Tag: University of Mumbai BMS Notes

Manufacturing costs are the costs incurred during the production of a product. These costs include the costs of direct material, direct labor, and manufacturing overhead. The costs are typically presented in the income statement as separate line items. An entity incurs these costs during the production process.

Direct material is the materials used in the construction of a product. Direct labor is that portion of the labor cost of the production process that is assigned to a unit of production. Manufacturing overhead costs are applied to units of production based on a variety of possible allocation systems, such as by direct labor hours or machine hours incurred.

Example of Manufacturing Costs

Manufacturing costs are typically divided into three categories:

1. Direct materials cost

The cost of raw materials used in the manufacturing process is one of the most common manufacturing expenses companies measure. You should always strive to deal with vendors to get the lowest possible prices on raw materials, and you should initiate quality control methods to avoid wasting raw materials. Another way raw materials costs can get out of hand is by keeping too much materials inventory. This costs you not only for the cost of the materials themselves, but also for warehousing and tracking them. Review your ordering methods to make sure you keep only the minimum amount of raw materials on hand.

2. Direct labor cost

Paying wages to employees will be one of your major manufacturing expenses. You will need to constantly monitor this cost to make sure you are getting enough production for the money you are putting into labor. Average all the wages of your production crew and calculate how much labor costs you per hour and per day. Here is how to do the calculaton. Add all wages paid in a month and divide by the number of employees. Divide this figure by the number of work days in the month. This is your daily average wage paid. Divide this figure by the number of hours in a shift to get wages paid per hour.

3. Manufacturing overhead

Manufacturing overhead is any manufacturing cost that is neither direct materials cost or direct labor cost. Manufacturing overhead includes all charges that provide support to manufacturing.

Manufacturing overhead includes

• Indirect labor cost: The indirect labor cost is the cost associated with workers, such as supervisors and material handling team, who are not directly involved in the production.
• Indirect materials cost: Indirect materials cost is the cost associated with consumables, such as lubricants, grease, and water, that are not used as raw materials.
• Other indirect manufacturing cost: includes machine depreciation, land rent, property insurance, electricity, freight and transportation, or any expenses that keep the factory operating.

4. Incidental Expenses

In addition to the three most common manufacturing costs, you have expenses for supplies such as tools, tape, lubricants and safety gear. Once you get a handle on your three largest manufacturing expenses, examine your facility to see where else you spend money that goes into your manufacturing costs. One issue you should pay particular attention to is defective products. The costs of manufacturing products that get rejected in quality control can add up quickly.

Production Costs vs. Manufacturing Costs Example

For example, a small business that manufactures widgets may have fixed monthly costs of $800 for its building and $100 for equipment maintenance. These expenses stay the same regardless of the level of production, so per-item costs are reduced if the business makes more widgets.

In this example, the total production costs are $900 per month in fixed expenses plus $10 in variable expenses for each widget produced. To produce each widget, the business must purchase supplies at $10 each. Each widget sells for $100. After subtracting the manufacturing cost of $10, each widget makes $90 for the business.

To break even, the business must produce 10 widgets every month. It must make more than 10 widgets to become profitable.

Cost can be classified into (i) fixed, (ii) variable and (iii) mixed costs, in terms of their vari­ability or changes in cost behaviour in relation to changes in output, or activity or volume. Activity may be indicated in any forms such as units of output, hours worked, sales, etc.

The classification of cost behaviour has been explained below:

1. Fixed Cost

Fixed cost is a cost which does not change in total for a given time period despite wide fluc­tuations in output or volume of activity. The ICMA (U.K.) defines fixed cost as “a cost which tends to be unaffected by variations in volume of output. Fixed costs depend mainly on the affluxion of time and do not vary directly with volume or rate of output.” These costs, also known as standby costs, capacity costs or period costs, arise primarily because of the provision of facilities, physical and human, to carry on business operations.

Fixed costs enable a business firm to do a business, but they are not purely incurred for manu­facturing. Examples of fixed costs are rent, property taxes, supervising salaries, depreciation on office facilities, advertising, insurance, etc. They accrue or are incurred with the passage of time and not with the production of the product or the job. This is the reason why fixed costs are expressed in terms of time, such as per day, per month or per year and not in terms of unit. It is totally illogical to say that a supervisor’s salary is so much per unit.

By nature, the total fixed costs are constant which means that the fixed costs per unit will vary. Shows the behaviour of fixed costs in total and on a per unit basis. When a greater num­ber of units are produced, the fixed cost per unit decreases. On the contrary, when a lesser number of units are produced, the fixed cost per unit increases. This variability of fixed cost per unit creates problems in product costing. The cost per unit depends on the number of units produced or the level of activity achieved.

However, it should be improper to say that total fixed costs never change in amount. Rents, insurance, rates, taxes, salaries and other similar items may go up or down depending on the circum­stances. The basic concept is that the term “fixed” refers to fixity (non-variability) related to specific volume (or relevant range); the term does not imply that there will be no changes in fixed cost. This characteristics of fixed cost has been shown in below.

According to Exhibit. 2.4, the following are the fixed costs at different levels of production:

(a) Rs 50,000 fixed cost between 20,000 and 80, 000 units of production.

(b) Rs 60,000 fixed cost in excess of 80,000 units. This assumes that increases in production after a certain level (80,000 units) requires increase in fixed expenses which have been fixed earlier, e.g., additional supervision, increase in quality control costs.

(c) Rs 25,000 fixed cost from zero units (shut down) to 20,000 units. This explains that if the level of activity comes to less than 20,000 units, some fixed costs may not be incurred. For example, if the plant is shut down or production is reduced, many of the fixed costs, such as costs on accounting functions, supplies, staff, will not be incurred. However, if laying off of staff and personnel, etc. is not possible, then the fixed cost will remain at Rs 50,000.

2. Variable Cost

Variable costs are those costs that vary in total amount directly and proportionately with the output. There is a constant ratio between the change in the cost and change in the level of output. Direct material cost and direct labour cost are the costs which are generally variable costs. For example, if direct material cost is Rs 50 per unit, then for producing each additional unit, a direct material cost of Rs 50 per unit will be incurred.

That is, the total direct material cost increases in direct proportion to increase in units manufactured. However, it should be noted that it is only the total variable costs that change as more units are produced; the per unit variable cost remains constant. Variable cost is always expressed in terms of units or percentage of volume; it cannot be stated in terms of time. Fig. shows behaviour of variable costs in total and on a per unit basis.

Fig. shows graphically the behaviour pattern of direct material cost. For the every increase in the units produced there is a proportionate increase in the cost when production increases in direct proportion at the constant rate of Rs 50 per unit. The variable cost line is shown as linear rather than curvilinear. That is, on a graph paper, a variable cost line appears as unbroken straight line in place of a curve. Variable cost per unit is shown by constant.

3. Mixed Costs

Mixed costs are costs made up of fixed and variable elements. They are a combination of semi- variable costs and semi-fixed costs. Because of the variable component, they fluctuate with volume; because of the fixed component, they do not change in direct proportion to output. Semi-fixed costs are those costs which remain constant upto a certain level of output after which they become variable as shown in fig.

Semi-variable cost is the cost which is basically variable but whose slope may change abruptly when a certain output level is reached as shown in fig. An example of a mixed cost is the earnings of a worker who is paid a salary of Rs 1,500 per week (fixed) plus Re. 1 for each unit completed (variable). If he increases his weekly output from 1,000 units to 1,500 units, his earnings increase from Rs 2500 to Rs 3,000.

An increase of 50% in output brings only a 20% increases in his earnings.

Mathematically, mixed costs can be expressed as follows:

Total Mixed Cost = Total Fixed Cost + (Units x Variable Cost per Unit)

Cost Volume-Profit (CVP) relationship is an analysis which studies the relationships between the following factors and its impact on the amount of profits.

In simple words, CVP is a management accounting tool that expresses relationship among total sales, total cost and profit. Cost Volume-Profit relationship is one of the important techniques of cost and management accounting. It is a powerful tool which furnishes the complete picture of the profit structure and helps in planning of profits. It can also answer what if type of questions by telling the volume required to produce. This concept is relevant in all decision making areas, particularly in the short run.

Managerial accounting provides useful tools, such as cost-volume-profit relationships, to aid decision-making. Cost volume profit relationship helps you understand different ways to meet your company’s net income goals.

1. The Basics of Cost-Volume-Profit (CVP) Analysis

Cost-volume-profit (CVP) analysis is a key step in many decisions. CVP analysis involves specifying a model of the relations among the prices of products, the volume or level of activity, unit variable costs, total fixed costs, and the sales mix. This model is used to predict the impact on profits of changes in those parameters.

(a) Contribution Margin

Contribution margin is the amount remaining from sales revenue after variable expenses have been deducted. It contributes towards covering fixed costs and then towards profit.

(b) Unit Contribution Margin

The unit contribution margin can be used to predict changes in total contribution margin as a result of changes in the unit sales of a product. To do this, the unit contribution margin is simply multiplied by the change in unit sales. Assuming no change in fixed costs, the change in total contribution margin falls directly to the bottom line as a change in profits.

(c) Contribution Margin Ratio

The contribution margin (CM) ratio is the ratio of the contribution margin to total sales. It shows how the contribution margin is affected by a given dollar change in total sales. The contribution margin ratio is often easier to work with than the unit contribution margin, particularly when a company has many products. This is because the contribution margin ratio is denominated in sales dollars, which is a convenient way to express activity in multi-product firms.

2. Some Applications of CVP Concepts

CVP analysis is typically used to estimate the impact on profits of changes in selling price, variable cost per unit, sales volume, and total fixed costs. CVP analysis can be used to estimate the effect on profit of a change in any one (or any combination) of these parameters. A variety of examples of applications of CVP are provided in the text.

3. CVP Relationships in Graphic Form

CVP graphs can be used to gain insight into the behavior of expenses and profits. The basic CVP graph is drawn with dollars on the vertical axis and unit sales on the horizontal axis. Total fixed expense is drawn first and then variable expense is added to the fixed expense to draw the total expense line. Finally, the total revenue line is drawn. The total profit (or loss) is the vertical difference between the total revenue and total expense lines. The break-even occurs at the point where the total revenue and total expenses lines cross.

4. Break-Even Analysis and Target Profit Analysis

Target profit analysis is concerned with estimating the level of sales required to attain a specified target profit. Break-even analysis is a special case of target profit analysis in which the target profit is zero.

(a) Basic CVP equations

Both the equation and contribution (formula) methods of break-even and target profit analysis are based on the contribution approach to the income statement. The format of this statement can be expressed in equation form as:

Profits = Sales – Variable expenses – Fixed expenses

(b) Break-even point using the equation method

The break-even point is the level of sales at which profit is zero. It can also be defined as the point where total sales equals total expenses or as the point where total contribution margin equals total fixed expenses. Break-even analysis can be approached either by the equation method or by the contribution margin method. The two methods are logically equivalent.

Margin of Safety

The margin of safety is the excess of budgeted (or actual) sales over the break-even volume of sales. It is the amount by which sales can drop before losses begin to be incurred. The margin of safety can be computed in terms of dollars:

Margin of safety in dollars = Total sales – Break-even sales

Cost Structure

Cost structure refers to the relative proportion of fixed and variable costs in an organization. Understanding a company’s cost structure is important for decision-making as well as for analysis of performance.

Operating Leverage

Operating leverage is a measure of how sensitive net operating income is to a given percentage change in sales.

Assumptions in CVP Analysis

Simple CVP analysis relies on simplifying assumptions. However, if a manager knows that one of the assumptions is violated, the CVP analysis can often be easily modified to make it more realistic.

• Selling price is constant: The assumption is that the selling price of a product will not change as the unit volume changes. This is not wholly realistic since unit sales and the selling price are usually inversely related. In order to increase volume it is often necessary to drop the price. However, CVP analysis can easily accommodate more realistic assumptions. A number of examples and problems in the text show how to use CVP analysis to investigate situations in which prices are changed.
• Costs are linear and can be accurately divided into variable and fixed elements: It is assumed that the variable element is constant per unit and the fixed element is constant in total. This implies that operating conditions are stable. It also implies that the fixed costs are really fixed. When volume changes dramatically, this assumption becomes tenuous. Nevertheless, if the effects of a decision on fixed costs can be estimated, this can be explicitly taken into account in CVP analysis. A number of examples and problems in the text show how to use CVP analysis when fixed costs are affected.
• The sales mix is constant in multi-product companies: This assumption is invoked so as to use the simple break-even and target profit formulas in multi-product companies. If unit contribution margins are fairly uniform across products, violations of this assumption will not be important. However, if unit contribution margins differ a great deal, then changes in the sales mix can have a big impact on the overall contribution margin ratio and hence on the results of CVP analysis. If a manager can predict how the sales mix will change, then a more refined CVP analysis can be performed in which the individual contribution margins of products are computed.
• In manufacturing companies, inventories do not change: It is assumed that everything the company produces is sold in the same period. Violations of this assumption result in discrepancies between financial accounting net operating income and the profits calculated using the contribution approach. This topic is covered in detail in the chapter on variable costing.

Although management actions differ from organization to organization, they generally follow a four-stage management process. As illustrated at the beginning of this chapter and in the chapters that follow, the four stages of this process are:

• Planning
• Performing
• Evaluating
• Communicating

Management accounting is essential in each stage of the process as managers make business decisions.

1. Planning

Diagram below shows the overall framework in which planning takes place. The overriding goal of a business is to increase the value of the stakeholders’ interest in the business. The goal specifies the business’s end point, or ideal state. For example, Wal-Mart’s end point is “to become the worldwide leader in retailing.”

A company’s mission statement describes the fundamental way in which the company will achieve its goal of increasing stakeholders’ value. It also expresses the company’s identity and unique character.

The mission statement is essential to the planning process, which must consider how to add value through strategic objectives, tactical objectives, and operating objectives.

Strategic objectives are broad, long-term goals that determine the fundamental nature and direction of a business and that serve as a guide for decision making. Strategic objectives involve such basic issues as what a company’s main products or services will be, who its primary customers will be, and where it will operate.

Tactical objectives are mid-term goals that position an organization to achieve its long-term strategies. These objectives, which usually cover a three to five-year period, lay the groundwork for attaining the company’s strategic objectives.

Operating objectives are short-term goals that outline expectations for the performance of day-to-day operations. Operating objectives link to performance targets and specify how success will be measured.

To develop strategic, tactical, and operating objectives, managers must formulate a business plan. A business plan is a comprehensive statement of how a company will achieve its objectives. It is usually expressed in financial terms in the form of budgets, and it often includes performance goals for individuals, teams, products, or services

2. Performing

Planning alone does not guarantee satisfactory operating results. Management must implement the business plan in ways that make optimal use of available resources in an ethical manner. Smooth operations require one or more of the following:-

• Hiring and training personnel
• Matching human and technical resources to the work that must be done
• Purchasing or leasing facilities
• Maintaining an inventory of products for sale
• Identifying operating activities, or tasks, that minimize waste and improve the quality of products or services

Critical to managing any retail business is a thorough understanding of its supply chain. The supply chain is the path that leads from the suppliers of the material to its final consumers. The supply chain expresses the links between businesses growers to vendors to the business to their customers.

3. Evaluating

When managers evaluate operating results, they compare the organization’s actual performance with the performance levels they established in the planning stage. They earmark any significant variations for further analysis so that they can correct the problems. If the problems are the result of a change in the organization’s operating environment, the managers may revise the original objectives. Ideally, the adjustments made in the evaluation stage will improve the company’s performance.

4. Communicating

Whether accounting reports are prepared for internal or external use, they must provide accurate information and clearly communicate this information to the reader. Inaccurate or confusing internal reports can have a negative effect on a company’s operations. Full disclosure and transparency in financial statements issued to external parties is a basic concept of generally accepted accounting principles, and violation of this principle can result in stiff penalties.

Management Accounting also known as Managerial Accounting is the accounting for managers which helps the management of the organization to formulate policies and forecasting, planning and controlling the day to day business operations of the organization. Both the quantitative and qualitative information are captured and analyzed by the management accounting.

The functional area of management accounting is not limited to providing a financial or cost information only. Instead, it extracts the relevant and material information from financial and cost accounting to assist the management in budgeting, setting goals, decision making, etc. The accounting can be done as per the requirement of the management, i.e. weekly, monthly, quarterly, etc. and there is no format set on the basis of which it is to be reported.

Financial Accounting

Financial Accounting is an accounting system which is concerned with the preparation of financial statement for the outside parties like creditors, shareholders, investors, suppliers, lenders, customers, etc. It is the purest form of accounting in which proper record keeping and reporting of financial data are done, to provide relevant and material information to its users.

Financial Accounting is based on various assumptions, principles and convention like going concern, materiality, matching, realisation, conservatism, consistency, accrual, historical cost, etc. The financial statement consists of a Balance Sheet, Income Statement and Cash flow statement which are prepared as per the guidelines provided by the relevant statute.

Normally, the statements based on the financial accounting are prepared for one accounting year, to enable the user to make comparisons regarding the financial position, profitability and performance of the company in a specific period. Not only external parties but internal management also gets information for forecasting, planning, and decision making.

A common question is to explain the differences between financial accounting and managerial accounting, since each one involves a distinctly different career path. In general, financial accounting refers to the aggregation of accounting information into financial statements, while managerial accounting refers to the internal processes used to account for business transactions. There are a number of differences between financial and managerial accounting, which fall into the following categories:

1. Aggregation

Financial accounting reports on the results of an entire business. Managerial accounting almost always reports at a more detailed level, such as profits by product, product line, customer, and geographic region.

2. Efficiency

Financial accounting reports on the profitability (and therefore the efficiency) of a business, whereas managerial accounting reports on specifically what is causing problems and how to fix them.

3. Proven information

Financial accounting requires that records be kept with considerable precision, which is needed to prove that the financial statements are correct. Managerial accounting frequently deals with estimates, rather than proven and verifiable facts.

4. Reporting focus

Financial accounting is oriented toward the creation of financial statements, which are distributed both within and outside of a company. Managerial accounting is more concerned with operational reports, which are only distributed within a company.

5. Standards

Financial accounting must comply with various accounting standards, whereas managerial accounting does not have to comply with any standards when information is compiled for internal consumption.

6. Systems

Financial accounting pays no attention to the overall system that a company has for generating a profit, only its outcome. Conversely, managerial accounting is interested in the location of bottleneck operations, and the various ways to enhance profits by resolving bottleneck issues.

7. Time period

Financial accounting is concerned with the financial results that a business has already achieved, so it has a historical orientation. Managerial accounting may address budgets and forecasts, and so can have a future orientation.

8. Timing

Financial accounting requires that financial statements be issued following the end of an accounting period. Managerial accounting may issue reports much more frequently, since the information it provides is of most relevance if managers can see it right away.

9. Valuation

Financial accounting addresses the proper valuation of assets and liabilities, and so is involved with impairments, revaluations, and so forth. Managerial accounting is not concerned with the value of these items, only their productivity.

There is also a difference in the accounting certifications typically found in each of these areas. People with the Certified Public Accountant designation have been trained in financial accounting, while those with the Certified Management Accountant designation have been trained in managerial accounting.

a. Define the Investment Goals

What is the purpose of my investment? Answer to this should be the foundation of your mutual fund choices. For instance, if you want a regular income with capital protection, you can choose to invest in a debt fund. However, if you have a higher risk appetite and an aim to build your wealth, equities will suit your purpose. So it is crucial to define your financial goal first and then decide your investment. This also has a pivotal role in fund evaluation.

b. Shortlist a few peer Funds to compare

It is difficult to assess a mutual fund in isolation. So, you should always make a small list of comparable funds and continuously compare them. There are many FinTech firms and third party websites that offer free mutual fund screener tools.

c. Check the historical Performance Data

Now every mutual fund handbook comes with a disclaimer stating that past performance is no indicator of future performance. However, this data can help you check how the fund has fared across different market cycles. Consistency can also shed light on the skill of the fund manager. In short, it will be easier for you to find a fund with lower risks but higher returns.

d. Fee Structure of the Fund

A mutual fund company charges you for its services and expertise. Some funds require deft management and quick decisions on whether to buy, sell or hold on to an asset. Please remember that a fund with a higher fee is automatically better. Do check out other parameters too before choosing.

e. Risk-Adjusted Returns

Every fund expects certain risks related to the market and the industry. When fund strategies in such a way that they make more returns against anticipated risks, we call them risk-adjusted returns.

f. Performance against Index

Indexes like Nifty, BSE Sensex and BSE 200 set benchmarks, and all fund performances are evaluated on this basis. Comparing different timelines against the benchmark as well as peers, can be insightful. A well-managed fund won’t fall too hard during a market low.

Why track the Investment Performance

You might have seen the disclaimer that past performance does not indicate the future performance of a fund’. It means that you cannot expect guaranteed returns on investment. Therefore, you need to look beyond the previous years’ returns to assess a mutual fund. Primarily, you should monitor your investments so that you can make informed decisions that can lead to higher returns.

You know that the capital market keeps fluctuating with changes in the overall economic conditions. Such a change disturbs the asset allocation of the portfolio. For instance, an original allocation of 50:50 in equity and debt may change to 60:40 owing to a market rally. It may increase the risk profile of the fund beyond your requirements. Fund evaluation also helps you to compare the performance of your investment against other similar funds. Additionally, a change in fund manager or fundamental attributes of your fund may also trigger an evaluation. Hence, a review and rebalancing might be required to keep the risk profile of the portfolio intact.

How often to Evaluate Fund Performance

The market is subject to fluctuations. However, that doesn’t mean you need to assess the fund performance daily. Ideally, you should evaluate your fund every six months to a year, depending on the tenure of the investment. Evaluating the funds in a shorter period does not give an accurate insight into the performance of your investments. If all this sounds too much, you may invest in regular funds. As qualified intermediaries, they advise you to invest in funds based on your financial goals and risk profile.

Financial Ratios & Fund Performance 

While you may have taken due diligence and advice before investing, you still need to track the performance of your funds. The easiest way to do it is by using the fund fact sheet. In simple terms, the fund fact sheet shows the performance of all the schemes managed by your fund house, including your investment. You must compare these financial ratios with the mutual fund schemes in the same category to understand where your fund stands.

a. Alpha

The fund’s Alpha gives an overview of the fund manager’s skills and strategies and how they fared in the past. It should always be higher than the expense ratio of the fund. Additionally, your fund’s Alpha needs to be higher than the peers, which are at a similar level of beta.

b. Expense Ratio

This is essentially the fee for the fund house for managing your mutual fund. Expense ratios reflects the value-for-money aspect of a fund. It consists of fund management charges and all the other costs related to that of fund management. It impacts your ultimate take-home returns.

c. Benchmark

It is always advisable to compare the fund performance against the benchmark. The benchmark acts as a standard for funds’ performance. If your fund is outperforming the benchmark consistently, it is a sign that the fund is doing well. You can also compare the average return during a specific time frame with its peer funds in the same category.

d. Portfolio Holdings

Look for considerable changes and probable overlapping in the portfolio holdings. The fund needs to hold good quality stocks which have a lower Price to Earnings-per-share (P/E) Ratio vis-a-vis Price to Book Value (P/B) ratio. Additionally, ensure that the fund is investing as per its investment objective. For instance, fund having a high portfolio turnover ratio vis-a-vis lower returns is a bad indicator.

e. Sharpe Ratio

This ratio shows how much extra return you receive for the additional risks you undertake. It is a rule of thumb that higher risks must be compensated more. Moreover, you deserve a reward (excess returns) for the added volatility. Sharpe Ratio tells you how much exactly that reward should be.

Most Mutual Funds invest in 50 to 100 different investments based on market capitalisation, sectors and many other demographics. Only on a rare occasion do all stocks decline at the same time and in the same proportion. Hence, Mutual Funds offer a diversified investment portfolio even with a small amount of investment that would otherwise require big capital. Even with big capital, it is extremely difficult and time-consuming to purchase and manage a wide range of investments individually.

While investing in few shares or debentures directly is possible, the risk of potential loss is all on the investor. However, Mutual Funds reduce the risk of loss as the portfolio is largely diversified and the purchases are backed by research and experience of the fund house. Moreover, the loss is also shared with other investors in the same fund. This diversification of risk is one of the key benefits of a collective investment instrument like mutual funds.

Only Sector funds invest across one industry making them less diversified and therefore more volatile.

Professional Management

Mutual Fund schemes are managed by qualified experienced professionals who work towards the fund’s defined objective. These financial experts are accompanied by a specialized investment research team. The experts and their teams diligently and judiciously study companies, their products and performance. After thorough analysis, the best investment option most aptly suited to achieve the scheme’s objective is chosen. This continuous process adds value to your investment and helps obtain higher returns.

While, investors may differ in their investment needs based on their financial goals, currently, they have over 8000+ schemes to choose from to meet their goals. Therefore, mutual funds make the best way one can invest in Equities, Debt or Commodities (mainly Gold)

Affordability

A mutual fund invests generally buy and sell various asset classes in large volumes allowing investors to benefit from lower trading costs. Investors can get exposure to such portfolios with an investment as modest as Rs.500/-* in mutual funds through a Systematic Investment Plan. Such portfolio would otherwise be extremely expensive to purchase and maintain for an investor investing directly in stock market.

Liquidity

With open ended funds, investors can redeem (encash) all or part of their investments at prevailing net asset value, at any point of time. Mutual Funds are more liquid than most investments in shares, deposits, and bonds. In addition, a standardised process enables quick and efficient redemption allowing investors to get cash in hand as soon as possible. For closed ended schemes, investors can redeem their investments at prevailing Net Asset Value, subject to exit load at specific intervals, if provided in the scheme. In certain schemes, where lock in period is mentioned, investor cannot redeem his investment until that period.

Transparency

Mutual Funds are the most transparent form of investment. Investors receive detailed information and timely updates about the nature of investments made, fund manager’s investment strategy behind the investments, the exact amount invested in each type of security, etc. Moreover, the performance of a Mutual Fund is reviewed by various publications and rating agencies, making it easy for investors to compare one fund to another.

Rupee-cost Averaging

Rupee cost averaging or SIP provides the investor a disciplined approach of investing specific amount at regular intervals regardless of the unit price of the investment. Therefore, the money invested fetches more units when the price is low and lesser when the price is high. Thus, allowing you to achieve a lower average cost per unit over time. The strategy helps smoothen out market ups and downs in the long run, while reducing the risk of investing in volatile markets.

Regulations

All Mutual Funds are required to register with Securities Exchange Board of India (SEBI). With investor interest at the helm, SEBI has laid down strict regulations to safeguard investors against possible frauds. It is even mandatory for Mutual Fund distributors to register with Association of Mutual Funds in India (AMFI) and abide the norms laid by the Securities and Exchange Board of India (SEBI) and AMFI for the distributors.

Choice of Investment

Mutual Funds are the only product category that caters to every one’s needs. You will always find a mutual fund that matches your time horizon long, medium, or short; and your risk-taking ability low, medium, high. All this irrelevant of how much you invest, be it a very small investment or a huge Lumpsum. Your adviser will help choose the right fund/s for you keeping in mind your profile.

Minimizing Costs

Mutual Funds help investors to benefit from economies of scale as mutual funds pool money from vast number people with common interest and invest their money in the relevant asset class/classes. This helps the investors share the cost of management of their money.

The Securities and Exchange Board of India (SEBI) is the regulator for the securities market in India. It was established in 1988 and given statutory powers on 30 January 1992 through the SEBI Act, 1992.

Initially SEBI was a non statutory body without any statutory power. However, in 1992, the SEBI was given additional statutory power by the Government of India through an amendment to the Securities and Exchange Board of India Act, 1992. In April 1988 the SEBI was constituted as the regulator of capital markets in India under a resolution of the Government of India.

Its main objective was to promote orderly and healthy growth of securities and to provide protection to the investors.

The main objective is to create such an environment which facilitates efficient mobilization and allocation of resources through the securities market. This environment consists of rules and regulations, policy framework, practices and infrastructures to meet the needs of three groups which mainly constitute the market i.e. issuers of securities (companies), the investors and the market intermediaries.

(i) To the Issuers

SEBI aims to provide a market place to the issuers where they can confidently look forward to raise the required amount of funds in an easy and efficient manner.

(ii) To the Investors

SEBI aims to protect the right and interest of the investors by providing adequate, accurate and authentic information on a regular basis.

(iii) To the Intermediaries

In order to enable the intermediaries to provide better service to the investors and the issuers, SEBI provides a competitive, professionalized and expanding market to them having adequate and efficient infrastructure.

Sebi Guidelines

(1) Formation:

Certain structural changes have also been made in the mutual fund industry, as part of which mutual funds are required to set up asset management companies with fifty percent independent directors, separate board of trustee companies, consisting of a minimum fifty percent of independent trustees and to appoint independent custodians.

This is to ensure an arm’s length relationship between trustees, fund managers and custodians, and is in contrast with the situation prevailing earlier in which all three functions were often performed by one body which was usually the sponsor of the fund or a subsidiary of the sponsor.

Thus, the process of forming and floating mutual funds has been made a tripartite exercise by authorities. The trustees, the asset management companies (AMCs) and the mutual fund shareholders form the three legs. SEBI guidelines provide for the trustees to maintain an arm’s length relationship with the AMCs and do all those things that would secure the right of investors.

With funds being managed by AMCs and custody of assets remaining with trustees, an element of counter-balancing of risks exists as both can keep tabs on each other.

(2) Registration:

In January 1993, SEBI prescribed registration of mutual funds taking into account track record of a sponsor, integrity in business transactions and financial soundness while granting permission.

This will curb excessive growth of the mutual funds and protect investor’s interest by registering only the sound promoters with a proven track record and financial strength. In February 1993, SEBI cleared six private sector mutual funds viz. 20th Century Finance Corporation, Industrial Credit & Investment Corporation of India, Tata Sons, Credit Capital Finance Corporation, Ceat Financial Services and Apple Industries.

(3) Documents:

The offer documents of schemes launched by mutual funds and the scheme particulars are required to be vetted by SEBI. A standard format for mutual fund prospectuses is being formulated.

(4) Code of advertisement:

Mutual funds have been required to adhere to a code of advertisement.

(5) Assurance on returns:

SEBI has introduced a change in the Securities Control and Regulations Act governing the mutual funds. Now the mutual funds were prevented from giving any assurance on the land of returns they would be providing. However, under pressure from the mutual funds, SEBI revised the guidelines allowing assurances on return subject to certain conditions.

Hence, only those mutual funds which have been in the market for at least five years are allowed to assure a maximum return of 12 per cent only, for one year. With this, SEBI, by default, allowed public sector mutual funds an advantage against the newly set up private mutual funds.

As per basic tenets of investment, it can be justifiably argued that investments in the capital market carried a certain amount of risk, and any investor investing in the markets with an aim of making profit from capital appreciation, or otherwise, should also be prepared to bear the risks of loss.

(6) Minimum corpus:

The current SEBI guidelines on mutual funds prescribe a minimum start-up corpus of Rs.50 crore for a open-ended scheme, and Rs.20 crore corpus for closed-ended scheme, failing which application money has to be refunded.

The idea behind forwarding such a proposal to SEBI is that in the past, the minimum corpus requirements have forced AMCs to solicit funds from corporate bodies, thus reducing mutual funds into quasi-portfolio management outfits. In fact, the Association of Mutual Funds in India (AMFI) has repeatedly appealed to the regulatory authorities for scrapping the minimum corpus requirements.

(7) Institutionalisation:

The efforts of SEBI have, in the last few years, been to institutionalise the market by introducing proportionate allotment and increasing the minimum deposit amount to Rs.5000 etc. These efforts are to channel the investment of individual investors into the mutual funds.

(8) Investment of funds mobilised:

In November 1992, SEBI increased the time limit from six months to nine months within which the mutual funds have to invest resources raised from the latest tax saving schemes. The guideline was issued to protect the mutual funds from the disadvantage of investing funds in the bullish market at very high prices and suffering from poor NAV thereafter.

(9) Investment in money market:

SEBI guidelines say that mutual funds can invest a maximum of 25 per cent of resources mobilised into money-market instruments in the first six months after closing the funds and a maximum of 15 per cent of the corpus after six months to meet short term liquidity requirements.

Private sector mutual funds, for the first time, were allowed to invest in the call money market after this year’s budget. However, as SEBI regulations limit their exposure to money markets, mutual funds are not major players in the call money market. Thus, mutual funds do not have a significant impact on the call money market.

(10) Valuation of investment:

The transparent and well understood declaration or Net Asset Values (NAVs) of mutual fund schemes is an important issue in providing investors with information as to the performance of the fund. SEBI has warned some mutual funds earlier of unhealthy market

(11) Inspection:

SEBI inspect mutual funds every year. A full SEBI inspection of all the 27 mutual funds was proposed to be done by the March 1996 to streamline their operations and protect the investor’s interests. Mutual funds are monitored and inspected by SEBI to ensure compliance with the regulations.

(12) Underwriting:

In July 1994, SEBI permitted mutual funds to take up underwriting of primary issues as a part of their investment activity. This step may assist the mutual funds in diversifying their business.

(13) Conduct:

In September 1994, it was clarified by SEBI that mutual funds shall not offer buy back schemes or assured returns to corporate investors. The Regulations governing Mutual Funds and Portfolio Managers ensure transparency in their functioning.

(14) Voting rights:

In September 1993, mutual funds were allowed to exercise their voting rights. Department of Company Affairs has reportedly granted mutual funds the right to vote as full-fledged shareholders in companies where they have equity investments.

SEBI objectives

(1) Regulation of Stock Exchanges:

The first objective of SEBI is to regulate stock exchanges so that efficient services may be provided to all the parties operating there.

(2) Protection to the Investors:

The capital market is meaningless in the absence of the investors. Therefore, it is important to protect the interests of the investors.

The protection of the interests of the investors means protecting them from the wrong information given by the companies in their prospectus, reducing the risk of delivery and payment, etc. Hence, the foremost objective of the SEBI is to provide security to the investors.

(3) Checking the Insider Trading:

Insider trading means the buying and selling of securities by those people’s directors Promoters, etc. who have some secret information about the company and who wish to take advantage of this secret information.

This hurts the interests of the general investors. It was very essential to check this tendency. Many steps have been taken to check inside trading through the medium of the SEBI.

(4) Control over Brokers:

It is important to keep an eye on the activities of the brokers and other middlemen in order to control the capital market. To have a control over them, it was necessary to establish the SEBI.

Mutual Fund industry plays a key role in the Indian Financial Sector. This industry has come a long way since its inception in the year 1963. The expansion of this sector has been tremendous as it has seen growth in all parameters namely assets under management, number of schemes, funds, fund houses etc. Investing in mutual fund has seen an upfront growth in India because of the nature of this instrument. Mutual fund is a type of financial intermediary that empowers million small as well as large investors across the country to participate and invest in capital market and derive benefits from it. Let us understand more about mutual fund, its history and growth in India.

Growth of mutual fund industry in India

Internationally, the dawn of mutual fund industry was witnessed in 19th century in Europe. It was Robert Fleming who set up the first ever mutual fund company called as ‘foreign and colonial investment trust’ in 1868 who promised to invest and overlook the finances of the investors. While in India, the introduction of mutual fund came a lot later. The journey of mutual fund in India started in the 1963 with the incorporation of ‘Unit Trust of India (UTI)’. The growth of mutual fund in India has happened in phased manner as under:

• Phase 1: Formation and Growth of UTI (1964 to 1987) The phase 1 witnessed the incorporation and introduction of Unit Trust of India by passing an Act by Parliament. The incorporation of UTI was done by Reserve Bank of India. Post its incorporation, it was the only institution that accepted investments and offered mutual fund units. The first scheme launched by UTI was the Unit Scheme in the year 1964. Later in the years of 70s and 80s, UTI introduced various schemes as per the needs of Indian investors. The first ULIP (Unit Linked Insurance Plan) was introduced by UTI in the year 1971, while the 1st Indian Offshore Fund was launched in the year 1986. In this phase i.e. from the date of inception to the year 1987, the growth of UTI multiplied tremendously.
• Phase 2: Establishment of Public Sector Funds (1987 to 1992) The year 1987 witnessed the establishment of public sector funds i.e. other public sector institutions like banks and NBFCs were allowed to start mutual fund houses. This resulted in opening up of economy and State Bank of India was the first bank to establish a mutual fund company in the year 1987. The footsteps of SBI were then followed by various other institutions like Canbank, Life Insurance Corporation of India, Indian Bank, Bank of India, General Insurance Corporation of India and Punjab National Bank introducing their own mutual fund companies. During this period, the asset under management under this sector increased from Rs. 6700 Crores to a whooping Rs. 47004 Crores as investors in India showed great interest in this financial tool and started investing a large part of their salary in Mutual funds.
• Phase 3: Introduction of Private Sector Funds (1992 to 1997) After the successful introduction of Public Sector Funds, the mutual fund industry opened up and witnessed the establishment of private sector funds from the year 1993, giving Indian investors the extensive opportunity to choose mutual funds from public and private sector. On the other hand, it increased the competition for Indian mutual fund companies.
• Phase 4: Growth and introduction of SEBI regulations (1997 to 1999) As the mutual fund sector was witnessing and achieving newer heights, it was important to create a body that created comprehensive rules and regulation for this industry and creating a responsible organisation to overlook the working of this sector. This gave birth to incorporation of SEBI Regulation in 1996. SEBI introduced standardization and set uniform rules and regulations for all funds. It was during this phase that SEBI and AMFI launched an awareness scheme for investors of mutual funds.
• Phase 5: Emergence of a Large and Stable Industry (1999 to 2004) This phase witnessed the integration of the entire industry with a similar set of rules and regulations. The uniform and standardized operations and regulations made it easier for investors to invest in various mutual fund companies resulting in increase of asset under management from Rs. 68000 crores in previous phase to over Rs. 1.50 lakh crores during this phase.
• Phase 6: Amalgamation and Growth (2004 onwards) The mutual fund industry has seen immense growth and globalisation since the day of its incorporation. From the year 2004, this industry witnessed integration as there were many mergers, demergers and acquisitions of companies and schemes like Allianz Mutual Fund taken over by Birla Sun Life, PNB mutual fund by Principal etc. Thus, since the year 2004, this industry is coping and integrating new players, dealing with mergers and acquisitions and continuing its journey towards growth.

Structure of Mutual Funds in India

Let us understand the structure and working of best mutual fund to invest in India. The structure of mutual funds in India is designed by SEBI, thus determining it to be very well crafted and regulated. The regulations laid by SEBI has made the operations and working of this industry very transparent and SEBI working closely towards protecting the investor’s interest. The mutual fund industry operates on 4 tier structure as under:

• Sponsor: A sponsor is a corporate body acting alone or with another corporate body who establishes the mutual fund. This sponsor must contribute to 40% to the asset management companies’ net worth.
• Board of Trustees: Board of trustee is an independent third-party board who are responsible to working towards protecting the interest of the unit-holders by holding and overlooking the property owned by the mutual fund.
• Asset Management Company (AMC): The AMC are the fund managers of the investor. This body is responsible to invest the investor’s money in various capital market instruments.
• Custodian: The SEBI regulation specifies that all mutual funds must park their securities with SEBI registered custodian bank.

Over decades, the Indian Mutual Fund Industry has seen a lot of development and growth. It has become more organized and transparent in terms of its functioning, since the inception few mutual fund companies have been offering top notch mutual fund schemes. If you wish to invest in mutual funds, you can invest in these top equity funds of 2019: SBI Bluechip Fund, SBI Magnum Multicap Fund, Axis Bluechip Fund, ICICI Prudential Bluechip Fund, UTI-ST Income fund.

A money market fund (also called a money market mutual fund) is an open-ended mutual fund that invests in short-term debt securities such as US Treasury bills and commercial paper. Money market funds are managed with the goal of maintaining a highly stable asset value through liquid investments, while paying income to investors in the form of dividends. Although they are not insured against loss, actual losses have been quite rare in practice.

Money market mutual funds (MMF) invest in short-term debt instruments, cash, and cash equivalents that are rated high quality. It is for this reason that money market mutual funds are considered safe or investment with minimal to low risk. As these funds invest in high-quality instruments, they offer a predictable risk-free return rate.

Money market mutual funds (MMMF) are used to manage short-term cash needs. These funds are open-ended in the debt fund category and deal only in cash or cash equivalents. Money market securities have an average maturity of one-year; that is why these are termed as money market instruments.

The fund manager invests in high-quality liquid instruments such as treasury bills (T-Bills), repurchase agreements (Repos), commercial papers, and certificates of deposit. Money market funds mainly target earning interest for the unitholders. The primary aim of money market funds is to minimise the fluctuation of the Net Asset Value (NAV) of the fund.

Types of Money Market Instruments

Following are the most popular money market instruments:

1. Certificate of Deposit (CD)
   These are time deposits such as fixed deposits that are offered by scheduled commercial banks. The only difference between FD and CD is that investors are not allowed to withdraw CD until maturity.
2. Commercial Paper (CPs)
   These are issued by companies and financial institutions which have a high credit rating. Commercial papers are also known as promissory notes, commercial papers are unsecured instruments, which are issued at the discounted rate and redeemed at face value.
3. Treasury Bills (T-bills)
   T-bills are issued by the Government of India to raise money for a short-term of up to 365 days. Treasury bills are considered one of the safest instruments as the government backs these. The rate of return, also known as the risk-free rate, is low on T-bills as compared to all other instruments.
4. Repurchase Agreements (Repos)
   It is an agreement under which RBI lends money to commercial banks. It involves the sale and purchase of agreement at the same time.

A money market fund tries to offer the highest short-term income by maintaining a well-diversified portfolio of money market instruments. Investors having a short investment horizon of up to one year may invest in these funds.

Those individuals with low-risk appetite having their surplus cash parked in a savings bank account can invest in money market funds. These funds have the potential to offer higher returns than a regular savings bank account. The investors could be corporate as well as retail investors.

If you have a medium to long-term investment horizon, then money market fund won’t be an ideal option. Instead, you may go for dynamic bond funds or balanced funds, which are capable of providing relatively higher returns.

Things to Consider as an Investor

1. Risk
   Money market funds face interest rate risk, credit risk, and reinvestment risk. In interest rate risk, the prices of the underlying asset increases as interest rates decline and decrease as interest rates rise. The fund manager may invest in risky securities which have a higher probability of default.
2. Return
   Money market funds have the potential to offer higher returns than a regular savings bank account. However, the returns are not guaranteed. The Net asset value (NAV) fluctuates with changes in the overall interest rate regime. A fall in interest rates may increase the prices of an underlying asset and deliver good returns.
3. Costs
   Expense ratio refers to the fee charged by fund houses to manage your investment. SEBI has capped the expense ratio at 1.05%. As the assets under management (AUM) increases, the scheme tends to reduce the cost of operations.
4. Investment Horizon
   Money market funds are suitable for very short-term to short-term investment horizons, i.e. three months to one year. For medium-term horizons, you may invest in other debt funds like dynamic bond funds.
5. Financial Goals
   If you have to make EMI payments or invest extra cash while maintaining liquidity, then you can use money market funds. A small portion of your portfolio can be invested in these for diversification.
6. Tax on Gains
   Investing in debt funds provides you with taxable capital gains. The tax rate depends on the holding period, i.e. for how long you stayed invested in the fund. You make a Short-term Capital Gain (STCG) when you stay invested for a period of fewer than three years.

Long-term Capital Gains (LTCG) are made when you stay invested for over three years. STCG from money market funds are added to your income and taxed according to your income slab. LTCG from money market funds is taxed at the flat rate of 20% after indexation.