analysis:

It is difficult to separate the cost into the fixed and variable cost.
It is not correct to assume that total fixed cost would remain unchanged over the entire range of volume.
The assumptions of constant selling price and unit variable cost are not valid.
BEA is difficult to use in the multi-product form.
It is a short term concept and has a limited use in long range planning.

Payback Period

The period of time required to recover the net investment is called payback period, PB.

The project which pays back the initial investment in the smallest period is acceptable under this method.

Decision:

If (calculated PB < standard  PB) => Accept the project

If (calculated PB > standard  PB) => Reject the project

Merits of payback period:

ü  Easy to understand and inexpensive to use.

ü  Easy and crude way to analyze the risk.

ü  Uses all cash flow information.

ü  Considers liquidity.

 

Demerits:

û  Ignores the time value of money.

û  Ignores cash flow occurring after payback period.

û  Not objective way to determine the standard payback period.

û  Not a measure of profitability.

û  Payback period ignores the wealth maximization.

 

Types of Payback period:

  1. 1. Simple payback period
  2. 2. Discounted payback period

Social Cost Benefit Analysis SCBA vs Cost Benefit Analysis CBA

SOCIAL COST BENEFIT ANALYSIS (SCBA)

  1. Introduction
  • Social Cost Benefit Analysis(SCBA) is a methodology developed for evaluating investment projects from the point of view of the society (or economy) as a whole. It is a tool for economic appraisal of a project from social consideration.

For the example, when consumers go to the grocery shop to buy vegetables they may be disappointed with their high price, as consumer wants them cheaper. At the same time, when the farmers bring the vegetable to the market, they wish the price of the vegetables were even higher. These views are not surprising. Buyer always want to pay less, and seller always wants to be paid more. But, what is the right price from the perspective of both the buyer and seller? Analysis of these economics-prices, costs, and benefits etc from the perspective of buyer, seller and society as a whole is the SCBA.

  • CBA (Cost Benefit Analysis) performs the economic analysis of a project without considering social issue. It is very much close to financial analysis.
  • SCBA is also referred to as economic analysis.
  • SCBA considers all the intangible benefits and converts into monetary value/ costs.
  • SCBA is performed mainly for public investment project, particularly in developing countries, where governments play a significant role in economic development. However, in recent years SCBA has also become mandatory even for private investments as these also influence the socio economic setting of the area .For the example, in Nepal, all private sector investment in hydropower projects needs to conduct EIA. An EIA does encompass the socio economic and cultural impacts.
  • In the context of planned economics, SCBA evaluates individual projects within the framework of national economic development objectives and broad allocation of resources to various sectors.

Real World Problems in Controlling Information Systems

One of the most important responsibilities of the management of computer using business firms is to assure the security and quality of its information services activities. Controls are needed that ensure the accuracy, integrity, and safety of the information processing activities and resources of the organization and its end users.

Here are three real world problems in controlling information system, sourced from Computer Magazines (individual source quoted below), for analysis in Professional Management of Information Systems and related engineers of the field. These examples are purely educational in purposes (Engineering Professional Practice), please do not take them otherwise.


Polymerics Corporation

After receiving a negative performance review, an employee at craft manufacturer Polymeric’s Pawtucket Rhode Island warehouse ended his Friday shift with a network-based spree of destruction. “He ripped network cards and cable out of PCs,” said Geoffrey Clarkson, the chairman of the $80 million manufacturer of Tulip-brand craft paints. “He also edited the password file to stop people from logging in and altered the inventory control, which could have caused a fair amount of chaos. We were prepared for this and were able to recover from it quickly,” said Clarkson. Just two months ago, Polymerics installed LAN Investigator Plus, a LAN software-monitory utility.

“We protect all our program files, including order-entry, accounting, and inventory control,” said Clarkson. “These (are) mega-thousands of dollars’ worth of expensive software and data on our system.” Shortly after the vandal corrupted the system from a PC in Rhode Island LAN Investigator identified the corrupted files and flashed an alert to Clarkson, who is based in the firm’s Waltham Massachusetts headquarters. “First thing Monday morning, all we had to do was look at the audit trace in Investigator. It showed what was altered and what he tried to do.” The product not only indicated the trouble, it also repaired the damage. “We restored everything by a simple instruction to Investigator,” Clarkson said. Polymerics uses Investigator for other purposes, too. “We could catch a virus, for example, and it helps us keep track of alterations to our systems,” said Clarkson.

  1. How did Polymerics protect its Local Area Network of PCs from the effects of this computer crime?
  2. What capabilities does LAN Investigator Plus have to control computer misuse and malfunction?

(Source: Bob Evan “Software Security System Thwarts Attack on Data”, PC Week April 10, 1989, pp 37-38)

Strategic Anticompetitive Systems

Strategic Information Systems can run into antitrust problems if they provide too much of a competitive advantage. That point was driven home by two recent antitrust actions involving computerized networks run companies that have achieved market dominance. Recent antitrust lawsuits have involved American Airlines, which has the largest online reservation system in the United States, and MasterCard International Inc. and Visa International Inc., which together control 90 percent of the revolving credit industry.

Antitrust liability is one of the legal risks that corporations run when they use information as a competitive weapon, especially if the company has a dominant market share in a particular niche or region of if it controls an essential network, according to Peter Marx, a Wellesley, Massachusetts-based attorney who specializes in information law. Such companies are vulnerable to charges of conspiracy to create monopolies, unfair competition, price fixing, or illegal barriers to entry.

  1. Why do strategic information systems have the potential to violate antitrust law?
  2. When does the use of Information Systems as a competitive weapon become anticompetitive and illegal?

(Source: Milch Bens, “Strategic Systems Pitfalls in Stomping Competitors”, Computer World, August 7, 1989, pp 1-14)

IBM Corporation

We’ve done plenty of IBM bashing in the pages of PC Week over the years but sometimes the company does something that’s so right we can’t resist giving it a pat on the back. The latest “something so right” corners in the form of SpeechViewer, a PS/2-based product designed to help speech-impaired people improve their speech. As the person speaks into a microphone, the system presents such things as pitch, loudness, and vowel accuracy as pictures on the screen. A child learning to control how loudly he or she speaks would, for example, see a clown opening its mouth wider as he or she spoke louder.

It’s easy, popular, and sometimes true to see IBM as the lumbering behemoth of the computer industry. According to this view, IBM is either a bully trying to bend competitors and customers to its will or a pitiful giant too muscle-bound to keep up with the market. But there’s another reality, and SpeechViewer is a good example of it. It sometimes takes a company the size of IBM to develop a product like this. According to IBM, it took 10 years of working with speech pathologists to develop SpeechViewer. We’re doubtful it will ever turn much, if any, of a profit. But how many “cloners” would have had the time and money to invest in it?

This product is the second in IBM’s Independence Series. The first is the ScreenReader, which lets visually impaired persons hear text just as sighted person would see it on the screen. IBM even runs a National Support Center for Persons with Disabilities in Atlanta, which can be reached at (800)-IBM-2133.

We’re lucky to be part of the PC industry. It’s one of the most fast-moving, fascinating, and important pieces of the entire economy. But because of that, it’s all too easy to get caught up in either outracing your competition or outdazzling yourself with technology. Hats off to IBM for reminding us that there’s another side to technology: the good it can do for our fellow human beings.

  1. Do you agree with the points made in this article about IBM’s actions and the computer industry?
  2. What other examples of the good that information system technology can do you see or experience?

(Source: “Cheers to IBM for Uncovering Technology’s Human Side”, PC Week, January 16, 1989, pp 60)

Note: If you are the author or copyright holder of above three examples and think that we should not publish these articles on our site for entirely educational purposes, please give us a buzz on the contact sheet. We would be happy to remove them for you.)

 

Economic Variances in Engineering Economics

Types of Economic Variances

There are mainly 4 types of variances in engineering economics, namely

  1. Direct material cost variance
  2. Direct wages/labor cost variance
  3. Variable overhead variance
  4. Fixed overhead variance

Negative (-) variance is always favorable ie actual cost (-) << standard cost (+).

1. Direct material cost variance

This is the difference between standard cost of direct material specified for the o/p and the actual cost of direct materials used. Is the aggregate of direct material price variance and direct material usage variance ie

DMCV = material price variance + material usage variance

  1. Direct material price variance:
    i. cost varies due to difference between standard price specified and actual price paid for
    ii. DMPV = (actual quantity consumed * actual rate) – (actual quantity consumed * standard rate) = (AQ * AR)-(AQ * SR) = AQ (AR – SR) = Actual qty (actual rate – std rate)
  2. Direct material usage variance:
    i. cost variance due to difference between standard qty specified and actual qty variance
    ii. DMUV = (actual qty consumed * std rate) – (std qty consumed * std rate) = (AQ * SR)-(SQ * SR) = SR (AQ – SQ)

 

2. Direct labor/wage rate variance

Variance between std direct wages specified for the activity achieved and actual direct wages paid
Aggregate of direct wage rate variance and direct labor efficiency

a. Direct wage/labor rate variance:
i. variance due to difference between std rate of pay specified and actual rate paid
ii. DLRV = (actual hours worked at actual rate)-(actual hours worked at standard rate) = AH * AR – AH * SR = AH (AR-SR)

b. Labor efficiency variance:
i. variance due to difference between std labor hour specified for the activities achieved and the actual labor hour expanded
ii. LEV = (actual hours worked @ std rate) – (std hour * std rate) = (AH * SR) – (SH * SR) = SR (AH-SH)

 

3. Variable Overhead variance

Is the difference between the actual variance overhead and std variable overhead cost for the production

The aggregare of variable overhead, expenditure variance and the variable overhead efficiency variance

a. Variable overhead expenditure variance = (AH * AR) – (AH * SR) = AH (AR –SR)

b. Variable overhead efficiency = (AH * AR) – (AP * SH/UNIT * SR)

where AH = actual hours, SH = std hours, AP = actual production, unit = std production unit

 

4. Fixed overhead variance

Is the difference between actual fixed overhead and the standard cost of fixed overhead observed in the actual o/p

Is the aggregate of the following 3 variances

a. Fixed overhead expenditure variance = actual fixed overhead – budgeted overhead

b. Fixed overhead capacity variance = budgeted fixed overhead – AH * SR/UNIT

c. Fixed overhead efficiency variance = (AH *SR/UNIT) – (AP * SH/UNIT *SR)