Depending on the industry and production process, companies employ various methods for costing.
To understand different types of costing methods, it is worthwhile to understand different types of production processes first. There are four major types of production processes
1. Job Production:
This type of production involves a process where each deliverable (output of the process) is unique. This can be service jobs such as automobile repair, custom house construction or small manufacturers who supply custom parts to larger manufacturers.
2. Batch Production:
This type of production is used where each deliverable is not unique but there are a large variety of similar deliverables. For example, an electronics manufacturer who offer different options in their products. The products can be produced using the same facilities but some parts used and the production process may vary by product. So, the produce the items in batches with batch size decided by the demand for each product.
3. Mass Production:
Also known as Flow Production, this production process is employed in the assembly line where each workstation does only a single or very few jobs but repeatedly. This production process is mainly employed in the automobile industry. The deliverables produced by this type of production process are identical to each other.
4. Continuous Production:
Also knows as Process production, this is used for the production of commodities such as in oil refineries, cement production, chemicals etc. Generally, there is least human involvement in this kind of production process.
1. Job Costing
As the name suggests, this type of costing is used for job production processes where each item is unique. This means that the cost for each item is to be calculated separately. This also means that the costing process involves more time and is expensive.
2. Contract Costing
While job costing deals with a specific deliverable, contract costing deals with a specific client contract. This costing is used in large scale construction contracts.
3. Batch Costing
As the name suggests, this kind of costing method is used in batch production. A batch can be regarded as a single job and accordingly the cost for each batch be calculated. This cost for the batch can be used to calculate per unit cost.
4. Process Costing
As the name suggests, process costing is used for process production processes. As it is practically impossible (or very expensive) to track the cost of each deliverable (or by volume or weight in case of commodities) in process production, process costing involves understanding the cost of each stage in the production process.
5. Operation Costing
This costing method combines job costing and process costing to ascertain the cost of products which are similar but can have some differences. For example, a company producing laptops with the same enchasing, screen and keyboard etc. but with a different processor, RAM and Hard Disk will use this costing process to determine different costs for laptops with different specifications.
6. Operating Costing
Operating costing is used in case of services such as transportation and consumable supplier companies etc. Cost for a period is tracked then divided by units of service to calculate cost per unit of service.
7. Unit Costing
Also known as Output Costing, this costing method is used in a continuous production process to calculated cost per unit produced. The cost for the whole production run is tracked and per unit, the cost is calculated by dividing the total cost with a number of units produced.
8. Composite Costing
Sometimes a single costing method is not sufficient. It can happen for complex products which require various production techniques to produce. For such products, various different methods are used to calculate different types of cost and then added to get the cost of production.
This series will cover different facets of cost accounting and cost management. The concepts discussed here will be beneficial not only for entrepreneurs but also for investors who want to analyse a company’s cost structure.
We will start with the different classifications of costs and then move to other concepts in later posts.
There are different ways to classify costs and we will cover some major ways in this post.
DIRECT AND INDIRECT COSTS
The classification of direct and indirect costs is based on the traceability of the source of the costs.
Raw material, direct labour costs are easier to track for a particular product or a business function whereas administrative costs, rent etc. are difficult (and/or expensive) to distribute to the products or service units. This is why raw material, direct labour can be classified as direct costs whereas administrative costs and rent as an indirect cost.
FIXED AND VARIABLE COSTS
To evaluate whether a cost is a fixed or a variable cost ask yourself a question - “ Will this cost change with the output volume of product or service?”
Costs which increase or decreases with the level of output are called variable cost. Costs which are not correlated with output volume are called fixed costs.
Note: it will be wrong to assume that fixed costs never change. Certain fixed costs are pretty unaffected to the production volume but certain fixed costs can increase in steps depending on the level of output. For example, if the production volume increases significantly, a company may have to hire new administrative personnel or lease new factory space to manage the higher production volume.
PRODUCT AND PERIOD COSTS
Product costs are costs which are part of the production process- they are included in the inventory costs, and at the end, in the Cost of Goods Sold in the Profit and Loss statement. Landed cost of raw materials, raw material storage and handling costs, labour costs associated with the production process etc. are product costs.
Period costs are costs which cannot be traced to the production process but with the time period. These costs are required to keep the business running. Examples of such costs are rent, salaries of employees who are not part of the production process, management cost etc. Most of these costs are fixed in nature i.e. they do not increase or decrease with output volume to a certain extent.
CAPITAL AND REVENUE COSTS
The idea between capital and revenue costs is whether the benefit of the cost is received in one accounting period or multiple.
If a company buys a machine which will be used for years in the production process, it does not make sense to consider the cost of the machine in one year. Rather the cost of the machine is capitalised and depreciated over several years. How long the cost of the machine can be depreciated and how the depreciation can be calculated depends on relevant tax and accounting laws.
Benefits of costs such as rent, electricity bills and salaries etc. cannot be justified to be creating benefits for more than one period. Such costs are thus expensed on one financial period.
What costs can be capitalised and which ones cannot depend on the accounting laws followed.
It should take 2-3 weeks if they do not find any issue with the documents. They will call you in case they need any clarification (which could be related to your tax documents if I remember). I would recommend that you track the application package and check with the SEBI local office about the progress a few days after the delivery of the application package to them. But, avoid being too pushy.
Link for SEBI Contact
Analysts will often start to analyse the economics of a business from the profit and loss Statement (also called an income statement). For entrepreneurs also profit and loss statement can be helpful in analysing operational efficiency.
A word of caution though – for an early stage company the operations are not stable at all. The operations often go through a lot of changes as the entrepreneur tries to find a market fit often with a lot of experimentations. Also, due to lower negotiating power, an early-stage company often have to extend discounts for customer acquisition. Due to all these, the profit and loss statement will not reflect the true economics of the business for an early stage company.
Let us discuss some important factors related to profit and loss statements.
CASH AND NON-CASH EXPENSES
An important step for an entrepreneur is to separate the cash-expenses from the non-cash expenses. Inventory cost, labour, SG&A, interest, income tax etc. involve cash-flows whereas depreciation, amortisation, stock-based compensation etc. do not involve any cash-flow.
This is important to analyse the trend in the economics of the business without getting distracted by the accounting entries for non-cash expenses.
Note: Even though the non-cash expenses can be ignored for short term decision making, they cannot be ignored in the long term. For example, depreciation reflects the cost associated with usage of plants and machinery. It is a reality that without the use of capital assets, the revenue could not be generated. Though the calculation of non-cash expenses depends on the accounting rules which may not completely reflect the real cost, entrepreneurs need to be aware that the capital assets will need to be maintained and replaced when necessary and allocate cash accordingly.
FIXED AND VARIABLE COSTS
Variable costs are the costs which vary with the production volume and fixed costs do not depend on the production volume. Example of variable costs are raw material, direct labour, etc. whereas renting expenses, administrative expenses etc. are examples of fixed costs.
One way to look at it is that to register any profit, the business needs to have net revenue more than the fixed costs. For an early stage company with unstable revenue or companies in cyclical industries, keeping the fixed cost low is an absolute priority in designing the business model.
At the outset, it may seem that income taxes are very straight forward, you just calculate the tax and pay – right? Unfortunately, things are not that simple. A complication arises due to the difference between the accounting or book income and the taxable income.
According to AS 22, accounting income (loss) “is the net profit or loss for a period, as reported in the statement of profit and loss, before deducting income tax expense or adding income tax saving”, whereas taxable income (tax loss) “is the amount of the income (loss) for a period, determined in accordance with the tax laws, based upon which income tax payable (recoverable) is determined”.
The difference between the accounting income (loss) and taxable income (loss) arises mainly from the differences between accounting norms and the income tax laws. Some of these differences are reversible in future accounting periods and some of them are not. The reversible differences are called 'timing differences' and the non-reversible are called 'permanent differences'.
Current tax is the amount determined to be payable or recoverable in the relevant period calculated based on the tax laws. A deferred tax which can be an asset or a liability which arises due to the aforementioned difference between accounting income (loss) and taxable income (loss) but only for the reversible part i.e. timing differences.
Any excess payment of income tax as per the tax laws which can be revered is recorded a 'deferred tax asset' on the balance sheet of the company and can be used to reduce the future tax burden. Similarly, any shortfall in the tax payment creates 'deferred tax liability' which the company needs to pay in the future.
The point is that the income taxes may not be straightforward and may need special attention of the entrepreneur.
As per my knowledge, the SEBI regulation does not say anything in this regards. That being said, there are many norms regarding compensation, supervision and disclosure which you need to follow. These norms become especially important when you are working for an investment firm or merchant banking firm.
Please make note of the norms - https://www.sebi.gov.in/sebi_data/commondocs/RESEARCHANALYSTS-regulations_p.pdf
So, now we have covered the cash flow statement, we understand the cash movements due to operating, investing and financial activities. Now, let us move to the Balance Sheet.
The balance sheet, which also referred to as 'Statement of Financial Position', gives you an idea about what the company owns and how it financed them.
The balance sheet is divided into three parts – Assets, Liabilities and Equity which are related as below
ASSETS = LIABILITIES + EQUITY
Assets are something which is either cash or can generate positive cash flow in the future.
An asset which is either in cash form or can be converted to cash quickly (such as accounts receivable, short term investments, inventories) – are called Current Assets. An asset which takes longer to liquidate is called Non-Current Asset which includes long term investments, Fixed Assets (plants and machinery) and Goodwill.
The value of the non-current assets is generally calculated based on the cost of acquisition adjusted for the depreciation calculated using prevailing accounting rules.
Note: Any entrepreneur can see the problem here. The value of an asset for a going concern is not dependent on the procurement cost but the economic value it can create. Consider that business bought two similar (but not identical) machines at the same time for the same cost. They produce similar parts with a slight difference. Given both machines are similar, the depreciated value for the both will be same (or very similar) say after two years if calculated the written down value method which is prevalent in India or straight-line method.
Now, consider for some reason, the part produced by the first machine is highly popular and the utilisation of the machine is very hight. Whereas, the second machine is rarely used. These trends are not expected to change in the foreseeable future.
Are both the machines of the same value?
From an economic consideration, the first machine is much more valuable because the expected cash-flow it generates in future is much higher than the second one.
Even the liquidation value of the assets are not expected to match the book value. The point is that the value of an asset depends on the expected economic benefit irrespective of what the book value is.
Liabilities tell you about the debt issued by the company – in form of financial debt such as bank loans, bonds & debentures issued, commercial papers issued etc. or operational debt in the form of accounts payable or unearned revenue.
Practically, this section tells you about the contractually obligated future cash outflows with some ideas about the expected timeline. The contractual cash outflows which are expected to happen in the current financial year are grouped together as the current liabilities and the rest in non-current liabilities.
As mentioned, debt is contractual and missing debt payments have significant implication for your company. Depending on debt contract creditors can take hold of pledged assets, start legal action or, in extreme cases, force the liquidation of the company.
So, as an entrepreneur, your priority is to arrange cash for the debt payments in a timely fashion because default can put your business at risk.
This part of the Balance Sheet, also known as Net-Worth, shows the ownership interest or capital invested in the business. The Equity value (book value) shows a theoretical value which the shareholders (also knows as owners and members) of the company receive if the company is liquidated.
EQUITY = ASSETS – LIABLITIES
As per the definition by Companies Act 2013, the net-worth is defined as
“ the aggregate value of the paid-up share capital and all reserves created out of the profits and securities premium account, after deducting the aggregate value of the accumulated losses, deferred expenditure and miscellaneous expenditure not written off, as per the audited balance sheet, but does not include reserves created out of revaluation of assets, write-back of depreciation and amalgamation”
So, let us discuss some terms here
1. Paid-Up share capital
Share Capital is the amount that the company has raised by issuing shares. Do not confuse this with the market value of shares.
There are two types of Share Capital – Equity Share Capital for shares with voting rights and Preference Share Capital for the issuance of preference shares.
Paid-Up Share Capital means the amount the company has already received for the issuance of shares.
2. Securities premium account
If a company issues shares at a higher issue price than the par value, the excess amount acquired in reported in this account.
3. Retained earnings and accumulated loss
When a company makes a profit, part of the profit gets invested back in the company. Same way, if a company makes a loss, it is accumulated in a loss account. If the aggregate amount of income and losses from the inception is positive, it is called retained earnings and a negative value is called accumulated loss or accumulated deficit.
For an entrepreneur, retained earnings or the accumulated losses are an important indication for raising of outside capital. A company which has been profitable and has increasing retained earnings may not need to raise equity capital. The accumulated deficit, which is often experienced by early-stage companies, is not necessarily a bad thing as long as the company is successfully implementing its strategy – product development and customer acquisition. But, it gives an indication about the future capital requirements.
I personally do not think that SEBI has the resources to audit registered address and office space for every registration. That being said, the Certificate of Registration will be sent to the address you mention as the registered address. Audit of the registered address is less likely for an individual applicant than a body corporate.
The office may not be anything grand but must be a legit address which can be easily reached by the postal system.
“Business runs on a cash basis, reported on accrual basis”
Many resources on financial accounting will start with the income statement (also known as profit and loss statement). But, as we discussed in the last post (link below) that for an entrepreneur, understanding cashflows is much more important than calculating profit.
Especially for a startup founder, a healthy profit and loss statement is what to strive for but business is managed based on cash-flows statement and the balance sheet (will be discussed in the next post).
WHAT DOES A CASH-FLOW STATEMENT SHOW?
A cash-flow statement shows you where the cash is coming from and where it is going. Cash coming into the companies account(s) is considered as positive cash flow and cash coming out of the business is considered as negative cash flow.
SOURCES OF CASH FLOWS
The cash-flow statement is divided into three parts based on sources of positive and negative cash flows. The sum of these three parts gives the aggregate change in the cash position of the company.
Note: I am going to avoid formulas here. For an entrepreneur, the challenge is to balance the cash flows, not calculating them.
1. Cashflow from Operating activities (CFO)
This part of the statement gives you an idea of whether your operations are generating cash or burning cash. For a startup, CFO is often negative and that is not a big concern as long as the company is building a strong foundation for sustainable operating cash flows in the future i.e. creating a loyal customer base and a competitive moat to defend the strategic position.
Revenue is a positive CFO whereas money spent to buy raw materials, pay salaries, pay for consumables and pay income tax payment are negative CFO.
2. Cash flow from investing activities (CFI)
So, what are the investments for a company? A company can invest in plant and machinery or buy securities of other companies (which can be as short term investment to acquisition of the company).
Acquisition of such long term assets means negative cash flow from investing activities i.e. negative CFI. A company may decide to divest some plants or machinery or sell securities of other companies. These divestitures will bring in cash and will be considered as positive CFI.
3. Cash flow from financing activities (CFF)
Buying plants and machinery costs money. For a matured business there is (hopefully) enough cash flow generated from the operating activities to support the acquisition and maintenance of plants and machinery required. For a new business, this is not the case and will require money for the capital expenses as well as support a cash-burning operation. Also, in a growing business, you need cash more than that is generated by the operations to support the growth.
This capital can be raised as equity (i.e. ownership in the company) or debt (contractual obligation to pay back).
A positive CFF involves the issuance of equity/ debt and receiving cash in return. A negative CFF involves making repayment of debt or buying back equity.
Note: The treatment of interest and dividends require special attention.
As per section 31 of Ind AS 7, interest paid is to be considered as a negative CFO in case of a financial institution but considered a negative CFF for other entities. Interest received is considered a positive CFO for the financial institution but a considered positive CFI for other entities.
Dividends received are considered positive CFO for financial institutions but considered positive CFI for other entities. Dividends paid are considered as negative CFF for all entities.
This series is primarily for entrepreneurs, especially for people who are just starting up or thinking of starting a company. I know that there are various resources available for financial accounting. Unfortunately, most such resources assume that the reader is going to become an analyst or an accountant. There is some fundamental difference between how an analyst looks at finances and an entrepreneur looks at finances.
The difference lies in the goals of an analyst, an accountant and an entrepreneur. An analyst’s goal is primarily to value the business so that he can take advantage of any wrong valuation by the market, an accountant's goal is to report the finances in a way that follows the prevailing regulations but an entrepreneur's goal is to run, grow and often, simply survive the business. Looking at the finances from the lenses of an analyst or an accountant can lead to decisions detrimental to business.
The primary reason can be described as an adage:
“Business runs on a cash basis, reported on accrual basis”
Now, we will understand the differences between cash and accrual basis accounting. The fundamental difference is how revenue and expenses are recorded.
Consider that you produce small appliances and sell to resellers. Now, on March 28th 2019 you invoiced items worth Rs. 1 crore to a large reseller. You provide a 15 day credit period to the reseller. According to this, you are expected to get the money from the reseller on 11-12th or April 2019.
In which year will you recognise this Rs. 1 crore revenue? In the financial year 2018-19 or 2019-20?
Note: In India, the financial years runs from 1st April to 31st March of next year.
According to the accrual basis accounting which is used for reporting, you will recognise the revenue the day invoice is created i.e. in the financial year 2018-19. But, the reality is that you did not receive the cash yet. There are many things which can happen after invoicing and before the cash payment. Things that can limit the amount of cash received or delay in the payment. For large corporations, who enjoy significant negotiating power over the resellers, this is not a problem but small companies especially startups may have a hard time collecting payments. The point is that for small companies there is some amount of uncertainty associated with the accounts receivable which accrual basis accounting fail to consider.
Now, in a cash basis accounting, revenue is recognised when cash is received. In the above-mentioned example, the revenue of Rs. 1 crore will be recognised when cash is received which is (hopefully) in the financial year 2019-20.
You can see that how an accrual basis revenue recognition distorts the picture for an entrepreneur. The reality is that you cannot pay your bills with the accounts receivable.
Consider another situation. You also dealt with a smaller reseller and negotiated an advance payment of 50% before the delivery of the items. Consider you got the advance on 28th March 2019 but delivered the items on 15th April 2019.
As per accrual accounting, the 50% advance will be recorded as unearned revenue and will appear on the balance sheet of the company as a liability.
But, the reality is that you can use that money for procuring raw materials and paying for labour to produce the products.
Consider that the facility you use to produce the appliances is rented. The owner of the property demanded one year’s rent in advance. So, you have to make payment for the next financial year on March 31st of this financial year.
As per the accrual accounting rules, you recognise the expenses when you actually consume the goods or services. So, the payment made on the 31st March 2019 is recorded as prepaid expenses and no expenses are registered in the profit and loss statement.
On a cash basis, you have already paid the amount in the financial year 2018-19 and expense are registered accordingly. This is also the business reality. You are out of that money which could have been used to pay salaries or buy tools.
Consider now, you have a good relationship with the property owner and he allowed you to pay rent quarterly after you use the property. For example, rent for April- May-June 2019 is payable on 30th June. What is your rent expenses as of 30th April 2019?
As per accrual basis accounting, you have to register rent for one month in the financial year 2019-20 although you have not departed with any cash. This will appear on the balance sheet as accounts payable which is a liability.
As per cash basis accounting, there is no expense yet because there is no cash outflow.
Note: Even though I am emphasising that for an entrepreneur tracking the cash is more important, balances in accounts payable and unearned revenue are important too. These show kinds of contractual liabilities which the entrepreneur should always be aware of.
The point of this post is not to imply that accrual basis accounting is not important but to make the entrepreneurs realise that tracking the cash is vital for your business.
If you are a startup founder and designing the business processes, you must consider the cash-flow implications. A highly profitable business (on the basis of accrual accounting) may run out of cash especially when it is growing fast.
Many young people face this problem. You get a job and earning money for the first time in your life. You think -
“Okay, let me enjoy my life for some time and then I will think about saving”
Fast-forward 2-3 years, you have set your lifestyle based on your earnings without caring about saving. Now, starting to save means compromising on lifestyle. So, you delay the saving. Now, you are the no-saving cycle which most urban youth face these days. This means you live lavishly at the beginning of the month and scramble at the month end.
You think of saving but somehow cannot live with the idea of not buying new clothes every month or not eating-out every weekend.
Note: I do not want to imply that there are no people who face real scarcity and struggle with money. This post is not about them but the people who are facing problems because they have fallen into the lifestyle trap.
UNDERSTAND WHAT YOU HAVE AND WHAT YOU NEED?
This is the first and most important step.
I strongly recommend not to analyse your spending habits before this. The problem with analysing existing spending habits before you understanding your needs is classification bias. Your whole focus will revolve around simply rearranging the spending habits rather than creating the spending and saving habits that you really need.
Make a list of clothes, shoes and accessories you need keeping in mind different occasions – formals for work, casuals for work, clothes different types of social events etc.
Understand what kind of foods you really should eat. Try to understand what kind of diet is suitable for you from your past experience.
Now, are there purchases that you were postponing – such as utensils, home appliances etc. ? This question may seem unrelated but it is not. How many times not having proper utensils become the excuse for ordering food online or eating out? How many times not having proper appliances become the excuse for paying someone to do the chores?
Now, match what you have with your needs. If you are honest in judging your needs – you will be surprised to see the disturbing gap between your needs and what you spend money on. You will find that you do not have enough clothes needed for different occasions but closet filled with clothes you are never going to wear. Same with shoes and accessories.
You will also realise that you pay a higher price for unhealthy food that ruins your health on a regular basis.
Above all, you will realise that you postponed the purchase of the things you really need like utensils and appliances which would have helped you create better spending habits.
GET RID OF THE THINGS YOU DO NOT NEED
Another difficult step. We love to acquire things but are fundamentally bad at getting rid of things. This is why it is important.
Separate the things you did not wear for the last 6 months or used in the last 6 months. Now, some of the items are such that they cannot be used frequently. You can decide them separately. Make a plan to get rid of all other stuff in this bucket- sell them if you can, donate them or simply throw them. Getting rid of them is important. Without getting rid of them you cannot make room for things you really need.
GET THE THINGS YOU REALLY NEED
Get the utensils and appliances you avoided to buy. The mental block people face while buying such things is that they cost more. Yes, they do but they are not expenses like eating at a restaurant, they are investments. The benefits of such purchases are long-term. Do not compare them with short term expenses.
It may not be possible to get all the things you really need at once. Make a list of them and look out for opportunities to acquire them at a discount etc. When you know what you need, you will be in a much better position to take advantage of the offers.
UNDERSTAND YOUR SPENDING TRIGGERS
Now, that you know what you need and have a plan to acquire, you need to avoid buying things that you do not need.
Like all impulses, impulsive buying also can be tied to some triggers. It is often seen that you spend more money at shops and buy more useless stuff when you are hungry. These triggers differ from one person to another. That is why you need to understand them yourself.
What causes your impulsive purchases – Loneliness? Anger?
Understanding the triggers may not be enough to eliminate impulsive purchases but will help you moderate such behaviour.
SET SAVING AND INVESTING GOALS
At this point, you have a much better understanding of your needs and habits. It is not time to set goals.
Do not rush to invest. It is quite likely that you do not have an emergency fund. Creating a large enough emergency fund (at least to cover 6 months of expenses) is the first goal you should set. The reason for first creating the emergency fund is to avoid relapse to old spending (and no-saving) habits when faced with a lack of liquidity and market volatility.
After you are done with the emergency fund, plan an investment portfolio suitable for you with the help of an advisor. Then slowly start building that portfolio. It is better to start with low volatility investments and slowly move to high volatility investments. It takes some time to get used to market volatility.