Month: December 2021

Feasibility Analysis refers to the process of examining the viability of a business idea. It means assessment of the potential and practical applicability of business idea. It is not just concerned with product or service but it is study of business viability as a whole. Feasibility analysis helps in identifying possibility, practicality, capacity and achievability of the project.

A prospective entrepreneur having creative and innovative idea must conduct feasibility analysis. It may not only add vitality to the viability of the underlying business proposition but also add vision to the business opportunity.

The following points equips an entrepreneur to decide if he should continue with the existing business idea or not:

• Is this business possible?
• Is this business practicable?
• Probability of success of business in future?
• Do I have access to all the resources required to start the business?

Feasibility analysis helps to critically analyze the business concept in detail. It requires use of both primary as well as secondary data.

Primary data can be collected from potential customers, industry experts etc. while secondary data can be collected through previous studies (if any), published sources, reports and feedback taken by other firms.

Need for Feasibility Analysis

• Feasibility analysis helps in providing guidelines for preparing business plan.
• Through feasibility study, Shortcomings/gaps if any can be detected and measures can be taken to resolve them.
• It helps in understanding the viability of the concept or business idea.
• It boosts up the confidence level of an entrepreneur w.r.t the business idea.
• It reduces the chances of business failure.
• It apprises entrepreneur about the risk involved.
• It Saves an entrepreneur from potential business loss and instills the prospects of success driven by hard work and risk taking capability.
• It also ropes in the confidence of potential investors.

Elements of Feasibility Analysis

Feasibility analysis includes study of various aspects of a business. It includes identifying product viability, technical feasibility and commercial feasibility.

Following are some of the important aspects that should be considered by an entrepreneur while conducting a feasibility analysis:

1. Product/Service Feasibility Analysis – Give Example:

It includes studying various aspects of product/service to be provided to customers. The main aspect to be examined here is testing the desirability and demand for product/service.

In order to test the desirability, one needs to examine following factors:

• What excites consumer about the product. What attributes makes him desire a product? Is it look of the product, is it the fragrance, do users provide importance to size and shape of the product (e.g. soaps).
• What need does the product satisfy?
• Does it fill a gap in market?
• Does it solve customer’s problem?

1. Not only these, it also includes the study of right time to introduce a product? Is there any particular occasion when people buy/try new product e.g. during the time of Diwali, Wedding Season etc. For example, during wedding season there is not only wide range of Indian clothes available in the market but there is also increase in related products like ornaments, footwear’s etc.

So, in order to test desirability and demand for the product, concept testing is done at this stage. Under this, description about product/service is mentioned and shared with potential customers, industry experts to solicit their responses. Their feedback on the same, provides insights about the viability of a product. It provides answers to questions like preferences/dislikes about the product, suggestions that can be incorporated to improve the utility of the product.

Given the volatile nature of the market, these days forecasting the demand for the product is not an easy task. Therefore start-ups can go for “Buying Intention Survey”. It helps entrepreneurs identify/ estimate the demand for a product in the market in future.

An entrepreneur may use questionnaire for this and distribute it among targeted markets. It gives them an indication about intention of customers to buy the product. Any modifications required in the product may be brought to the notice of the entrepreneur at this stage. It improves chances of successfully launching the product in the market.

2. Industry Analysis/Target Market Accessibility (Primary Search, Secondary Search):

Industry refers to groups of firms producing similar or substitute products/services.

An Entrepreneur should conduct feasibility analysis to find, industry attractiveness for the product. Various parameters can be used to study an industry like demographic characteristics of the target group, growth pattern in industry, number of firms competing against each other, profit margins, entry barriers in the industry etc.

Industry is considered attractive enough if profit margins are high, number of competitors are low and firm’s life cycle is in initial stages. This gives lot of scope for the firm to venture in the industry and innovate.

3. Technical Feasibility/Concept Test:

Technical feasibility is study of most appropriate technology to be adopted by business to transform business idea into easily marketable product. Under this, factors like technology to be used, production process involved, type of raw materials needed, ideal size of plant to be installed and equipments required are assessed.

Also factors like manpower requirement, funds needed to support use of latest technologies, cost involved in developing or buyout along with implementation, are judged for success of business.

4. Commercial Feasibility/Business Concept:

Commercial viability is the study of viability of business idea on commercial scale. It is possible to develop environmentally sustainable as well as useful products, yet such products may not be commercially appropriate. Therefore, it is imperative to conduct commercial feasibility test before taking the final decision to commence the production of a product.

A commercial feasibility facilitates an entrepreneur to identify following relevant factors:

• Manufacturing cost of production over short run and long run.
• Anticipating demand for product in near future and in long run.
• Competition level in the market.

Higher cost of production, intense competition level and inefficiency in operations can pose serious threats for firm in long run. One should either be able to fight these challenges to survive or should scrap the project at its planning stage only to avoid wastage of time, resources, manpower and capital.

5. Financial Feasibility:

Assessing financial feasibility of the product involves study of various costs aspects related with carrying of the project.

Under financial feasibility firm identifies following factors:

• Cost of the Project-Fund Required to Start Sustain Initial Losses:

Cost of project primarily includes capital budgeting expenditure on acquisition of capital assets like land and building, plant and machinery, furniture and fixture and other long term revenue yielding assets. It is a long term commitment of substantial amount therefore decisions for investment in these types of assets should be taken carefully. Investments in long term assets are irreversible in nature and expose the firm to substantial risks.

• Working Capital:

Estimation of Working capital requirements should be done with utmost care as both over investments as well as under investments in working capital can hamper routine nature activities to great extent. Having insufficient working capital will lead to liquidity crunch and will stall the business activities while excessive investments in working capital will block the funds that will undermine the profitability.

• Break Even Analysis:

Break-even level is that level of activity at which a firm is able to meet all the variable costs out of its revenue. Identifying the possible sales volumes at which break-even level will be achieved is important for working of business, as it indicates the stage till which firm will continue to make losses. Break-even level will give an idea about resources and time required to reach that particular level of activity,

• Projected Income Statements:

Finance is the backbone of any business. Future sales are projected and revenue charts are prepared to assess the inflow and outflow of funds in the business. Projected income and expenditure statements reflect the magnitude of gap between the income and expenditure so that the difference between the two can be bridged by arranging for funds or deploying excess funds in lucrative avenues.

Debt financing occurs when a firm raises money for working capital or capital expenditures by selling debt instruments to individuals and/or institutional investors. In return for lending the money, the individuals or institutions become creditors and receive a promise that the principal and interest on the debt will be repaid. The other way to raise capital in debt markets is to issue shares of stock in a public offering; this is called equity financing.

A company can choose debt financing, which entails selling fixed income products, such as bonds, bills, or notes, to investors to obtain the capital needed to grow and expand its operations. When a company issues a bond, the investors that purchase the bond are lenders who are either retail or institutional investors that provide the company with debt financing. The amount of the investment loan also known as the principal must be paid back at some agreed date in the future. If the company goes bankrupt, lenders have a higher claim on any liquidated assets than shareholders.

Cost of Debt

A firm’s capital structure is made up of equity and debt. The cost of equity is the dividend payments to shareholders, and the cost of debt is the interest payment to bondholders. When a company issues debt, not only does it promise to repay the principal amount, it also promises to compensate its bondholders by making interest payments, known as coupon payments, to them annually. The interest rate paid on these debt instruments represents the cost of borrowing to the issuer.

The sum of the cost of equity financing and debt financing is a company’s cost of capital. The cost of capital represents the minimum return that a company must earn on its capital to satisfy its shareholders, creditors, and other providers of capital. A company’s investment decisions relating to new projects and operations should always generate returns greater than the cost of capital. If a company’s returns on its capital expenditures are below its cost of capital, the firm is not generating positive earnings for its investors. In this case, the company may need to re-evaluate and re-balance its capital structure.

The formula for the cost of debt financing is:

KD = Interest Expense x (1 – Tax Rate)

where:

KD = cost of debt

Since the interest on the debt is tax-deductible in most cases, the interest expense is calculated on an after-tax basis to make it more comparable to the cost of equity as earnings on stocks are taxed.

Debt Financing Options

Bond issues

Another form of debt financing is bond issues. A traditional bond certificate includes a principal value, a term by which repayment must be completed, and an interest rate. Individuals or entities that purchase the bond then become creditors by loaning money to the business.

Bank loan

A common form of debt financing is a bank loan. Banks will often assess the individual financial situation of each company and offer loan sizes and interest rates accordingly.

Family and credit card loans

Other means of debt financing include taking loans from family and friends and borrowing through a credit card. They are common with start-ups and small businesses.

Debt Financing Over the Short-Term

Businesses use short-term debt financing to fund their working capital for day-to-day operations. It can include paying wages, buying inventory, or costs incurred for supplies and maintenance. The scheduled repayment for the loans is usually within a year.

A common type of short-term financing is a line of credit, which is secured with collateral. It is typically used with businesses struggling to keep a positive cash flow (expenses are higher than current revenues), such as start-ups.

Debt Financing Over the Long-Term

Businesses seek long-term debt financing to purchase assets, such as buildings, equipment, and machinery. The assets that will be purchased are usually also used to secure the loan as collateral. The scheduled repayment for the loans is usually up to 10 years, with fixed interest rates and predictable monthly payments.

Advantages of Debt Financing

Tax-deductible interest payments

Another benefit of debt financing is that the interest paid is tax-deductible. It decreases the company’s tax obligations. Furthermore, the principal payment and interest expense are fixed and known, assuming the loan is paid back at a constant rate. It allows for accurate forecasting, which makes budgeting and financial planning easier.

Preserve company ownership

The main reason that companies choose to finance through debt rather than equity is to preserve company ownership. In equity financing, such as selling common and preferred shares, the investor retains an equity position in the business. The investor then gains shareholder voting rights, and business owners dilute their ownership.

Debt capital is provided by a lender, who is only entitled to their repayment of capital plus interest. Hence, business owners are able to retain maximum ownership of their company and end obligations to the lender once the debt is paid off.

Disadvantages of Debt Financing

Adverse impact on credit ratings

If borrowers lack a solid plan to pay back their debt, they face the consequences. Late or skipped payments will negatively affect their credit ratings, making it more difficult to borrow money in the future.

The need for regular income

The repayment of debt can become a struggle for some business owners. They need to ensure the business generates enough income to pay for regular installments of principal and interest.

Many lending institutions also require assets of the business to be posted as collateral for the loan, which can be seized if the business is unable to make certain payments.

Potential bankruptcy

Agreeing to provide collateral to the lender puts their business assets at risk, and sometimes even their personal assets. Above all, they risk potential bankruptcy. If the business should fail, the debt must still be repaid.

Equity finance is generally the issue of new shares in exchange for a cash investment. Your business receives the money it needs and the investor will own a share in your company. This means the investor will benefit from the success of your business.

The most common types of equity investors include:

• Angel investors and angel networks
• Friends and family
• The crowd (through crowdfunding platforms)
• Government funds
• Private equity funds
• Venture capitalists
• Corporates (directly or through venturing arms)

Major Sources of Equity Financing

When a company is still private, equity financing can be raised from angel investors, crowdfunding platforms, venture capital firms, or corporate investors. Ultimately, shares can be sold to the public in the form of an IPO.

1. Angel investors

Angel investors are wealthy individuals who purchase stakes in businesses that they believe possess the potential to generate higher returns in the future. The individuals usually bring their business skills, experience, and connections to the table, which helps the company in the long term.

2. Crowdfunding platforms

Crowdfunding platforms allow for a number of people in the public to invest in the company in small amounts. Members of the public decide to invest in the companies because they believe in their ideas and hope to earn their money back with returns in the future. The contributions from the public are summed up to reach a target total.

3. Venture capital firms

Venture capital firms are a group of investors who invest in businesses they think will grow at a rapid pace and will appear on stock exchanges in the future. They invest a larger sum of money into businesses and receive a larger stake in the company compared to angel investors. The method is also referred to as private equity financing.

4. Corporate investors

Corporate investors are large companies that invest in private companies to provide them with the necessary funding. The investment is usually created to establish a strategic partnership between the two businesses.

5. Initial public offerings (IPOs)

Companies that are more well-established can raise funding with an initial public offering (IPO). The IPO allows companies to raise funds by offering its shares to the public for trading in the capital markets.

Advantages of Equity Financing

Access to business contacts, management expertise, and other sources of capital

Equity financing also provides certain advantages to company management. Some investors wish to be involved in company operations and are personally motivated to contribute to a company’s growth.

Their successful backgrounds allow them to provide invaluable assistance in the form of business contacts, management expertise, and access to other sources of capital. Many angel investors or venture capitalists will assist companies in this manner. It is crucial in the startup period of a company.

Alternative funding source

The main advantage of equity financing is that it offers companies an alternative funding source to debt. Startups that may not qualify for large bank loans can acquire funding from angel investors, venture capitalists, or crowdfunding platforms to cover their costs. In this case, equity financing is viewed as less risky than debt financing because the company does not have to pay back its shareholders.

Investors typically focus on the long term without expecting an immediate return on their investment. It allows the company to reinvest the cash flow from its operations to grow the business rather than focusing on debt repayment and interest.

Disadvantages of Equity Financing

Lack of tax shields

Compared to debt, equity investments offer no tax shield. Dividends distributed to shareholders are not a tax-deductible expense, whereas interest payments are eligible for tax benefits. It adds to the cost of equity financing.

In the long term, equity financing is considered to be a more costly form of financing than debt. It is because investors require a higher rate of return than lenders. Investors incur a high risk when funding a company, and therefore expect a higher return.

Dilution of ownership and operational control

The main disadvantage to equity financing is that company owners must give up a portion of their ownership and dilute their control. If the company becomes profitable and successful in the future, a certain percentage of company profits must also be given to shareholders in the form of dividends.

Many venture capitalists request an equity stake of 30%-50%, especially for startups that lack a strong financial background. Many company founders and owners are unwilling to dilute such an amount of their corporate power, which limits their options for equity financing.

Tasks of a Professional Manager

Specialization in every field, technological advancement, globalization of business results into appointment of qualified managers. They can be called as professional managers.

A professional manager is an expert, trained and experienced enough to adeptly manage any type of organization be it a manufacturing house, a service organization, a hospital or a government agency. Professional managers:

• Are objective, focussed and performance oriented.
• Help in meeting competitive challenges of business.
• Are creative and dynamic.
• Follow management practices based on world wide experiences and information.
• Apply theories of management to solve emerging organizational problems.

Providing direction to the firm: The first task, envisioning goals, is one of the tasks that should never be delegated. This is the ability to define overarching goals that serve to unify people and focus energies. It’s about effectively declaring what’s possible for the team to achieve and compelling them to accomplish more than they ever thought possible.

Managing survival and growth: Ensuring survival of the firm is a critical task of a manager. The manager must also seek growth. Two sets of factors impinge upon the firm’s survival and growth. The first is the set of factors which are internal to the firm and are largely controllable. These internal factors are choice of technology, efficiency of labour, competence of managerial staff, company image, financial resources, etc. The second set of factors are external to the firm like government policy, laws and regulations, changing customer tastes, attitudes and values, increasing competition, etc.

Maintaining firm’s efficiency: A manager has not only to perform and produce results, but to do so in the most efficient manner. The more output a manager can produce with the same input, the greater will be the profit.

Meeting the competition challenge: A manager must anticipate and prepare for the increasing competition. Competition is increasing in terms of more producers, products, better quality, etc.

Innovation: Innovation is finding new, different and better ways of doing existing tasks. To plan and manage for innovation is an on-going task of a manager. The manager must maintain close contact and relation with customers. Keeping track of competitor’s activities and moves can also be a source of innovation, as can improvements in technology.

Renewal: Managers are responsible for fostering the process of renewal. Renewing has to do with providing new processes and resources. The practices and strategy that got you where you are today may be inadequate for the challenges and opportunities you face tomorrow.

Building Human Organization: Man is by far the most critical resource of an organization. A good worker is a valuable asset to any company. Every manager must constantly look out for people with potential and attract them to join the company.

Leadership: Organizational success is determined by the quality of leadership that is exhibited. “A leader can be a manager, but a manager is not necessarily a leader,” says Gemmy Allen (1998). Leadership is the power of persuasion of one person over others to inspire actions towards achieving the goals of the company. Those in the leadership role must be able to influence/motivate workers to an elevated goal and direct themselves to the duties or responsibilities assigned during the planning process. Leadership involves the interpersonal characteristic of a manager’s position that includes communication and close contact with team members. The only way a manager can be acknowledged as a leader is by continually demonstrating his abilities.

Change management: A manager has to perform the task of a change agent. It’s the managers task to ensure that the change is introduced and incorporated in a smooth manner with the least disturbance and resistance.

Selection Information technology: Today’s managers are faced with a bewildering array of information technology choices that promise to change the way work gets done. Computers, the Internet, intranets, telecommunications, and a seemingly infinite range of software applications confront the modern manager with the challenge of using the best technology.

Role of a manager

Different managers perform at different levels and require different skills. To meet the demands of performing their functions, managers assume multiple roles. A role is an organized set of behaviors. Henry Mintzberg has identified ten roles common to the work of all managers. The ten roles are divided into three groups: interpersonal, informational, and decisional.

Interpersonal Roles

The three interpersonal roles are primarily concerned with interpersonal relationships. By assuming these roles, the manager also can perform informational roles, which, in turn, lead directly to the performance of decisional roles.

In the figurehead role, the manager represents the organization in all matters of formality. Some examples of the figurehead role include a college dean who hands out diplomas at graduation, a shop supervisor who attends the wedding of a subordinate’s daughter, and the CEO who cuts the ribbon on a new office building.

The leader role defines the relationships between the manger and employees. It involves directing and coordinating the activities of subordinates. It may involve; hiring, training, motivating, and encouraging employees. First-line managers, in particular, feel that effectiveness in this role is essential for successful job performance.

The liaison role involves managers in interpersonal relationships outside of their area of authority. This role may involve contacts both inside and outside the organization. The top-level manager uses the liaison role to gain favors and information, while the supervisor uses it to maintain the routine flow of work.

Informational Roles

Receiving and communicating information are perhaps the most important aspects of a manager’s job. There are three informational roles in which managers gather and disseminate information.

As monitor, the manager constantly looks for information that can be used to advantage. The information gathered might be competitive moves that could influence the entire organization or the knowledge of whom to call if the usual supplier of an important part cannot fill an order.

In the disseminator role, the manager distributes to subordinates important information that would otherwise be inaccessible to them. Example: The president of a firm may learn during a lunch conversation that a large customer of the firm is on the verge of bankruptcy. Upon returning to the office, the president contacts the vice president of marketing, who in turn instructs the sales force not to sell anything on credit to the troubled company.

In the role of spokesperson, the manager disseminates the organization’s information into its environment. Thus, the top-level manager is seen as an industry expert, while the supervisor is seen as a unit or departmental expert.

Decisional Roles

According to Mintzberg, there are four decisional roles the manager adopts. In the role of entrepreneur, the manager tries to improve the unit. For example, when the manager receives a good idea, he or she launches a development project to make that idea a reality.

In the disturbance handler role, the manger deals with threats to the organization. Examples: An emergency room supervisor responds quickly to a local disaster, a plant supervisor reacts to a strike, etc.

The resource allocator role places a manager in the position of deciding who will get what resources. These resources include money, people, time, equipment, and information. This is one of the most critical decisional roles. Example: A college dean must decide which courses to offer next semester, based on available faculty.

Managers spend a great deal of their time as negotiators, because only they have the information and authority that negotiators require. The negotiations may concern work, performance, objectives, resources, or anything else influencing the unit. Examples: A company president works out a deal with a consulting firm; A front line supervisor may negotiate for new typewriters.

Skills of a Manager

A skill is the learnt capacity or talent to carry out pre-determined results often with the minimum outlay of time, energy, or both1. In other words, a skill is an ability or proficiency that a person possesses that permits him or her to perform a particular task.

Analytical Skills

These skills are the abilities to identify key factors and understand how they interrelate, and the roles they play in a situation. Analytical skills involve being able to think about how multiple complex variables interact, and to conceive of ways to make them act in desirable manner.

Technical Skills

Technical skill is the ability to use specific knowledge, techniques, and resources in performing tasks. Examples of technical skills are writing computer programs, completing accounting statements, analyzing marketing statistics, writing legal documents, or drafting a design for a new airfoil on an airplane. Technical skills are usually obtained through training programs that an organization may offer its managers or employees or may be obtained by way of a college degree. Indeed, many business schools throughout the country see their role as providing graduates with the technical skills necessary for them to be successful on the job.

Decision Making skills

These skills are present in the planning process. A manager’s effectiveness lies in making good and timely decisions and is greatly influenced by his or her analytical skills.

Digital Skills

These are important because using digital technology substantially increases a manager’s productivity. Computers can perform in minutes tasks in financial analysis, HRP, and other areas that otherwise take hours, even days to complete.

Human Skills

Human skill involves the ability to interact effectively with people. Managers interact and cooperate with employees. Human skills, therefore, relate to the individual’s expertise in interacting with others in a way that will enhance the successful completion of the task at hand.

Conceptual Skills

Conceptual skill is the ability to see the “big picture,” to recognize significant elements in a situation, and to understand the relationship among the elements. Examples of situations that require conceptual skills include the passage of laws that affect hiring patterns in an organization, a competitor’s change in marketing strategy, or the reorganization of one department which ultimately affects the activities of other departments in the organization.

Communications Skills

Effective communication is vital for effective managerial performance. The skill is critical to success in every field. Communication skills involve the ability to communicate in ways that other people understand, and to seek and use feedback from employees to ensure that one is understood.

Design Skills

It is the ability to solve problems in ways that will benefit the organization. To be effective, particularly at upper levels, mangers must be able to do more than see a problem. They must also be able to design a workable solution to the problem.

Goal setting involves the development of an action plan designed in order to motivate and guide a person or group toward a goal. Goals are more deliberate than desires and momentary intentions.

Goal-setting theory is a theory based on the idea that setting specific and measurable goals is more effective than setting unclear goals.

Therefore, setting goals means that a person has committed thought, emotion, and behavior towards attaining the goal. In doing so, the goal setter has established a desired future state which differs from their current state thus creating a mismatch which in turn spurs future actions. Goal setting can be guided by goal-setting criteria (or rules) such as SMART criteria. Goal setting is a major component of personal-development and management literature. Studies by Edwin A. Locke and his colleagues, most notably Gary Latham, have shown that more specific and ambitious goals lead to more performance improvement than easy or general goals. The goals should be specific, time constrained and difficult. Vague goals reduce limited attention resources; goals require realistic time restrictions, illogically short time limits, intensify the difficulty of the goal outside the intentional level and, disproportionate time limits are not encouraging.[4] Difficult goals should be set ideally at the 90th percentile of performance assuming that motivation and not ability is limiting attainment of that level of performance. As long as the person accepts the goal, has the ability to attain it, and does not have conflicting goals, there is a positive linear relationship between goal difficulty and task performance.

The theory of Locke and colleagues states that the simplest most direct motivational explanation of why some people perform better than others is because they have different performance goals. The essence of the theory is:

• Difficult specific goals lead to significantly higher performance than easy goals, no goals, or even the setting of an abstract goal such as urging people to do their best.
• Holding ability constant, and given that there is goal commitment, the higher the goal the higher the performance.
• Variables such as praise, feedback, or the participation of people in decision-making about the goal only influence behavior to the extent that they lead to the setting of and subsequent commitment to a specific difficult goal.

Principles of the Goal-setting theory

According to Locke’s goal-setting theory, there are five main principles of setting effective goals:

Challenge: Goals should be sufficiently challenging to keep employees engaged and focused while performing the tasks needed to reach each goal. Goals that are too tedious or easy have a demotivating effect and will, therefore, result in less achievement satisfaction.

Clarity: Goals must be clear and specific. When employees understand project objectives and deadlines, there is much less risk for misunderstandings.

Commitment: Employees need to understand and support the goal they are being assigned from the beginning. If employees don’t feel committed to the goal, they are less likely to enjoy the process and ultimately achieve the goal.

Task Complexity: Goals should be broken down into smaller goals. Once each smaller goal is reached, a review should be performed to update the employee on the overall progress towards the larger goal.

Feedback: Feedback is an important component of the goal-setting theory. Regular feedback should be provided throughout the goal-achieving process to ensure tasks stay on track to reach the goal.

Advantages of Goal Setting Theory

• Goal setting leads to better performance by increasing motivation and efforts, but also through increasing and improving the feedback quality.
• Goal setting theory is a technique used to raise incentives for employees to complete work quickly and effectively.

Limitations of Goal Setting Theory

• Very difficult and complex goals stimulate riskier behaviour.
• At times, the organizational goals are in conflict with the managerial goals. Goal conflict has a detrimental effect on the performance if it motivates incompatible action drift.
• If the employee lacks skills and competencies to perform actions essential for goal, then the goal-setting can fail and lead to undermining of performance.
• There is no evidence to prove that goal-setting improves job satisfaction.

Inflation accounting comprises a range of accounting models designed to correct problems arising from historical cost accounting in the presence of high inflation and hyperinflation. For example, in countries experiencing hyperinflation the International Accounting Standards Board requires corporations to implement financial capital maintenance in units of constant purchasing power in terms of the monthly published Consumer Price Index. This does not result in capital maintenance in units of constant purchasing power since that can only be achieved in terms of a daily index.

Inflation Accounting Methods

There are two main methods used as inflationary accounting methods. The first is current purchasing power (CCP), and the second, being current cost accounting (CCA).

The current purchasing power method involves adjusting the financial statements and associated numbers to the current price. For non-monetary items, this is done by taking the historical figures and applying a specific conversion rate based on a price index.

The conversion rate is found by dividing the index price at the end of the period by the index price at the beginning of the period. Monetary items are subject to a net gain or loss during adjustment.

The current cost accounting method takes the fair market value (FMV) instead of the historical cost. With this method, all monetary and non-monetary assets must be adjusted to their current values.

Current Purchasing Power (CPP)

Under the CPP method, monetary items and non-monetary items are separated. The accounting adjustment for monetary items is subject to the recording of a net gain or loss. Non-monetary items (those that do not carry a fixed value) are updated into figures with a conversion factor equivalent to price index at the end of the period divided by price index at the date of transaction.

Current Cost Accounting (CCA)

The CCA approach values assets at their fair market value (FMV) rather than historical cost, the price incurred during the purchase of the fixed asset. Under the CCA, both monetary and non-monetary items are restated to current values.

The Inflation Accounting Process

The measurement of income from continuing operations on a current cost basis requires the accountant to complete the following steps:

• Measure the cost of goods sold as of the date sold, using either its current cost or lower recoverable amount, or when those resources are used on or at least committed to a designated contract.
• Measure depreciation, amortization, and depletion based on either the average current cost of the service potential of the underlying fixed assets or their lower recoverable amount during the usage period.