Tag: Business economics

Management Notes

Nidhi Company, Chit funds, RNBC

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Nidhi Company

A nidhi company is a type of company in the Indian non-banking finance sector, recognized under section 406 of the Companies Act, 2013. Their core business is borrowing and lending money between their members. They are also known as Permanent Fund, Benefit Funds, Mutual Benefit Funds and Mutual Benefit Company. They are regulated by Ministry of Corporate Affairs, which is also empowered to issue directions to them in matters relating to their deposit acceptance activities. However, in recognition of the fact that these companies deal with their shareholder-members only. Nidhi means a company which has been incorporated with the object of developing the habit of thrift and reserve funds amongst its members and also receiving deposits and lending to its members only for their mutual benefit.

Nidhi companies existed even prior to the existence of companies Act 2013. The basic concept of nidhi is “Principle of Mutuality” These companies are more popular in South India, and 80% of Nidhi companies are located in Tamil Nadu.

Requirements for Nidhi Company

  • A Nidhi company to be incorporated under this Act shall be a Public Company;
  • It shall have a minimum paid up equity share capital of 5,00,000/-.
  • No preference shares shall be issued.
  • If preference shares had already been issued by a Nidhi Company before commencement of this Act, such preference shares are to be redeemed in accordance with the terms of issue of such shares.
  • The object of the company shall be cultivating the habit of thrift and savings amongst its members, receiving deposits from and lending to its members only for their mutual benefits.
  • It shall have the words ‘Nidhi Limited’ as part of its name

Functions of Nidhi company

  • The rules of funding in a Nidhi company is done through the contribution of its forming members.
  • Later that money is used to offer loans to its own members according to their needs at very reasonable rates.
  • The funds or deposits of a Nidhi company are limited when compared with other banks because they are only able to operate their as they will be working with specific fund base in a limited area.

The Central Government made ‘Nidhi Rules, 2014’ for the purpose of carrying out the objectives of ‘Nidhi’ companies. These rules shall be applicable to-

  • Every company which had been declared as a Nidhi or Mutual Benefits under Section 620A(1)of Companies Act, 1956;
  • Every company functioning on the lines of a Nidhi company or Mutual benefit society but has either not applied for or has applied for and is awaiting notification to be a Nidhi or Mutual Benefit Society under Section 620A(1)of Companies Act, 1956;
  • Every company incorporated as a Nidhi pursuant to the provisions of Section 406 of the Companies Act, 2013.

Chit funds

Chit fund is defined as per the Section 2(b) of the Chit Fund Act, 1982. According to this act; A chit fund is a type of rotating savings and agreement among different persons i.e. friends, relatives, neighbours and family members to subscribe a certain sum of money for a specified period of time. Chit funds are often microfinance organizations. Chit Funds are also known as the Chitty, Kuree, chit.

A chit fund is a type of rotating savings and credit association system practiced in Pakistan, India, Bangladesh, Sri Lanka and other Asian countries. Chit fund schemes may be organized by financial institutions, or informally among friends, relatives, or neighbours. In some variations of chit funds, the savings are for a specific purpose. Chit funds are often microfinance organizations.

Risk

Both organizers and subscribers in chit funds are exposed to credit risk because subscribers might default on their periodic payments. One analysis of data from two chit fund companies found that 35% of subscribers have defaulted at least once during their tenure at one of the companies and 24% of them have defaulted after winning an auction for the pot. Chit fund companies can sue defaulters in court but the procedure is time-consuming and is unlikely to produce a timely settlement. It’s up to the chit fund organizers to vet the credit-worthiness of subscribers. To reduce the risk of default, some organizers also require subscribers who win auctions to submit sureties for their future liabilities.

Since chit fund payments are not insured by the government, the system is a riskier method of saving than using a bank savings account.

Popular Chit Funds in India

Chit funds limit only to India. Normally we do not find chit funds in any other part of the world. Some of the most famous and successful chit fund houses are:

  • Mysore Sales International: Government of Karnataka
  • Kerala State Financial Enterprise (KSFE): Government of Kerala
  • Shriram Chits: Shriram Group
  • Margadarsi Chits: Ramoji Rao Group

RNBC

Residuary Non-Banking Company is a class of NBFC which is a company and has as its principal business the receiving of deposits, under any scheme or arrangement or in any other manner and not being investment, asset financing, loan company.

These companies are required to maintain investments as per directions of RBI, in addition to liquid assets. The functioning of these companies is different from those of NBFCs in terms of method of mobilisation of deposits and requirement of deployment of depositors’ funds. However, Prudential Norms Directions are applicable to these companies also.

  • They offer a rate of interest of not less than 5% per annum on term deposits and 3.5% on daily deposits both compounded annually.
  • They can’t accept deposits for a period less than 12 months and not more than 84 months.
  • They can’t offer any gifts or incentives to solicit deposits from public.
  • They can’t accept deposits repayable on demand, i.e., they cant open saving or current accounts.
Management Notes

IIBI

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Industrial Investment Bank of India Ltd. (IIBI): The Industrial Investment Bank of India Ltd. (IIBI) was formed by transforming the Industrial Reconstruction Bank of India (IRBI). It was set up by IDBI at the instance of the Government of India in April 1971 for rehabilitation of sick industrial companies. IRBI was incorporated under the Companies Act, 1956 and renamed as the Industrial Investment Bank of India Ltd. in March 1997. 

IIBI offered a wide range of products and services, including term loan assistance for project finance, short duration non-project asset-backed financing, working capital/other short-term.

It is a full-fledged all-purpose development bank with adequate operational flexibility and autonomy. After the reconstruction its focus has changed from rehabilitation finance to development banking.

Functions:

  • Short duration non-project asset backed financing working capital/ other short-term loans to companies.
  • Term-loan assistance for project finance.
  • Investments in Capital Market and Money market instruments.
  • Equity Subscription Asset Credit.
  • Equipment finance.
Management Notes

Unit Trust of India (UTI)

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UTI Mutual Fund was carved out of the erstwhile Unit Trust of India (UTI) as a Securities and Exchange Board of India (SEBI) registered mutual fund from 1 February 2003. The Unit Trust of India Act 1963 was repealed, paving way for the bifurcation of UTI into: Specified Undertaking of Unit Trust of India (SUUTI) and UTI Mutual Fund (UTIMF).

UTI Mutual Fund has been the pioneer for launching various schemes viz. UTI Unit Linked Insurance Plan (ULIP) with life and accident cover (Launched in 1971), UTI Mastershare (Launched in 1986), India’s first Offshore Fund, India fund (Launched in 1986), UTI Wealth Builder Fund, the first of its kind in the Indian mutual fund industry combining different asset classes i.e. equity and gold which are lowly correlated.

Functions of UTI:

  • To grant loans and advances.
  • To accept discount, purchase or sell bills of exchange, promissory note, bill of lading, warehouse receipt, documents of title to goods etc.,
  • To provide merchant banking and investment advisory service.
  • To extend portfolio management service to persons residing outside India.
  • To provide leasing and hire purchase business.
  • To buy or sell or deal in foreign exchange dealings.
  • To invest in any security floated by the Central Government, RBI or foreign bank.
  • To formulate unit scheme or insurance plan in association with or as agent of GIC.

Objectives:

(i) To enable them to share the benefits and prosperity of the industrial development in the country.

(ii) To encourage and pool the savings of the middle and low-income groups.

Advantages of Unit Trust:

  • There is a high degree of liquidity of investment as the units can be sold back to the trust at any time at prices fixed by trust.
  • The Unit-holders will be getting regular and good income, as 90 percent of its income will be distributed.
  • The investment is safe and the risk is spread over a wide range of securities.
  • Dividends up to Rs. 1,000 received by the individual are exempt from income-tax.

Management Notes

SIDCO

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‘Small Industries Development Corporations (‘SIDCO‘) are state-owned companies or agencies in the states of India which were established at various times under the policy of Government of India for the promotion of small scale industries.

Objectives of SIDCO

  • To provide infrastructure facilities like roads, drainage, electricity, water supply, etc. is one of the primary objectives of SIDCO.
  • The main objective of SIDCO is to stimulate the growth of industries in the small-scale sector.
  • To Promote industrial estates which will provide industrial sheds of different sizes with all basic infrastructure facilities.
  • To Promote skilled labor through the setting up of industrial training institutes.
  • To Provide technical assistance through training facilities to the entrepreneurs.

Functions of SIDCO

SIDCO promotes women entrepreneurs:

In addition to the above, in order to promote women entrepreneurs, a separate industrial estate for women has been set up at Tirumullaivoyal, near Chennai, where women entrepreneurs are trained in various fields of small scale industries.

SIDCO promotes skill development centres:

In an effort to supply skilled laborers to various small scale industries, skill development centres are being set up in various industrial estates which will be training workers in varied industrial activities and they will be trained in modern skill.

SIDCO set up Captive power plants:

In order to provide uninterrupted and good quality power supply, SIDCO has taken up a plan to set up captive power plants in major industrial estates. It is now planning to set up these plants in 10 industrial estates.

SIDCO provides Export marketing assistance:

To promote export marketing among the small scale industries, SIDCO has developed websites because of which it is able to display the products of the small scale industries in foreign markets and obtain export orders. Once an export order is obtained, the Common export manager of SIDCO will make arrangements for extending various services for export of the product.

SIDCO assists in Bills discounting:

When small scale units supply goods to government departments, there is a delay in receiving payments. In such a situation, the bills drawn on government departments will be discounted by SIDCO and upto 80% of the bill value is given to the supplier. This helps the SSI units in solving their working capital crisis.

SIDCO provides marketing assistance:

In order to provide an efficient marketing support to small scale industries, the corporation has taken up various schemes. In fact, the corporation participates in the tenders floated by the state government departments and also with the DGS & D (Director General of Supplies and Disposal). SIDCO makes advance payments for obtaining orders and distribute them among the various small scale units.

Management Notes

Meaning and Definition Market

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Market is meant a place where commodities are bought and sold at retail or wholesale prices. Thus, a market place is thought to be a place consisting of a number of big and small shops, stalls and even hawkers selling various types of goods.

(a) A market may be a region, which may be a district, state, country or even the whole world from which buyers and sellers are drawn and not any particular place where they assemble.

(b) The same price must rule for the same thing at the same time.

(c) There must be business intercourse among the dealers, i.e., buyers and sellers. They must be in touch with one another, so that they are aware of the prices offered or accepted by other buyers and sellers.

Features of Market:

  1. Buyers and Sellers:

To create a market for a commodity what we need is only a group of potential sellers and potential buyers. They must be present in the market of course at different places.

  1. One commodity:

In practical life, a market is understood as a place where commodities are bought and sold at retail or wholesale price, but in economics “Market” does not refer to a particular place as such but it refers to a market for a commodity or commodities i.e., a wheat market, a tea market or a gold market and so on.

  1. Area:

In economics, market does not refer only to a fixed location. It refers to the whole area or region of operation of demand and supply

  1. Perfect Competition:

In the market there must be the existence of perfect competition between buyers and sellers. But the opinion of modern economist is that in the market the situation of imperfect competition also exists, therefore, the existence of both is found.

  1. Sound Monetary System:

Sound monetary system should be prevalent in the market, it means money exchange system, if possible, be prevalent in the market.

  1. Business relationship between Buyers and Sellers:

For a market, there must exist perfect business relationship between buyers and sellers. They may not be physically present in the market, but the business relationship must be carried on.

  1. One Price:

One and only one price be in existence in the market which is possible only through perfect competition and not otherwise.

  1. Perfect Knowledge of the Market:

Buyers and sellers must have perfect knowledge of the market regarding the demand of the customers, regarding their habits, tastes, fashions etc.

Types of Markets

  • Physical Markets: Physical market is a set up where buyers can physically meet the sellers and purchase the desired merchandise from them in exchange of money. Shopping malls, department stores, retail stores are examples of physical markets.
  • Non-Physical Markets/Virtual markets: In such markets, buyers purchase goods and services through internet. In such a market the buyers and sellers do not meet or interact physically, instead the transaction is done through internet.
  • Auction Market: In an auction market the seller sells his goods to one who is the highest bidder.
  • Market for Intermediate Goods: Such markets sell raw materials (goods) required for the final production of other goods.
  • Black Market: A black market is a setup where illegal goods like drugs and weapons are sold.
  • Knowledge Market: Knowledge market is a setup which deals in the exchange of information and knowledge-based products.
  • Financial Market: Market dealing with the exchange of liquid assets (money) is called a financial market.
Management Notes

Brown marketing

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Color plays an important part in the psychology of marketing and branding and can influence people’s perception of a brand’s personality.3 It’s more important to pick a color that supports the personality of your brand than it is to try to instill certain feelings in potential customers since everyone has different experiences and opinions.

While there are generalities we can make about colors and what people associate with them, colors and our affinity toward them have a lot to do with our personalities, upbringing, environment, and experiences.

One recent study on how adults perceive color showed that more females than males chose brown as their overall favorite color. But it was still one of the three least favorite colors for both genders.

Some of the key characteristics associated with brown in color psychology include:

  • Feelings of warmth, comfort, and security. Brown is often described as natural, down-to-earth, and conventional, but brown can also be sophisticated.
  • A sense of strength and reliability. Brown is often seen as solid, much like the earth, and it’s a color often associated with resilience, dependability, security, and safety.
  • Feelings of loneliness, sadness, and isolation. In large quantities, it can seem vast, stark, and empty, like an enormous desert devoid of life.
  • Negative emotions. Like other dark colors, is associated with more negative emotions.
Management Notes

Reverse Marketing

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Reverse marketing is the concept of marketing in which the customer seeks the firm rather than marketers seeking the customer. Usually, this is done through traditional means of advertising, such as television advertisements, print magazine advertisements and online media. While traditional marketing mainly deals with the seller finding the right set of customers and targeting them, reverse marketing focuses on the customer approaching potential sellers who may be able to offer product.

Rather than actively promoting a specific brand, product or service, reverse marketing aims to encourage people to seek out a business, product or service of their own accord.

In other words, reverse marketing doesn’t exist to convince someone to buy something. Instead, it causes intrigue and attracts interest.

Leenders and Blenkhorn define Reverse Marketing as “an aggressive and imaginative approach to achieving supply objectives. The purchaser makes the initiative in making the proposal.

Aside from traditional methods of reverse marketing, this technique is also used in B2B markets. In this instance the buyer (business) will take the initiative to approach the supplier (manufacturer) with its needs. This tactic is often used by large companies in order to decrease redundancies in their supply chain and decrease costs. The concept of reverse marketing also corresponds with Supply Chain Management. The strategy of reversing roles in some cases, has been very successful. In 2001 Richard Plank and Deborah Francis published an article studying the impact reverse marketing has on the buyer-seller relationship.

Uses

Improve brand image

Companies that feature advertising on their companies’ principles, social responsibility and ethical profile create customer loyalty because customers believe they are not supporting a mass-producing socially reprobated conglomerate.

Build relationships with customers

Once the customer recognizes your brand or company as an authority, they do all the searching and find your product through all the help and advice you have offered them. This way through the relationship that was constructed over time, they develop confidence in your firm to offer them benefits and useful products or service.

Cuts out “hard sales” and abrasive tactics

Sales tactics push for the purchase of products designed to fix specific problems, but the attraction-marketing model enforces the building of relationships and ensures rapport so the customers’ needs are met.

Some of the points to keep in mind while crafting a Reverse Marketing campaign are:

  • Do a genuine evaluation of your business’s current image and your target consumer groups. Once you have understood this, try to understand what is important for your target consumer and what they value.
  • Once you have understood the above, tell them about your product or service.
  • Close the sale but not before you give your consumer something of value.
Management Notes

Virtual Marketing

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Virtual marketing is essentially just another name for digital marketing or viral marketing. All three of these terms simply mean marketing that is done in a virtual or digital space. It is marketing, without physical presence.

Virtual marketing is one of the most popular forms of marketing, rising in conjunction with the wide use of social media across the world.

Simply put, virtual marketing is a term used to describe online advertising. Common formats include email marketing, social media marketing, display advertising, blogs, and other digital formats.

Virtual marketing serves as a contrast to traditional advertising methods, such as print and broadcast. Because virtual marketing relies on clicks, impressions, hits, and other data, it can be easier to measure a conversion for a virtual advertisement rather than a print newspaper ad.

Virtual marketing is not necessarily limited to virtual businesses (e.g. Amazon.in), but it is possible to use virtual marketing exclusively, especially for an online business. Someone who sells jewelry on the shopping site Etsy, for example, probably wouldn’t place an advertisement in a local paper. Instead, she might use display ads on affiliate websites and a personal blog or a Pinterest account to promote those products.

Several companies, both small and large, rely on virtual marketing strategies to engage with users over the internet. Content marketing which includes the creation of blog posts, infographics, games, and other pieces helps businesses develop a more recognizable brand online. These methods are often paired with a social media campaign on platforms such as Facebook, Twitter, and Pinterest in order to drive traffic to a website or online store. Companies may also utilize email newsletters to keep customers updated on promotions and events.

Virtual, viral or digital marketing has many forms, but some of the most popular include content marketing, social media and pay-per-click (PPC) advertising.

Digital Marketing Categories

  • SEM (Search Engine Marketing)
  • SEO (Search Engine Optimisation)
  • PPC (Pay-per-click)
  • SMM (Social Media Marketing)
  • Content Marketing
  • Email Marketing
  • Influencer / Affiliate Marketing
  • Viral Marketing
  • Radio Advertising
  • Television Advertising
  • Mobile Advertising
Management Notes

Working Capital Management – Operating Cycle

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The operating cycle refers to the time period required for converting raw materials into finished goods, selling them, and finally collecting cash from customers. In simple words, it represents the circulation of working capital in the business from cash to inventory, inventory to sales, and sales back to cash. It shows how efficiently a firm utilizes its current assets. A shorter operating cycle indicates efficient working capital management, while a longer cycle means funds remain blocked in operations for a longer period.

Cash operating cycle = Inventory days + Receivable’s days – Payable’s days

Where:

Inventory Holding Period = Raw Material Period + WIP Period + Finished Goods Period
Receivables Collection Period = Time taken to collect cash from debtors

Stages of Operating Cycle

Stage 1. Purchase of Raw Materials

The operating cycle starts with the purchase of raw materials required for production. The firm buys materials either in cash or on credit from suppliers. These materials are stored in the warehouse as raw material inventory. Proper purchasing policy is important to avoid excess stock or shortage. Excess inventory blocks working capital and increases storage cost, while shortage interrupts production. Efficient purchasing and inventory control ensure smooth production and proper utilization of working capital.

Stage 2. Conversion into Work-in-Progress (WIP)

After purchase, raw materials enter the production process and become work-in-progress. At this stage, the business incurs manufacturing expenses such as labor cost, power, fuel, and factory overheads. Working capital is invested in partially completed goods until the production process is completed. The duration of this stage depends on the type of industry and production technology used. Efficient production planning and supervision reduce processing time and cost, thereby shortening the operating cycle.

Stage 3. Conversion into Finished Goods

When production is completed, work-in-progress is converted into finished goods. These finished goods are stored in warehouses until they are sold in the market. The firm incurs expenses on storage, insurance, and handling. Capital remains blocked in inventory during this period. If the goods remain unsold for a long time, the working capital requirement increases. Effective demand forecasting and marketing strategies help in reducing the storage period and improving cash flow.

Stage 4. Sale of Finished Goods

The firm then sells finished goods to customers. Sales may be made either in cash or on credit. Cash sales immediately generate cash inflow, while credit sales create accounts receivable (debtors). Most businesses provide credit facilities to increase sales and maintain competition. However, excessive credit sales increase the working capital requirement because funds remain tied up until payment is received from customers.

Stage 5. Collection from Debtors (Accounts Receivable)

The final stage of the operating cycle is the collection of money from debtors. The time taken by customers to pay their dues is called the collection period. Efficient credit policy, proper follow-up, and effective receivable management help in timely collection. Delayed payments create liquidity problems and may lead to bad debts. Once payment is received, cash is again available to purchase raw materials and the cycle starts again.

Components of Operating Cycle

The operating cycle represents the total time required for converting cash invested in business operations back into cash through sales and collection from customers. It shows how working capital moves through different stages of production and sales. The operating cycle mainly consists of inventory holding period and receivables collection period. Inventory holding period further includes raw material period, work-in-progress period, and finished goods period.

1. Raw Material Holding Period

This is the time during which raw materials remain in the store before they are issued to the production department. The firm purchases raw materials either in cash or on credit and keeps them as inventory until required. During this period, funds remain blocked without generating revenue. Proper purchasing policy and inventory control help reduce unnecessary storage. If raw materials are held for too long, storage, insurance, and handling costs increase. Therefore, efficient management of raw material stock shortens the operating cycle and improves liquidity.

2. Work-in-Progress Period

Work-in-progress period refers to the time taken to convert raw materials into finished goods during the production process. At this stage, the business invests additional working capital in wages, power, fuel, and manufacturing overheads. The duration of this stage depends on the nature of production, type of industry, and technology used. Efficient supervision, modern machinery, and proper production planning help in reducing production time. A longer production process keeps capital tied up for a longer period, while a shorter process improves efficiency and working capital turnover.

3. Finished Goods Holding Period

After completion of production, goods are transferred to the warehouse as finished goods inventory. The finished goods remain stored until they are sold in the market. During this time, funds are invested in storage, insurance, transportation, and maintenance. If the company fails to sell goods quickly, capital remains blocked and storage cost increases. Effective marketing strategies, proper demand forecasting, and efficient distribution channels help reduce this period. A shorter finished goods holding period ensures faster conversion of goods into sales and improves cash flow.

4. Receivables Collection Period (Debtors Period)

The receivables collection period is the time taken to collect cash from customers after credit sales. Most firms sell goods on credit to attract customers and increase sales volume. However, credit sales create accounts receivable and block funds until payment is received. The longer the collection period, the higher the working capital requirement. Efficient credit policy, proper credit evaluation of customers, and regular follow-up help in faster recovery. Quick collection improves liquidity and reduces the risk of bad debts.

5. Payables Deferral Period (Creditors Period)

Although not always included in the gross operating cycle, the payables deferral period is important in determining the net operating cycle. It represents the time allowed by suppliers to pay for purchases. During this period, the firm uses goods without immediate payment, which reduces working capital requirement. Proper use of trade credit improves liquidity. However, excessive delay in payment may damage goodwill and supplier relationships. Deducting this period from the operating cycle gives the cash conversion cycle or net operating cycle.

Importance of Operating Cycle in Working Capital Management

  • Determination of Working Capital Requirement

The operating cycle helps a firm estimate how much working capital is required to run daily operations. It shows the time gap between investment in raw materials and recovery of cash from sales. If the cycle is long, more funds are needed to finance inventory and receivables. If it is short, the requirement is lower. Therefore, understanding the operating cycle enables management to maintain adequate liquidity and avoid shortage or excess of working capital.

  • Ensures Smooth Business Operations

A properly managed operating cycle ensures uninterrupted production and sales activities. When raw materials are purchased, converted into goods, sold, and cash is collected on time, the firm can easily pay wages, suppliers, and expenses. Efficient movement of funds prevents operational delays. Without proper operating cycle management, businesses may face shortage of cash, which can stop production and damage reputation. Thus, it helps maintain continuous functioning of the enterprise.

  • Helps in Inventory Control

The operating cycle highlights how long inventory remains in stores at different stages—raw materials, work-in-progress, and finished goods. This helps management plan optimal inventory levels. Excess stock blocks capital and increases storage costs, while low stock disrupts production. By analyzing the operating cycle, firms can implement effective inventory control techniques like EOQ and reorder levels. Proper inventory management reduces wastage and improves efficiency of working capital utilization.

  • Improves Receivables Management

The operating cycle includes the collection period from debtors, which helps management monitor credit sales and collection efficiency. If customers take too long to pay, funds remain blocked and liquidity problems arise. By analyzing the cycle, the firm can revise credit policy, offer discounts for early payment, and strengthen collection procedures. Efficient receivable management reduces bad debts and improves cash flow, thereby strengthening the financial position of the business.

  • Facilitates Cash Flow Planning

The operating cycle helps the financial manager forecast future cash inflows and outflows. By knowing the duration of each stage, the firm can estimate when cash will be required and when it will be received. This allows better planning for payments such as wages, rent, taxes, and supplier bills. Proper cash flow planning avoids idle cash and prevents emergency borrowing, thereby maintaining financial stability and reducing unnecessary interest cost.

  • Reduces Need for External Financing

When the operating cycle is short and efficient, the firm quickly recovers cash from customers. This reduces dependence on bank loans, overdrafts, or other external sources of finance. Efficient utilization of internal funds lowers interest expenses and financial risk. Conversely, a long operating cycle increases the need for borrowed funds. Therefore, proper management of the operating cycle helps minimize borrowing and improves profitability.

  • Enhances Profitability

Efficient working capital management through a well-controlled operating cycle increases profitability. Faster conversion of inventory into cash reduces holding costs, storage expenses, and interest burden. Timely collection from debtors prevents bad debts and improves turnover. Lower operating costs and better fund utilization increase net profit. Thus, managing the operating cycle effectively not only maintains liquidity but also contributes to higher earnings and shareholder value.

  • Improves Liquidity Position

The operating cycle directly affects the liquidity position of a business. A shorter cycle ensures that cash is quickly available for meeting short-term obligations. This enables the firm to pay suppliers and creditors on time and maintain goodwill. A longer cycle may create cash shortages and lead to financial stress. Therefore, controlling the operating cycle is essential to maintain a healthy liquidity position and financial stability.

  • Assists in Credit Policy Formulation

By analyzing the collection period within the operating cycle, management can design an appropriate credit policy. It helps decide the credit period, credit standards, and discount policy offered to customers. A balanced credit policy increases sales while ensuring timely collection of payments. Without analyzing the operating cycle, excessive credit may block funds and increase bad debts. Thus, it helps maintain a balance between profitability and liquidity.

  • Helps in Performance Evaluation

The operating cycle acts as an important performance measurement tool. By comparing the actual cycle with industry standards or past performance, management can judge operational efficiency. A shorter cycle indicates effective management of inventory, production, and receivables, whereas a longer cycle signals inefficiency. This evaluation helps managers identify problem areas and take corrective actions. Therefore, it plays a vital role in improving managerial efficiency and overall business performance.

Management Notes

Absorption of Factory Overheads

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  1. Standard Rate:

This method is adopted by those industries which adopt standard Costing technique. The standard overheads and standard base is set on the basis of past experience and necessary adjustments are made based on the factors which affect it. The standard overhead is divided by a standard base, gives a standard rate of overhead absorption.

The following formula is used for the purpose:

Overhead Rate = Standard overhead for a Period / Standard base for the period

  1. Rate Per Unit of Output:

Under this method, the overheads are absorbed on the basis of number of units produced. The overhead absorption rate is obtained by dividing the overheads to be absorbed by the number of units produced.

It is expressed in the form of formula as follows:

Overhead Rate = Overhead to be absorbed / No. of units produced

Suitability:

This method is suitable where the finished goods are identical in nature.

Advantages:

It is the simplest method among all the methods.

Disadvantages:

  1. This method is not suitable where different varieties of finished products are manufactured.
  2. If historical overhead rate of recovery is adopted it involves considerable delay in computing the overhead rate as one has to wait for the completion of production for the given period.

Machine Hour Rate:

This method refers to the overheads incurred for running a machine for one hour. This rate is ascertained by dividing the amount of factory overhead apportioned to a machine by the number of machine hours for the concerned period.

Expressed in the form of a formula:

Machine hour rate = Factory Overhead/ No. of Machine Hours

Suitability:

This method is most suited where machines are used predominantly for production purpose.

Advantages:

  1. This is most scientific, accurate and logical method of overhead absorption.
  2. It helps in knowing the existence and extent of idle time of machines.
  3. This method takes into account time factor and hence gives accurate results.
  4. It helps in comparing the efficiency and cost of operating different machines.
  5. It helps management in choosing between manual labour and machines.

Disadvantages:

  1. This method is not suitable in manual labour-based factories.
  2. It involves maintenance of additional records for noting down the machines hours operated.

Labour Hour Rate:

Under this method, overheads are absorbed on the basis of direct labour hours worked. The overhead rate is obtained by dividing the overheads to be absorbed by the number of direct labour hours.

The following formula can be used for its calculation:

Overhead Rate = Production Overhead / Direct Labour Hours

Suitability:

This method is most suitable where manual labour is engaged in the factory.

Advantages:

  1. This method gives full consideration to time factor.
  2. This is not affected by the methods of wage payment (i.e., time rate or piece rate method)
  3. This method gives accurate results.

Disadvantages:

  1. This method requires additional clerical work and separate records are necessary for recording direct labour hours.
  2. This method is not desirable where machines are used to a great extent.

Prime Cost Percentage Rate:

This method is based on the assumption that both materials and labour give rise to factory overheads and thus total of the two i.e., material and labours should be taken as the base for absorption of factory overheads. In other words, this method is a combination of the material cost and labour cost methods.

Under this method overhead rate is calculated by dividing the production overheads by Prime Cost.

Overhead Rate = ( Factory Overheads/Prime Cost) * 100

Suitability:

This method is suitable where direct material cost and direct labour cost are equally important and overheads are related to both.

Advantages:

  1. It is simple to understand and easy to operate.
  2. Information regarding materials and wages are readily available and there is no need to keep separate account for them.
  3. This method gives satisfactory result because it takes into account direct material cost and direct labour cost.

Disadvantages:

  1. Under this method, equal importance is given to both material cost and labour cost, though most of the overheads are closely related to labour cost.
  2. Where material cost is predominant element of cost, the method ignores time factor.

Direct Labour Cost Percentage Rate:

This is the oldest method of overhead absorption and still it is more popularly used. Under this method, the overhead to be absorbed is divided by direct labour cost and the quotient is expressed in the form of percentage.

It is calculated with the help of following formula:

Overhead Rate = (Production Overhead/Direct Labour Cost) * 100

Suitability:

  1. Where labour cost forms a high proportion to total cost of production.
  2. Where skill of labour does not differ widely.
  3. Where the wage rate does not fluctuate widely.

Advantages:

  1. The method is simple to understand and easy to operate.
  2. It gives stable results as labour rates are more constant than material prices.
  3. Under this method special consideration is given to time factor, as higher the charge to a job for wages, the longer will have been the time spent on that job.
  4. This method can be adopted with advantage where rates of workers are same, where workers are more or less of equal skill and where uniform types of works are performed.

Disadvantages:

  1. This method is not suitable, where machines are used at a great extent.
  2. As it ignores time factor, this method is not suitable in those industries where piece rate system of wage payment is adopted.
  3. Where the work is done by both skilled and unskilled workers, the method is not suitable. If works are done by unskilled workers overheads incurred will be more.
  4. No distinction is made between work done by skilled and unskilled workers.
  5. It also does not distinguish between production of hand workers and that of machine workers. Machines give rise to certain overheads like depreciation, power etc. which should be charged only to the work done on machines.

Percentage on Direct Material Cost:

Under this method, the amount of overheads to be absorbed by cost unit is determined by the cost of direct materials consumed in producing it. This rate is ascertained by dividing the total overheads by the total cost of direct materials consumed in the department and multiplied by 100.

Overhead Rate = (Production/Factory Overheads/ Direct material Consumed) * 100

Suitability:

  1. Where only one variety of the product is manufactured.
  2. Where the materials used are common for different jobs or process or products.
  3. Where the prices of the raw materials remain stable.
  4. Where material costs constitute highest proportion to total cost.

Advantages:

  1. This method is simple and easy to operate because cost of direct materials is readily available and no additional records are required to be maintained for this purpose.
  2. This method gives fairly accurate rates where material prices do not fluctuate widely and where output is uniform.

Disadvantages:

  1. Most of the factory overheads are not directly related to direct materials cost. So the method is not logically correct and hence gives misleading results.
  2. This method fails to take into account the jobs performed by skilled and unskilled workers. A job which is performed by unskilled workers requires more amount of overheads. This method also fails to distinguish the jobs done by manual labour and machines.
  3. This method does not take time factor into account. Most of the overheads are related to time element. A job which requires a longer period to complete may need more of overheads than a job which is completed in a shorter period of time.
  4. This method is quite illogical and inaccurate because overheads are in no way related to the cost of materials consumed. The amount of overheads does not change because the work is being done on copper instead of iron. Both metals are quite different in prices and by applying the same percentage for both will be obviously incorrect.
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