Advanced Financial Management Question Paper June 2025 [Dibrugarh University BCOM 4th SEM NEP Syllabus]

Advanced Financial Management Question Paper June 2025
Dibrugarh University BCOM 4^th SEM NEP Syllabus

COMMERCE (Core)

Paper: COM (FIN/MKT/BNI/HRM)

Full Marks: 60

Time: 2 hours

The figures in the margin indicate full marks for the questions.

1. (a) Fill in the blanks: (1 × 4 = 4)

(i) The value of the firm can be maximized, if the shareholders’ wealth is ______.

Ans: Maximize

(ii) Cost of retained earnings is the ______ of dividends foregone by the shareholders.

Ans: Opportunity cost

(iii) According to ______ Model, the dividend decision is irrelevant.

Ans: Modigliani-Miller (MM)

(iv) Working capital is also known as ______ capital.

Ans: Circulating or revolving capital

(b) Write True or False: (1 × 4 = 4)

(i) Capital structure is the mix of preference and equity share capital.

Ans: False

(ii) Payback period method measures the true profitability of a project.

Ans: False

(iii) Payment of dividend involves legal as well as financial considerations.

Ans: True

(iv) Net working capital is the excess of current assets over current liabilities.

Ans: True

2. Write short notes on any three of the following: (4 × 3 = 12)

(a) Optimal Capital Structure

Ans: The optimum capital structure may be defined as “that capital structure or combination of debt and equity that leads to the maximum value of the firm. At this, capital structure, the cost of capital is minimum and market price per share is maximum. But, it is difficult to measure a fall in the market value of an equity share on account of increase in risk due to high debt content in the capital structure. In reality, however, instead of optimum, an appropriate capital structure is more realistic.

Features of an appropriate capital structure are as below:

a. Profitability: The most profitable capital structure is one that tends to minimise financing cost and maximise of earnings per equity share.

b. Flexibility: The capitals structure should be such that the company is able to raise funds whenever needed.

c. Conservation: Debt content in capital structure should not exceed the limit which the company can bear.

d. Solvency: Capital structure should be such that the business does not run the risk of insolvency.

e. Control: Capital structure should be devised in such a manner that it involves minimum risk of loss of control over the company.

(b) Capital Budgeting

Ans: The term capital budgeting or investment decision means planning for capital assets. Capital budgeting decision means the decision as to whether or not to invest in long-term projects such as setting up of a factory or installing a machinery or creating additional capacities to manufacture a part which at present may be purchased from outside and so on. It includes the financial analysis of the various proposals regarding capital expenditure to evaluate their impact on the financial condition of the company for the purpose to choose the best out of the various alternatives.

Nature / Features of Capital budgeting decisions

a. Long term effect: Such decisions have long term effect on future profitability and influence pace of firm’s growth. A good decision may bring amazing returns and wrong decision may endanger very survival of firm. Hence capital budgeting decisions determine future destiny of firm.

b. High degree of risk: Decision is based on estimated return. Changes in taste, fashion, research and technological advancement leads to greater risk in such decisions.

c. Huge funds: Large funds are required and sparing huge funds is problem and hence decision to be taken after proper care.

d. Irreversible decision: Reverting back from a decision is very difficult as sale of high value asset would be a problem.

(c) Types of Dividend

Ans: Dividend may be divided into following categories:

* CASH DIVIDEND: A Cash dividend is the most common form of the dividend. The shareholders are paid in cash per share. The board of directors announces the dividend payment on the date of declaration.

* BONUS SHARE: Bonus share is also called as the stock dividend. Bonus shares are issued by the company when they have low operating cash, but still want to keep the investors happy. Each equity shareholder receives a certain number of additional shares depending on the number of shares originally owned by the shareholder.

* INTERIM DIVIDEND: This dividend is issued between two accounting year on the basis of expected profit. This dividend is declared before the preparation of final accounts.

* PROPERTY DIVIDEND: The company makes the payment in the form of assets in the property dividend. The asset could be any of this equipment, inventory, vehicle or any other asset. The value of the asset has to be restated at the fair value while issuing a property dividend.

* SCRIP DIVIDEND: Scrip dividend is a promissory note to pay the shareholders later. This type of dividend is used when the company does not have sufficient funds for the issuance of dividends.

* LIQUIDATING DIVIDEND: When the company returns the original capital contributed by the equity shareholders as a dividend, it is termed as liquidating dividend. It is often seen as a sign of closing down the company.

(d) Need of Working Capital Management

Ans: Working capital management involves the relationship between a firm's short-term assets and its short-term liabilities. The goal of working capital management is to ensure that a firm is able to continue its operations and that it has sufficient ability to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash.

a) Enables a company to meet its obligations: Working capital helps to operate the business smoothly without any financial problem for making the payment of short-term liabilities. Purchase of raw materials and payment of salary, wages and overhead can be made without any delay. Adequate working capital helps in maintaining solvency of the business by providing uninterrupted flow of production.

b) Enhance Goodwill:  Sufficient working capital enables a business concern to make prompt payments and hence helps in creating and maintaining goodwill. Goodwill is enhanced because all current liabilities and operating expenses are paid on time.

c) Facilitates obtaining Credit from banks without any difficulty: A firm having adequate working capital, high solvency and good credit rating can arrange loans from banks and financial institutions in easy and favourable terms.

d) Regular Supply of Raw Material: Quick payment of credit purchase of raw materials ensures the regular supply of raw materials for suppliers. Suppliers are satisfied by the payment on time. It ensures regular supply of raw materials and continuous production.

e) Smooth Business Operation: Working capital is really a life blood of any business organization which maintains the firm in well condition. Any day to day financial requirement can be met without any shortage of fund. All expenses such as salaries, rent, electricity bills and current liabilities are paid on time.

f) Ability to Face Crisis: Adequate working capital enables a firm to face business crisis in emergencies such as depression because during such periods there is much pressure on working capital.

3. (a) "Maximization of profits is regarded as the proper objective of investment decision, but it is not as exclusive as maximizing shareholders' wealth." Comment. (10)

Ans: Profit maximization is the traditional approach where a firm aims to produce maximum output with minimum input or achieve the highest possible price for its goods. It is often seen as a "barometer" for measuring efficiency and economic prosperity.

a) When profit earning is the aim of business then profit maximisation should be the obvious objective.

b) Profit is the barometer for measuring efficiency and economic prosperity of a business.

c) In adverse situation such recession, depression etc., a business can survive only when if it has past reserves to rely upon. Therefore, every business should try to earn more and more profit when situation is favourable.

d) The profits are the main source of finance for the growth of a business. So, a business should aim at maximisation of profits for enabling its growth and development.

e) Profitability is essential for fulfilling social goals also. A firm by pursuing the objective of profit maximisation also maximises socio-economic welfare.

While profit is important, it has significant flaws that prevent it from being the ultimate goal of financial management. Certain objections have been raised against the goal of profit maximization which strengthens the case for wealth maximization as the goal of business enterprise. The objections are:

(a) Profit cannot be ascertained well in advance to express the probability of return as future is uncertain. It is not at all possible to maximize what cannot be known.

(b) The executive or the decision maker may not have enough confidence in the estimates of future returns so that he does not attempt further to maximize.

(c)There must be a balance between expected return and risk. The possibility of higher expected yields is associated with greater risk to recognize such a balance and wealth maximisation is brought in to the analysis.

(d) The goal of maximisation of profits is considered to be a narrow outlook. Evidently when profit maximisation becomes the basis of financial decision of the concern, it ignores the interests of the community on the one hand and that of the government, workers and other concerned persons in the enterprise on the other hand.

(e) To make a distinction between profits and profitability. Maximisation of profits with a view to maximizing the wealth of shareholders is clearly an unreal motive.

Wealth maximization is considered more "exclusive" and appropriate because it focuses on maximizing the market value of the company’s shares in the long run. The following arguments are advanced in favour of wealth maximization as the goal of financial management:

a) It serves the interests of owners, (shareholders) as well as other stakeholders in the firm; i.e. suppliers of loaned capital, employees, creditors and society.

b) It is consistent with the objective of owners’ economic welfare.

c) The objective of wealth maximization implies long-run survival and growth of the firm.

d) It takes into consideration the risk factor and the time value of money as the current present value of any particular course of action is measured.

e) The effect of dividend policy on market price of shares is also considered as the decisions are taken to increase the market value of the shares.

f) The goal of wealth maximization leads towards maximizing stockholder’s utility or value maximization of equity shareholders through increase in stock price per share.

OR

(b) Gohain firm has Sales of 20,00,000, Variable Costs of 14,00,000, Fixed Costs of 4,00,000 and Debt of 10,00,000 at 10% rate of interest. Calculate Operating, Financial and Combined Leverages. (10)

Ans:

Income Statement

Particulars	Amount
(i) Sales Less: Variable Cost	20,00,000 14,00,000
(ii) Contribution Less: Fixed Cost	6,00,000 4,00,000
(iii) EBIT Less: Interest @ 10% in debt	2,00,000 1,00,000
(iv) EBT	1,00,000

(i) Operating leverage = Contribution/EBIT = 6,00,000/2,00,000 = 3

(ii) Financial Leverage = EBIT/EBT = 2,00,000/1,00,000 = 2

(iii) Combined Leverage = Contribution/EBT = 6,00,000/1,00,000 = 6

4. (a) Compute the Cost of Debt Capital in the following cases: (2.5 × 4 = 10)

(i) X Ltd. issues 50,000, 8% debentures at par. The tax rate applicable to the company is 50%.

(ii) Y Ltd. issues 50,000, 8% debentures at a premium of 10%. The tax rate applicable to the company is 60%.

(iii) A Ltd. issues 50,000, 8% debentures at a discount of 5%. The tax rate is 50%.

(iv) B Ltd. issues 1,00,000, 9% debentures at a premium of 10%. The costs of flotation are 2%. The tax rate applicable is 60%.

Ans: Asked in 2015 Exam, Video is already uploaded on our YouTube Channel

OR

(b) Discuss any four important methods of evaluating capital investment project. (10)

Ans: Techniques used in Investment decision making

Most commonly used technique in investment decision making are given below:

1) Payback period Method: It is one of the simplest methods to calculate period within which entire cost of project would be completely recovered. It is the period within which total cash inflows from project would be equal to total cash outflow of project. It is calculated by dividing initial investments in project by annual cash inflows. Here, cash inflow means profit after tax but before depreciation.

Merits of Payback Period Method

a) This method of evaluating proposals for capital budgeting is simple and easy to understand, it has an advantage of making clear that it has no profit on any project until the payback period is over i.e. until capital invested is recovered. This method is particularly suitable in the case of industries where risk of technological services is very high.

b) In case of routine projects also, use of payback period method favours projects that generates cash inflows in earlier years, thereby eliminating projects bringing cash inflows in later years that generally are conceived to be risky as this tends to increase with futurity.

c) By stressing earlier cash inflows, liquidity dimension is also considered in selection criteria. This is important in situations of liquidity crunch and high cost of capital.

d) Payback period can be compared to break-even point, the point at which costs are fully recovered but profits are yet to commence.

e) The risk associated with a project arises due to uncertainty associated with cash inflows. A shorter payback period means that uncertainty with respect to project is resolved faster.

Limitations of payback period

a) It stresses capital recovery rather than profitability. It does not take into account returns from the project after its payback period.

b) This method becomes an inadequate measure of evaluating 2 projects where the cash inflows are uneven.

c) This method does not give any consideration to time value of money, cash flows occurring at all points of time are simply added.

d) Post-payback period profitability is ignored totally.

2) Accounting rate of return (Average rate of return – ARR): ARR is a financial ratio used in capital budgeting. The ratio does not take into account the concept of time value of money. ARR calculates the return, generated from net income of the proposed capital investment. The ARR is a percentage return. Say, if ARR = 7%, then it means that the project is expected to earn seven cents out of each dollar invested. If the ARR is equal to or greater than the required rate of return, the project is acceptable. If it is less than the desired rate, it should be rejected. When comparing investments, the higher the ARR, the more attractive the investment. Over one-half of large firms calculate ARR when appraising projects. It is calculated with the help of the following formula:

ARR=Average Profit / Investment

Merits of ARR

a)       It is simple, common sense oriented method.

b)      Profits of all years taken into account.

c)       It considers actual net profit of the project.

Demerits of ARR

a)       Time value of-money is not considered

b)      Risk involved in the project is not considered

c)       Annual average profits might be same for different projects but accrual of profits might differ having significant implications on risk and liquidity

d)      The ARR has several variants and that it lacks uniform understanding.

3) Net present value (NPV) method: The best method for evaluation of investment proposal is net present value method or discounted cash flow technique. This method takes into account the time value of money. The net present value of investment proposal may be defined as sum of the present values of all cash inflows as reduced by the present values of all cash outflows associated with the proposal. Each project involves certain investments and commitment of cash at certain point of time. This is known as cash outflows. Cash inflows can be calculated by adding depreciation to profit after tax arising out of that particular project.

Merits of NPV method:

1) NPV method takes into account the time value of money.

2) The whole stream of cash flows is considered.

3) NPV can be seen as addition to the wealth of shareholders. The criterion of NPV is thus in conformity with basic financial objectives.

4) NPV uses discounted cash flows i.e. expresses cash flows in terms of current rupees. NPV's of different projects therefore can be compared. It implies that each project can be evaluated independent of others on its own merits.

Limitations of NPV method:

1) It involves different calculations.

2) The application of this method necessitates forecasting cash flows and the discount rate. Thus accuracy of NPV depends on accurate estimation of these 2 factors that may be quite difficult in reality.

3) The ranking of projects depends on the discount rate.

4) Internal rate of return (IRR): The internal rate of return method is also a modern technique of capital budgeting that takes into account the time value of money. It is also known as ‘time adjusted rate of return’ discounted cash flow’ ‘discounted rate of return,’ ‘yield method,’ and ‘trial and error yield method’. In the net present value method, the net present value is determined by discounting the future cash flows of a project at a predetermined or specified rate called the cut-off rate. But under the internal rate of return method, the cash flows of a project are discounted at a suitable rate by hit and trial method, which equates the net present value so calculated to the amount of the investment. Under this method, since the discount rate is determined internally, this method is called as the internal rate of return method. The internal rate of return can be defined as that rate of discount at which the present value of cash-inflows is equal to the present value of cash outflows.

Merits of IRR

1.       It considers the time value of money.   

2.       It considers entire cash flows over entire life of the project.

3.       It is consistent with the objective of maximizing the wealth of owners.

4.       It is a measure of profitability since entire cash flows over entire life of the project are considered.

5.       Unlike the NPV, cost of capital is not assumed to be known.

Demerits of IRR

1.       It requires the estimation of cash inflows and cash outflows, which is a difficult task.

2.       It assumes that intermediate cash inflows are reinvested at IRR.

3.       It may yield negative rates under certain circumstances. (e.g. when Cash Outflows are more than Cash Inflows).

4.       It may yield multiple rates under certain circumstances (e.g. when cash flows reverse their signs during the project.

5.       It is relatively difficult to compute.

5. (a) Explain the various factors which influence the dividend decision of a firm. (10)

Ans: Factors Influencing Dividend Decision/Determinants of dividend policy

The payment of dividend involves financial, legal and internal considerations. It is difficult to determine a general dividend policy which can be followed by different firms at different times because the dividend decision has to be taken considering the special circumstances of an individual case. There are various factors which affect dividend decision. These are enumerated below with brief explanation.

1. Dividend Payout ratio: A major aspect of the dividend policy of a firm is its dividend payout (D/P) ratio, that is, the percentage share of the net earnings distributed to the shareholders as dividends. Dividend policy involves the decision to pay out earnings or to retain them for reinvestment in the firm. The retained earnings constitute a source of financing. The payment of dividends results in the reduction of cash and, therefore, is a depletion of total assets. In order to maintain the asset level, as well as to finance investment opportunities, the firm must obtain funds from the issue of additional equity or debt. If the firm is unable to raise external funds, its growth would be affected. Thus, dividends imply outflow of cash and lower future growth.

2. Legal position: Section 123 (2) of the Companies Act, 2013 which lays down the sources from which dividend can be paid, provides for payment of dividend (i) out of past profits and (ii) out of moneys provided by the Central/State Government, apart from current profits. Thus, by law itself, a company may be allowed to declare a dividend even in a year when the profits are inadequate or when there is absence of profit.

3. Internal Constraints Such factors are unique to a firm and include:

a) Liquidity and Working Capital Position: Apparently, distribution of dividend results in outflow of cash and as such a reduction in working capital position. Even in a year when a company has earned adequate profit to warrant a dividend declaration, it may confront with a week liquidity position. Under the circumstance, while one company may prefer not to pay dividend since the payment may impair liquidity, another company following a stable dividend policy, may wish to declare dividends even by resorting to borrowings for dividend payment in cash.

b) Earnings Stability: The stability of earnings also has a significant bearing on the dividend decision of a firm. Generally, the more stable the income stream, the higher is the dividend payout ratio. Public utility companies are classic examples of firms that have relatively stable earnings pattern and high dividend payout ratio.

c) Control consideration: Where the directors wish to retain control, they may desire to finance growth programmes by retained earnings, since issue of fresh equity shares for financing growth plan may lead to dilution of control of the dominating group. So, low dividend payout is favoured by Board.

d) Restrictive covenants imposed by debt financiers: Debt financiers, especially term lending financial institutions, may impose restrictive conditions on the rate, timing and form of dividends declared. So, that consideration is also significant.

e) Floatation cost, cost of fresh equity and access capital market: When floatation costs and cost of fresh equity are high and capital market conditions are not congenial for a fresh issue, a low payout ratio is adopted.

4. Owner’s Considerations: The dividend policy is also likely to be affected by the owner’s considerations of (a) Taxes Status, (b) their opportunities of investment (c) Dilution of Ownership, and (c) the type of shareholders. It is well-nigh impossible to establish a policy that will maximise each owner’s wealth. The firm must aim at a dividend policy which has a beneficial effect on the wealth of the majority of the shareholders.

a) Taxes Status: The dividend policy of a firm may be dictated by the income tax status of its shareholders. If a firm has a large percentage of owners who are in high tax brackets, its dividend policy should seek to have higher retentions. Such a policy will provide its owners with income in the form of capital gains as against dividends. Since capital gains are taxed at a lower rate than dividends, they are worth more after taxes to the individuals in a high tax bracket. On the other hand, if a firm has a majority of low income shareholders who are in a lower tax bracket, they would probably favour a higher payout of earnings because of the need for current income and the greater certainty associated with receiving the dividend now, instead of the less certain prospects of capital gains later.

b) Investment opportunities for the company: If the company has better investment opportunities, and it is difficult to raise fresh capital quickly and at cheap costs, it is better to adopt a conservative dividend policy. By better investment opportunities we mean those with higher 'r' relative to the 'k'. So, if r>k, low payout is good. And vice versa.

c) Dilution of Ownership: The finance manager should recognize that a high dividend payout ratio may result in the dilution of both control and earnings for the existing equity holders. Dilution in earnings results because low retentions may necessitate the issue of new equity shares in the future, causing an increase in the number of equity shares outstanding and ultimately lowering earnings per share and their price in the market.

d) Type of Shareholders: When the shareholders of the company prefer current dividend rather man capital gain a high payment is desirable. This happens so, when the shareholders are in low tax brackets, they are less moneyed and require periodical income or they have better investment avenues than the company. Retired persons, economically weaker sections and similarly placed investors prefer current income i.e. dividend. If, on the other hand, majority of the shareholders are moneyed people, and want capital gain, then low payout ratio is desirable. This is known as clientele effect on dividend decision.

e) Age of the company: Newly formed companies adopt a conservative dividend policy so that they can get stabilized and think of growth and expansion.

5. Shareholders and stock market factors:

a) Impact on share price: The impact of dividends on market price of shares, though cannot be precisely measured, still one could consider the influence of dividend on the market price of shares. The dividend policy pursued by a company naturally depends on how far the management is concerned about the market price of shares. Generally, an increase in dividend payout results in a hike in the market price of shares. This is significant as it has a bearing on new issues.

b) Industry Norms: The industry norms have to be adhered to the extent possible. It most firms in me industry adopt a high payout policy, perhaps others also have to adopt such a policy.

c) Magnitude and Trend in EPS: EPS is the basis for dividend. The size of the EPS and the trend in EPS in recent years set how much can be paid as dividend a high and steadily increasing EPS enables a high and steadily increasing DPS. When EPS fluctuates a different dividend policy has to be adopted.

d) Financial signalling: Dividends are the best medium to tell shareholder of better days ahead of the company. When a company enhances the target dividend rate, it overwhelmingly signals the shareholders that their company is on stable growth path. Share prices immediately react positively.

OR

(b) What is the Modigliani-Miller approach of irrelevance concept of dividend? Under what assumptions to the conclusions hold good? (6 + 4 = 10)

Ans: Modigliani and Miller approach (M & M Hypothesis)

The residuals theory of dividends tends to imply that the dividends are irrelevant and the value of the firm is independent of its dividend policy. The irrelevance of dividend policy for a valuation of the firm has been most comprehensively presented by Modigliani and Miller. They have argued that the market price of a share is affected by the earnings of the firm and not influenced by the pattern of income distribution. What matters, on the other hand, are the investment decisions which determine the earnings of the firm and thus affect the value of the firm. They argue that subject to a number of assumptions, the way a firm splits its earnings between dividends and retained earnings has no effect on the value of the firm.

Like several financial theories, M&M hypothesis is based on the argument of efficient capital markets. In addition, there are two options:

(a) It retains earnings and finances its new investment plans with such retained earnings;

(b) It distributes dividends, and finances its new investment plans by issuing new shares.

The intuitive background of the M&M approach is extremely simple, and in fact, almost self-explanatory. It is based on the following assumptions:

a)       The capital markets are perfect and the investors behave rationally.

b)      All information is freely available to all the investors.

c)       There is no transaction cost.

d)      Securities are divisible and can be split into any fraction. No investor can affect the market price.

e)      There are no taxes and no flotation cost.

f)        The firm has a defined investment policy and the future profits are known with certainty. The implication is that the investment decisions are unaffected by the dividend decision and the operating cash flows are same no matter which dividend policy is adopted.

Their conclusion is that; the shareholders get the same benefit from dividend as from capital gain through retained earnings. So, the division of earnings into dividend and retained earnings does not influence shareholders' perceptions. So whether dividend is declared or not, and whether high or low payout ratio is follows, it makes no difference on the value of the share. In order to satisfy their model, MM has started with the following valuation model.

P0= 1* (D1+P1)/ (1+ke)

Where,

P0 = Present market price of the share

Ke = Cost of equity share capital

D1 = Expected dividend at the end of year 1

P1 = Expected market price of the share at the end of year 1

With the help of this valuation model we will create an arbitrage process, i.e., replacement of amount paid as dividend by the issue of fresh capital. The arbitrage process involves two simultaneous actions. With reference to dividend policy the two actions are:

a)       Payment of dividend by the firm

b)      Rising of fresh capital.

With the help of arbitrage process, MM have shown that the dividend payment will not have any effect on the value of the firm. Even if the firm pays dividends, resulting in an increase in market value of the share, the effect on the value of the firm will be neutralized by the decrease in terminal value of the share.

6. (a) Prepare a statement showing the Working Capital Requirements for a level of activity of 1,56,000 units of production for ABC Engineering Company Private Ltd. (10)

Cost Information per unit:

Raw Materials: ₹ 90

Direct Labour: ₹ 40

Overheads: ₹ 75

Total Cost: ₹ 205

Profit: ₹ 60

Selling Price: ₹ 265

Additional Information:

(i) Raw materials are in stock, on average 1 month.

(ii) Materials are in process, on average 2 weeks.

(iii) Finished goods are in stock, on average 1 month.

(iv) Credit allowed by suppliers, 1 month.

(v) Time lag in payment from debtors, 2 months.

(vi) Lag in payment of wages, 1½ weeks; Lag in payment of overheads, 1 month.

(vii) 20% of the output is sold against cash. Cash in hand/bank expected is ₹ 60,000.

(viii) Assume production is even throughout the year; wages and overheads accrue similarly; 4 weeks = 1 month.

Ans: Solution Available in our YouTube Channel

OR

(b) What do you mean by Inventory Management? Explain any two major techniques of Inventory Management. (2+4+4=10)

Ans: Inventory Management is the process of managing a company's stock (goods). It involves buying the right products at the right time and keeping track of them so the business doesn't run out of stock or waste money by buying too much. The main goal is to have enough stock to satisfy customers need without blocking too much cash in the warehouse.

Techniques of Inventory Management

ABC Analysis: ABC System: In this technique, the items of inventory are classified according to the value of usage. Materials are classified as A, B and C according to their value.

Items in class ‘A’ constitute the most important class of inventories so far as the proportion in the total value of inventory is concerned. The ‘A’ items constitute roughly about 5-10% of the total items while its value may be about 80% of the total value of the inventory.

Items in class ‘B’ constitute intermediate position. These items may be about 20-25% of the total items while the usage value may be about 15% of the total value.

Items in class ‘C’ are the most negligible in value, about 65-75% of the total quantity but the value may be about 5% of the total usage value of the inventory.

The numbers given above are just indicative, actual numbers may vary from situation to situation. The principle to be followed is that the high value items should be controlled more carefully while items having small value though large in numbers can be controlled periodically.

Advantages of ABC analysis

a. Reduction in investment: under ABC analysis, the materials from group 'A' are purchase in lower quantities as much as possible. With this, the effort to reduce the delivery period is also made. These in turn help to reduce the investment in material.

b. Optimization of Inventory management function: Each class of the inventory gets management attention as per its value and accordingly, manpower is allocated and expenses are incurred to manage it. It ensures that most important items are regularly monitored and closely observed whereas such efforts are expended with for the less important items.

c. Control on high value material: under ABC analysis, strict control can be exercised to the materials in group 'A' that have higher value.

Disadvantage of ABC analysis

* No Proper classification of material: ABC analysis will not be effective if the material is not classified into the groups properly.

* Not suitable if materials are of same value: It is not suitable for the organization where the costs of materials do not vary significantly.

* No scientific base: There is no any scientific base for the classification of material under ABC analysis.

Economics order quantity: Economics order quantity represents the size of the order for which both order, ordering and carrying costs together are minimum. If purchases are made in large quantities, inventory carrying cost will be high. If the order size is small, ordering cost will be high. Hence, it is necessary to determine the order quantity for which ordering and carrying costs are minimum. The formula used for determining economics order quantity is a s follows:

Where,

- A is the annual consumption of material in units.

- O is the cost of placing an order (ordering cost per unit)

- C is the cost of interest and storing one unit of material for the one year (carrying cost per unit per annum).

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