Modern entrepreneur and entrepreneurship : theory, process and practice

MODERN ENTREPRENEUR AND ENTREPRENEURSHIP (Theory, Process and Practice)

"This page is Intentionally Left Blank"

MODERN ENTREPRENEUR AND ENTREPRENEURSHIP (Theory, Process and Practice)

H.S. KUMAWAT

SUNRISE , PUBLISHERS & DISTRIBUTORS E-566, Vaishali Nagar, Jaipur - 302021 (Raj.)

Published by:

SUNRISE PUBLISHERS & DISTRIBUTORS E-566, Vaishali Nagar, Jaipur - 302021 (Raj.) Ph.:9413156675,9772299149 Email: [email protected]

First Published - 2009

©Reserved

ISBN: 978-93-80207-01-8

All rights reserved. No part of this book may be reproduced in any form or by any mean without permission in writing from the publisher.

Printed at: Jaipur

CONTENTS

•

v

Preface

1. Decision by Modern Entrepreneur

1

2.

Methods for Comparing Investment Alternatives

10

3.

Replacement Analysis

32

4.

Farm Management

44

5. Pre-Fabricated Irrigation Channels

61

6.

Purchasing Methods

74

7.

Stores Control

86

8. Credit System

106

9.

Kinds of Credit

124

10. Treasury Bill Market

138

11. Office Machines

160

12. Production Control

182

13. Typical Production-control Procedure

203

14. Decision-Making Framework for Export Operation

217

15. Privatisation

225

16. Industrial Sickness

247

17. Service Sector and Modern Entrepreneur

266

18. Commercial Banks

283

19. Insurance

292

20. Warehousing

313

•

21. Price Discrimination and Modem Entrepreneur

325

22. Leadership in Modem Entrepreneur

352

23. Organisation of Foreign Trade by Modem Entrepreneur

374

24. Import Decisions by Modem Entrepreneur

385

25. Bilateral Trade and Rupee Payment Agreements

398

26. Export Trade

405

PREFACE The book has been written to meet the requirements of the syllabus prescribed for B.Com., B.B.A., M.Com., and M.B.A. courses of Indian Universities. The book is exhaustive in every sense and cover a large spectrum of subject. In the present economic conditions Entrepreneurship is a subject with wide connotation. The present book deals with the subject matter which is changing which have acquired a critical significance at national and intemationallevel. I hope the book would receive an overwhelming response from the students, professors and other professionals and they will find it an invaluable text. It will also serve as an excellent reference for practising managers in their day-to-day application and understanding of the subject. Inspite of all efforts some errors might have crept in, for which I will be grateful to the teachers and students, if same are brought to my notice. Suggestions for further improvement of the book will be gratefully acknowledged. Author

"This page is Intentionally Left Blank"

Chapter

1

** DECISIONS BY MODERN ENTREPRENEUR

Every business organisation big or small has to invest huge capital for installation of the plant as well as during the process of manufacturing the product or service. The decisions regarding capital expenditures have far reaching consequences on the performance of the business organisation, e.g., capital hired/ acquired on long term credit creates a continuing liability to the business organisation. Capital investments can be divided into folluwing three major categories: Capital investments

Fixed Assets

I

Operational Expenses

Replacement/innovation expenses.

(i) Investment on Fixed Assets: These are the expenditures on men, material and machine/ equipment required for manufacturing. The planning of this type of expenditure is to be done either before the installation of the plant or before the start of actual production. One important feature of such expenditures is that once acquired, the capital assets cannot be disposed off without any loss. Similarly if additional assets does not adequately increase the earnings, then these may adversely affect the financial obligations of the company. It is observed that for producing any type of goods the company can

Decisions by Modem Entrepreneur

2

use varying amounts and kinds of input, i.e., man, machine and material. Thus, there are a number of alternatives in which the capital expenditure can be made.

(ii) Expenditures during course of production: This is also known as cost of production. It is a running expenditure and its magnitude depends on the nature of inputs. Wrong capital investment and misuse may result in increasing operating costs and proportionate decrease in return on investments. Thus, balancing expenditures against expected saving in future operating costs need proper analysis of various financial aspects of the operations of a company. This expenditure can also be done in a number of alternative ways. (iii) Replacement/Innovation Expenses : It is a natural phenomenon that in every system the efficiency of various factors of production deteriorates with time or sometimes the plant or machinery fails completely. Thus, adversely affecting the whole system. In such cases either the plant or machinery is to be replaced completely or there is a need of some remedial measure, i.e. maintenance, to restore the level of efficiency at the desired level. Replacement investments may be desired due to innovations in production technology i.e. for the modernisation of the production system. The capital expenditure may also relate to: (a) cost reduction by (i) replacement of machinery and equipment (ii) plant rearrangement programme or mechanisation of the production process. (b) providing facilities to manufacture £Omponents which are

currently purchased. (c) installation of new plant and machinery for taking up a new product on product lihes. In view of many uncertainties, scientific and systematic planning and control of capital expenditure is of great significance in modem management. The process of capital expenditure involves planning the availability and controlling the allocation and expenditure of long-term investment funds by determining:

3

Decisions by Modem Entrepreneur

(i) How much money is needed for the capital expenditure in future period? (ii) How much money will be available with the organisation

for investment? (iii) How the funds available will be allocated to the projects under consideration? The most common feature of all these expenditures is that there are a number of alternative ways to plan these expenditures to get the desired result and every company wants to formulate an investment policy which is most efficient and economic to the organisation as a whole. Thus, the study of entrepreneurship is a procedure to select the most profitable investment or replacement strategy. In this chapter a number of techniques for selecting the most appropriate investment/replacement alternative in different situations have been discussed in detailed manner. Present Value Concept:

Every capital expenditure made today has some opportunity cost associated with it i.e. there will be some return available on it depending upon the period of return. Alternately, whenever some capital expenditures are made, then the arrangement for these is done either through borrowing from some agencies and paying interest on that or paying it from one's savings which otherwise could have fetched some interest. Thus in each case some return in monetary terms is associated with each investment. This return depends on the amount of investment as well as the period for which the money is to be invested. The money borrowed or invested from savings is known as principal and the money paid as interest or loss of return on savings due to investment is known as interest. The sum of Principal (P) and Interest (I) is known as amount (A). Mathematically, the relationship between the three can be written as: Amount

=

Principal

+

A

=

P

+

Interest (1)

Decisions by Modern Entrepreneur

4

Thus, the present value of a sum to be spent within a given period depends on the rate of interest and the period within which the amount is to be repaid. There are two methods of paying interest (i) Simple interest and (ii) Compound interest.

(a) Simple interest: It is amount paid yearly or some other specified period on the principal amount e.g. if an amount P is borrowed at a fixed interest rate r per rupee per year, then in one year the interest will be iP. next year also the interest will be iP, and in rth year again the interest will be iP. So if total investment is to be paid back in r years, then the total interest paid in r years will be I = iP + iP + ..... iP r times = riP

... (2)

Thus putting the value of / from (2) in (1), we get A=P+riP = P(l + ri)

... (3)

Note: Generally interest rate is specified in percentage i.e. t% per year. r= -

t

100

peryear

...(4)

It is evident from (3), that the amount A increases progressively in arithmetic progression. (b) Compound Interest: In this case, the whole amount A is to be paid at the end of the period. Here every year the interest accrued is also added to the Principal amount of previous year to get the new principal for next year i.e. at the end of first year the new principal will be

PI = P + iP = P(l + i) at the end of second year the principal will be P2 =P1 +iP1 =P 1(1+i) P(l +i) (1 +i) = P (1 +i)2 and at the end of r th year the principal will become

Decisions by Modem Entrepreneur

5

A = Pr - 1 + iPr - 1 = Pr _ 1(1+i) = P(!+W-1 (1 +i) = P(l +i)f

... (5)

or A=P(CAF)

.. .(6)

where CAF known as compound amount factor is (1 +i)r From (5), we get A P = - - =A (PWF) (l+W

...(7)

where PWF = _1_ is known as present worth factor. (l+W There are standard tables of CAF and PWF for different values of i and r. The values of P or A can be immediately determined with the help of these tables. The method is explained by the following examples.

Example 1: Find the amount paid in 10 years for a Principal of Rs. 1000 at (i) simple interest of 10% and (ii) compound interest of 10% per year. Solution: Here t= 10% i.e. = t/100 = 10/100 =C.1 per year, r=10 (i) From (3)

A = P (1 Hi) =1000(1 + 10 x 0.1)= Rs. 2000/-

(ii) Now from (6)

A=P(CAF) Here,

P = Rs. 1000 and CAF at the rate of 10% in 10yrs from Table A-I = 2.594

Thus A = 1000 (2.594) = Rs. 2594/-

Example 2 : If the amount paid after 5 years is Rs. 5000/- then find the Principal at (i) simple interest, rate of 5%, (ii) compound interest of 5%. Solution: (i) Here i = 5/100 = 0.05, A ~ and we want to find P From (3), A = P(1 Hi)

Rs. 5000, r = 5 years

Decisions by Modern Entrepreneur

6

i.e. 5000 = P[l + 5 (0.05)} = P [1.251 P = (5000/1.25) = Rs. 4000 (ii) From (7), P = A (PWF)

(From Table A-2 for 1= 5% and r=5, PWF= 0.7835) = 5000 x 0.7835 = Rs. 3917.50

(iii) There are some situations, where the borrower agrees to repay some fixed amount at fixed intervals of time i.e. the money is repaid in fixed installments. If the total amount A accrued in r years is paid in r, installments of Rs. K, then

A = K[(l +W -l]/i = K(CAFS)

...(8)

where CAPS =[(1+i)f-1J/i is known as uniform annual series compound amount factor. Now, knowing A, we can write K = (Ai) j [(1+i)f-1] = A(SFF) where SFF=ij[(l+i)f~l)) ... (9) K= [P(1+W.i)j[(1+i)f-1] is Sinking Fund Factor = P(CRF) where CRF Factor.

= [i(1+i)r]![(1+i)f-1]

...(10) is known as Capital Recovery

or P = [K(1+W-1)j[(1+W.i)] = K(PWFS)

...(11)

where PWFS =[K(l+i)f -I]! [(1 +W. i] is known as uniform annual series present worth factor. Standard values of CAFS, SFF, CRF and PWFS (for given i and r) are respectively given in Tables. The use of Tables is illustrated with the following examples:

Example 3 : Mr. X deposits Rs. 500 j ~ every year at an interest rate of 10% for 5 years. Find the total amount at the end of 5 years.

Solution:

From (8), A = K(CAFS)

Here, K = Rs. 500, CAFS for 10% and r = 5 from Table A-3 is equal to 6.105. Hence A

=500 (6.105) = Rs. 3052.50

Decisions by Modem Entrepreneur

7

Example 4 : A person wants to have Rs. 10,000 in his account after a period of 5 years. The interest rate is 4%. Find his annual installment.

Solution: Here 0.18463.

From (9), K = A (SFF)

A = Rs.I0000 and SFF at4% and r=5 from table A-4 =

Hence K = 10000 (0.18463) = Rs. 1846.30

Example 5 : Mohan wants to borrow a sum of Rs. 20000 and desires to pay it in 10 equal installments. The annual interest rate is 5%. Find the" size of the installment.

Solution:

Here

P = 20,000, r = 10 and t = 5%.

Now from (10), K = P(CRF) From A-5, CRF for r=10 and t = 5% = 0.12950 Henct! K = 20000 (0.12950) = Rs. 2590.00 per year.

Example 6: There is an opportunity to invest some money with an assurance to get back Rs. 6000/- after 10 years. The investor wants to earn an interest of 1% per year. How much he should invest?

Solution: Here the following things are known: t = 15% per year, r = 10 years, and A = Rs. 6000/From (7) we get, P = A (Pwf) and from A-2, Pwf for r = 10 and and t = 15% = 0.2394. Hence,

P = 6000 x 0.2394 = Rs. 1436.40

Example 7 :A company sets aside for a reserve fund the sum of Rs. 20,000 annually to enable it to payoff a debenture issue of Rs. 2,39,000 at the end of 10 years. Assuming that the reserve accumulates at 5% per annum compound, find the surplus after paying off the debenture stock.

Solution: Here K = Rs. 20,000, r = 10 years, and t = 5% From (8), A = K (CAFS) CAFS from table A-3 for r = 10 and

Decisions by Modem Entrepreneur

8

t = 5% = 12.578 A = 20000 x 12.578 - Rs. 251560 Thus the surplus after paying Rs. 2,39,000 will be Rs. 251560 - Rs. 239000 = Rs. 12560.

Example 8 : On his 48th birthday a man decides to make a gift of Rs. 5000 to a hospital on his 60th birthday. He decides to save this amount by making annual installments up to and including his 60th birthday to a fund which gives 35% compound interest, the first payment being made at once. Calculate the amount of each annual payment. Solution: Here t = 31.5%, r = 12 years and, A = 5000 Now from (9),

K = A(SFF)

From Table A-4 we interpolate the value of SFF for r = 12 and t = 3.5% = 0.068505 K = SOOO (0.068505)

= Rs. 342.525 928.

The Loss Value of a Plant: The plant installed today start immediately to loose its value due to following two main reasons namely, Depreciation and Obsolescence.

Depreciation: The production capacity introduced by some Capital investment tends to decline with time. There is also diminution in the intrinsic value of an asset due to use as well as with passage of time. This diminution may also be due to bad handling, poor maintenance, accidents etc. This decline in the value of investment is known as Depreciation. Depreciation rate can be calculated in two ways: Straight line method : Here we assume that there is a constant rate of decline during an aS,set's life. Thus same absolute value is deducted from the value of the asset's for each period of use. (i)

i.e. Value = P -

P(n -1)

N

9

Decisions by Modern Entrepreneur

where n is the year at which the value is to be calculated and N is the total life of the assets. Alternately the depreciation rate can also be calculated by the formula

F-S

D=--

N

where D: annual depreciation rate F : investment cost 5: estimated salvage value N : estimated life of investment. (ii) Declining Balance Method: Here some constant percentage from book value is deducted.

,

Thus value of the asset after n years can be Value = p(l_R)n-l where R is the depreciation rate. ~lternately

Fixed percentage x F D=

N

Obsolescence: Loss in the intrinsic value of an asset due to its suppression which is the outcome of reduction in the market demand of the product manufactured by the plant or change in the design of the plant etc. is known as obsolescence. This may lead to formulation of suitable replacement policy.

***

Chapter

2

**

METHODS FOR COMPARING INVESTMENT ALTERNATIVES

In plax;ming any production strategy one very often faces a situation when decisions on investment and replacement proposals are to be taken. There are a number of alternatives, each involving huge capital expenditure. Evidently for making an appropriate decision an economic analysis is more useful for differentiating between various alternatives. The basic steps involved for critical appraisal of different alternatives are: (i) To evaluate the cost of products and other investment capital requirements i.e. how much money is needed for desired expenditure during the period under consideration. (ii) Determination of anticipated returns and life of the invested capital. (iii) Timing of the investment in relation to anticipated requirements. (iv) How much money can be made available for the purpose and what will be the sources and expenditure for these funds? The funds can be generated in different ways. Some of these can be:

(a) Hire-purcJzase: Contracts can be negotiated for long periods with the interest tied to the bank rate.ln some

Methods for Comparing Investment Alternatives

11

cases payments can fluctuate with a known seasonal variation in output.

(b) Leasing: Here the user never accurately owns the machinery leased. The use of the plant is considered to be more important than its ownership. (c) Hiring: In fact this is some sort of leasing but in it a maintenance contract is also implied or required. Methods to compare alternative proposals can be divided into following two main categories: Present Value Approach: (a) Present value basis. (b) Uniform annual value basis.

(c) Last basis. (d) Discounted cash flow method. Annual Cost Approach: (a) Pay-back period (b) Return on investment.

Present value Approach: (a) Present Value Basis: In this method, investment in capital expenditure decisions are based on the amount by which the present value of a projected income stream exceeds the cost of an investment. Here both the streams of inflows and outflows are discounted at a calculated rate. The basic assumption behind all discounting is that the cash inflows are re-invested at the discounting rate in net projects as soon as they arise.

Thus in this approach present values of all future expenditures and revenues are calculated for different alternatives and the Net present value of total cost is compared. The alternative with minimum net present value is considered to be most appropriate. Case (i) In the absence of any annual income: If there is an initial investment of P rupees with a recurring expenditure of K rupees per year for r years and at the end of r years the salvage value is 5, then the present value of total cost is given by

12

Methods for Comparing Investment Alternatives P + KPwfs - SPwf

where Pwfs and Pwf can be calculated at the given interest rate for a period of r years from tables. The procedure is explained by the following example.

Example 1 : An entrepreneur is planning to install a small machine in his factory. The relevant data about the two alternative machines are as under: Present investment in Rs.

Machine A

Machine B

1,00,000

1,50,000

20,000

12,000

5,000

2,000

10

10

Annual operating cost in Rs. Salvage value in Rs. Estimated life in years

As financial advisor of the company you have been asked to select the best machine, considering normal rate of return to be 12% per year. (Pwf-series at 12% for 10 years = 5.650 Pwf single payment at 12% for 10 years = 0.332).

Solution: Here we should calculate the present value of total cost incurred on each of the. machines in 10 years by using formula. For Machine A, P = 1,00,000, K = 20,000,5 = 5000, Pwfs = 5.6~ and Pwf= .332 Present of total cost value = P + KPwfs - SPwf = 1,00,000 + 20,000 (5.650) - 5000 (0.322) = 1,00,000 + 1,13,000 - 1610 = 2,13,000 -1610 = Rs. 2,11,390

For Machine B, P = 1,50,000, K = 12,000 and 3 = 2,000 Present of total cost value = 1,50,000+ 12000 (5.650)-2000 (0.322) = 1,50,000 + 6,78,00 - 644 = 2,17,800 - 644 = Rs. 2,17,156

Evidently, present value of total cost for Machine A is lesser than that for Machine B.

Methods for Comparing Investment Alternatives

13

Hence the company should select machine A. Case (ii) : There is some fixed annual income from the investment, say R every year. Then the present value of this annual income for the given period can be calculated by using Pwfs.

Then the present value of net income = Present value of Total Revenue - Present value of total cost

The alternative for which present value of net income is maximum is considered to be most appropriate. Alternately, calculate present value index for each alternative, and the alternative for which present value index is maximum is considered to be the best. Present value index is given by p Present value of future income P.V.1. = ---I-ru-.t-i-al-in-v-es-tm-e-n-t---

or P.V.1. =

Present value of annual income P resent va1ue 0 f tota1cost

Present value index provide some valuable information about the investment policy i.e. lf

P.V.!.

<

1 return is less than normal interest on

investment =

1 break even situation

>

1 return is more than normal interest on

investment. The method is explained by the following examples. Example 2: To start a business it needs an investment of Rs. 50,000: The income in next 25 years is expected to be Rs. 8,000/ - per year with an expenditure of Rs. 3,000 per year. The value of the establlshment at the end of 25 years is expected to be Rs. 18,000. If minimum interest rate is 10% then would you recommend the investment?

(Pwfs - 10% - 25) = 9.077, (Pwf - 10% - 25) = 0.0923.

14

Methods for Comparing Investment Alternatives

Solution:

Here P = Rs. 50,000 K = Rs. 3000 per year r = 25 years

i=lO% R = Rs. 8000 per year. Now from Present value of total cost

=Rs. 50,000 + 3000 (9.077) = Rs. 50,000

18000 (0.0923)

+ 27231 - 1661.40

= Rs. 77231 -

1661.40 = Rs. 75569.60.

Present value of total income

= Rs. 8000 x 9.077 = Rs.72616.

Now present value of total income is less than the present value of total cost. Thus it is not advisable to recommend the investment.

Aliter: Present va1ue 0 f In d ex =

Present value of future income I Initia investment

Now present value of future income = (income per year) Pwfs + (value of the establishment at

the end of 25 years) Pwtf - Annual expenditure (Pwfs) = (8000 x 9.077) + 18000 (0.0923) - (3000 x 9.077) = Rs. 72616

+ Rs. 1661.40 - Rs. 27231

= Rs. 74277.40 - Rs. 27231 = Rs. 47046.40

47046.40 Hence PVI = - - - = 094. 50,000 . Since PVI < 1, the project is not to be recommended for investment.

15

Methods for Comparing Investment Alternatives

Example 3 : A company is considering to purchase a new grinder. The cost data of alternative grinders are as follows: Grinders Present value in Rs.

A

B

C

20,000

15,000

17,000

Annual operating cost in As.

2,000

1,500

1,400

Annual repair cost in As.

1,000

1,100

1,100

Scrap value after 12 yrs. Rs.

2,000

-

1,000

12

12

12

Estimated life in years

Recommend the grinder to be purchased when the minimum rate of return is 8%. Solution: Total annual expenditure on each grinder can be calculated by Annual operating cost + Annual repair costs. Thus for the three grinders this cost will be Rs. 3000 for A, Rs. 2600 for B and Rs. 2500 for C. Now present value of total cost for each grinder can be calculated from (12). It is

P.V. = P +K(Pwfs -8%-12) -S (Pwf-8%-12) Pwf single payment at 12% for 10 years = 0.332). Now for Grinder A P.V.= 20000 + 3000 (7.536) - 2000 (0.3971)

=20000 + 22608 -

794.20

= Rs. 41813.80 For Grinder B = 15000 + 2600 (7.536) - 0 (0.3971) = Rs. 34593.60. For Grinder C P.V.= 17000 + 2500 (7.536) - 1000 (0.3971)

=17000 + 18840.00 -

397.10

= Rs. 35442.90 The present value of total cost is minimum for grinder B. Hence grinder B should be purchased.

Methods for Comparing Investment Alternatives

16

Case (iii) Operating Costs Varying: In practice running costs are never fixed. Actually these are found to be varying from period to period. Suppose a machine's expected life is r years, with running expenditures each year being Rl1 R2 ... Rr respectively. Now for the calculation of present value of these expenditures, we shall use Pwf with a period of one year for R1, two years for R2 and r years for Rr. Thus the present value of all running expenditures at an interest rate of t% per year will be given by the expression

R1(pwf - t% -1 year) + R2 (Pwf -1 % - 2 years) + ... + Rr (Pwf - t% - r years)

... (14)

The net total cost can be determined in the usual manner. The method is illustrated by the following example: Example 4 : A company is considering to replace a grinder X presently of worth Rs. 10,000 by a new grinder Y of Rs. 20000 but will be economic in running expenditures. The expected life of grinder A is 5 years with running expenditure of Rs. 4000 in first year and then an additional increase of Rs. 400 per year for next four years. For the new grinder annual running cost is Rs. 1000 per year and its scrap value is Rs. 2000. As an advisor to the company, find

(i) The present value of the cost of old and new grinders, considering 12% normal rate of return. (ii) Suggest whether the old grinder be replaced by the new

grinder assuming the life of the new grinder to be 5 years. Solution: The following is the summary of costs associated with two grinders Initial Price Rs.

Grinders X

V

10000

20000

Salvage Value Rs. Running Cost 1st. year Rs.

2000 4000

1000

4400

2nd. year Rs. 3rd. year Rs.

4800

1000 1000

4th. year Rs.

5200

1000

5th. year Rs.

5600

1000

Estimated life in years 5 5 Normal interest rate 12% 12%

17

Methods for Comparing Investment Alternatives (i) Present Value of Total Cost for X

=10,000 + 4000 (Pwf-12%-one year) + 4400 (Pwf-12%) - two years) + 4800 (Pwf-12°/o-three years)

+ 5200 (Pwf-12 -four years) %

+ 5600 (PY\. f-12°/o-five years) = 10,000 + 4000 (0.8929) + 4400 (0.7972) + 4800 (0.7118)

+ 5200 (0.6355) + 5600 (0.5674) = 10,000 + 3571.60 + 3507.68 + 3416.64

+ 3304.60 + 3177.44";' 26977.96

Present Value ofTotal Cost for Y = 20000 + 1000 (Pwfs -12% - 5years)

- 2000 (Pwf -12%-5 years)

=20,000 + 1000(3.005) -

2000 (0.5674)

= 20,000 + 3005 -1134.80 = 20,000 + 1870.20 = Rs. 21,870.20

(li) Evidently old grinder should be replaced by the new one. ('IJ) Annual Basis: Here net annual cost is calculated for each alternative and the alternative for which this cost is minimum is considered to be the best. CRF and SFF are used for the given period.

Let P: Principal Value S : Salvage Value r: Estimated life in year t: Normal rate of interest.

Case (i) Running expenditure annually be R. Annual Capital Cost = P (CRF-t%-r years) - S(SFF-t%-r years)

... (15)

Annual Running Cost = R Total Annual Cost = Annual Capital Cost + Annual Running

18

Methods for Comparing Investment Alternatives

Cost Case (ii) With annual expenditure, there is also annual income from the investment.

Here we calculate Annual income Annua I Va Iue In d ex = - - - - - - - Annual net total cost or

Annual value of net total income Annual value of present investment

Annual value of Net income =R (CRF- t%-r years)

+ S (SFF-t%-r years) The alternative with maximum annual value index is considered to be most appropriate. The methods are illustrated by the following examples: Example 5 : There are two investment alternatives A and B. They are briefly described as follows: Alternatives

A 20,000

Initial investment in As. Expected life in years

30,000

5

5

2000

3500

10000

8000

Salvage value in As. Annual operating costs

B

The company feels that if invested elsewhere, its money would yield a return of 10% per year. Find which of the alternatives is more economical. (CRF-I0%-5) =0.2638, (SFF-1O%-5) =0.1639 Solution: In this example CRF and SFF are given. So comparison of the two alternatives can be done on annual basis only, using (15). Alternative A

Annual net total capital cost = (20000) (CRF-I0%-5) - 2000 (SFF-I0%-5)

=20000 (0.2638) -

2000 (.1639)

= Rs. 5276 - Rs. 327.80 = Rs. 4948.20

Methods for Comparing Investment Alternatives

19

Net Annual Total Cost =Annual Capital Cost +Annual expenditure = Rs. 4,948.20 + Rs. 10000 = Rs. 14948.20 For alternative B Annual Capital Cost = 30000 (CRF-10%-5)-3500 (SFF-10%-5) = Rs. 7340.35 Net Annual Total Cost = Rs. 7340.35 + 8000 = Rs. 15340.35 Evidently alternative A is more economical. Example 6 : Project X requires at present, investment of Rs. 25000. Estimated annual receipts for 25 years are Rs. 5000 3.nd estimated annual disbursements as Rs. 5000. An alternative project Y requires a present investment of Rs. 35000, estimated annual receipts of Rs. 1000 for 25 years and estimated annual disbursements of Rs. 3000. Each project is estimated to have a salvage value of Rs. 5000 at the end of 25 years. The minimum attractive rate of return is 10%. Which project would you recommend?

Solution: Here annual income for project X is zero (5000-5000=0) Hencefromformula: Annual Value Index =

Annual Income 0 = =0 Net Annual Cost Net Annual Cost

For Project Y, Net Annual Income = 1000 - 3000 = - 2000 Net Annual Total Cost = 35000 (CRF-10%-25) -5000 (SFF-10%-25) = 35000 (0.11017) - 5000 (0.01017) = 3805.10 Annual Value Index =

2000 = - 0.53 3805.60

Since annual value index for both the projects is less than or,e, none of them is feasible.

20

Methods for Comparing Investment Alternatives

Example 7: If N.K. Ltd. wishes to have a minimum rate of return of 10% per annum on its investment, which of the following two plans should be preferred: Plan A

Plan B

40000

60000

Initial cost in As. Expected life in years

5

5

4000

18000

1st year

8000

8000

2nd year

8000

8000

3rd year

8000

10000

4th year

8000

12000

5th year

8000

12000

Salvage value in As. Excess of annual receipts over disbursements in As.

(CAF-10%-5) (Pwf--10%-1)

= 0.26380, = 0.9091

(Pwf--10%-2) = 0.8264

(SFF-10%-5)

= 0.1638

(Pwf-10%-4) = 0.6830 (Pwf-10%-5) = 0.6209

(Pwf--10%-3) = .7513

Solution: For Plan A

Annual Net income = 8000 + 4000 (SFF-1 0%-5) = 8000 + 4000(0.1638) = 8000 + 655.20 = 8655.20

Using formula Annual Value of Present Investment = 40000 (CRF-1O%-5) = 40000 (0.2638) = 10,552

Annual Value Index for Plan A

Annual Net Income =------Initial Investment 8655.20

= 10,552.00 = 0.8 approx. PlanB Present Value of Annual Income = Rl

(Pwf-10%-l) + R2 (Pwf-10%-2) + R3 (Pwf-10%-3) + R4 (Pwf-l 0%-4) + Rs (Pwf-l 0'10-5)

21

Methods for Comparing Investment Alternatives = 8000 (0.9091 ) + 8000 (0.8264) + 1 0000 (0.751 3)

+ 12000 (0,6830) + 12000 (0.6209)

= Rs. 37043.80 =Rs. 37043.80 (CRF-10%-5) + 18000 (SFF-10%-5) = Rs. 9772.15 + Rs. 2948.60 = Rs.12720.55

Annual Total Cost = 60,000 (CRF-10%-5) = Rs. 15828 Annual Value Index for Plan B =

12720.55 15828.00

=0.8 approx.

It is observed that annual value index in both the cases is less than one. Hence none of the plans is advisable.

(c) Last Basis: In this case the value of all the expenditures and incomes is projected over the expected years to the last year. Thus the total cost of the project after r years is then given by = P (CAF-f%-r years) + R(CAPS-t %-ryears) -5

... (17)

where CAP and CAPS can be seen from standard tables: The alternative for which Total cost is minimum is considered to be most appropriate. The method is illustrated by the following example. Example 8 : If R.K. Ltd. wish to have a minimum return of 10% per annum on its investment, which of the following plans would it prefer? Plan A

Plan B

Initial cost in Rs.

2,00,000

2,50,000

Scrap value after 15 yrs. in Rs.

1,50,000

1,80,000

25,000

30,000

Excess of annual revenue over disbursements in Rs. (CAF-10%-15) = 4.177,

(CMFS-10%-15) = 31.772.

. Solution: Here we are given CAP and CAPS.·So we should use the last basis approach to make a final decision. Now for Plan A: Total cost

=200,000 (CAF-1O%-15) -1,50,000 = Rs. 6,85,400.

22

Methods for Comparing Investment Alternatives The annual income projected over 15 years

=25000 (CAFS-1O%-15) = R<;. 7,94,300 Thus net Profit in Plan A = Revenue-Cost

= Rs. 7,94,300 -

Rs. 6,85,400

= Rs. 1,08,900

Similarly for Plan B the net profit will be Rs. 88,910. It is observed that net profit for Plan A is more than for Plan B. Hence plan A is better than Plan B. (d) Discounted Cash Flow Method:

This method is based on the concept that monies recovered over a period of time are not worth the same amounts at anyone point of time e.g. Re 1/- today and Rs. 1/- in a year time have quite different values today. Similarly a profit of Rs. 1000/- obtained in a stream of Rs. 200/- per year for 5 years has a different value to a stream ofRs.100/- per year for 10 years. The former is worth more than the later. Based on this principle an attempt is made to discount all income receivable at various points of time during the life of a given project. Similarly expenditure on a project also may be spread over a number of years and one may find its present worth. Here discounting is the act of taking a sum in the future and calculating its present value, assuming some particular rate of return. Discounting can be considered inverse of compounding. The principle appears to be simple but in practice it is complicated to determine rate of return. Mathematically, the discounted value is defined as: X

Discounted value = - - (I + i)n where X is the amount to be discounted, n is the period of discount and i is the interest rate. There may be situations where annual earnings are not constant, investment is incremental and the lives of the investments as uneven. In such case we can use the following formula:

Methods for Comparing Investment Alternatives where I n

23

investment in Rs. economic life in years time variable

Rt

revenue for a given period.

Et

expenses for a given period.

S(n):

scrap value at the end of the economic life discount rate.

II. Annual Cost Approach: There are two main techniques in this approach, namely (a) Pay-back method (b) Rate of return method.

(a) Pay-back method: Whenever any investment is made some

amount of return is always expected. Also it is hoped that the investment will be recovered within reasonable period of time. The period of recovery is of great significance for investment decisions. It is commonly known as Pay-back period and is defined to be the period within which the initial investment amount is recovered by net cash inflows. The rationale underlying the use of pay-back method is that the sooner the capital investment can be recovered, the sooner it can be reinvested in revenue producing projects. In pay-back method, the period of recovery for each alternative investment strategy is calculated and then various alternatives are ranked in terms of recovery period viz. alternative with minimum recovery period is ranked first and so on. Payback period is the time required for each investment to return earnings equal to the cost of investment. The method is based on the concept of net cash-inflows which is defined to be Net cash-inflow =

[Cash-inflow from earnings-expenditure on operating costs)

Note: Expenditure on operating costs is known as cash outflow. It should include income tax on earnings but should exclude depreciation costs.

24

Methods for Comparing Investment Alternatives

Now cash-inflow can be of two types (i) Even cash flow which is equal for different years and (ii) un-even cash inflow which is not same for different years In this case cumulative sum of cash-inflows is calculated for each year. The formula for pay-back period is given by b k . d Amount Invested Pay- ac peno = Ann 1 h ·nfl ua cas 1 ow

...(18)

The method is illustrated by the following example: Example 9 : In an investment of Rs. 40,000 the organisation expects (i) an even cash flow of Rs. 5000 per year and (ii) uneven cash-inflow of Rs. 8000, Rs. 8000, Rs. 10,000 and Rs. 15,000 for first four years respectively. Find the pay-back period in each case. Case(i) P

From (18)

b k . d Amount Invested ay- ac peno = Annual cash inflow

=

40,000 8 5000 = years

In the case of uneven cash-inflows, we calculate Case (ii) the cumulative cash-inflow year wise to know the year by which the investment amount is likely to be recovered. The calculations can be done in the following tabular form: Years

Cash-inflow

Cumulative cash-inflow

8000

8000

2

8000

16,000

3

10,000

26,000

4

15,000

41,000

It can be observed that up to 3rd year only Rs. 26,000 will be recovered. The balance of Rs. 14,000 will be recovered in fourth year. In this case:

Pay back Period in years. Amount Invested - Amount revmoved upto 3rd year

= 3 + (Total cash inflow upto 4th year - Total inflow upto 3rd year)

40,000 - 26,000 41,000 -26,000

= 3 + (14/15) years

Methods for Comparing Investment Alternatives

25

= 3 years 11 months

The following are the main drawbacks of payback method: (i) Highly profitable projects do not necessarily pay-off in the initial years. Larger gains may occur later. (ii) It completely ignores the time value of the money received

during and after the pay-back period. (iii) It does nO.t measure the rate of return. (b) Return on investments method: Here profit is considered as return on investment. For various alternatives, profit is calculated after allowing for depreciation (but before taxation) expressed as a percentage of original investment. Mathematically

Percentage return on investment Average annual income after depreciation but before taxation = xl00 Annual cash inflow In this method allowance is made for decrease in the value of the asset due to wear and age and the cost of interest charged is spread uniformly over the projected life of the asset. These methods may be classified as: (i) Unadjusted rate of return method. (ii) Time adjusted rate of return method. (i) Unadjusted rate of return method: The method is based on certain information's extracted from various financial statements. Here future earnings on investment are not converted to get its present value, that is why it is known as unadjusted return method. The rate of return on investment is calculated for each alternative and the one providing maximum return is considered to be the best. Unadjusted rate of return is given by

Unadjusted Rate of Return =

Average Annual net income A . t verage Inves ment

Average ammia cash inflor - Annual depreciation . x 100 .. .(19) Average Investment

26

Methods for Comparing Investment Alternatives

Now average investment can be calculated by any of the methods given below, depending upon the nature of the information available. (a) Average investment = (uncovered capital in the beginning +uncovered capital at theend)/2 (b) Average investment = (Initial investment + Scrap value)/2 (c) Average investment = [(capital recovered)/2] + Scrap value ... (20)

Example 10 : Rank the investment proposals in order of their profi tability using rate of return method: Proposal

It:lvestment in Rs.

Annual Cash flow in Rs.

Life In years

A

25000

3000

10

8

3000

1000

5

C

12000

2000

8

0

20000

4000

10

E

40000

8000

10

Solution: Assuming scrap value to be zero and depreciation rate to be linear, we can find depreciation for each proposal by dividing the investment from life in years. The calculations can be done in the following tabular form: Proposals Average investment

Depreciation

Cashin in flow - Depreciation

rate of return

A

25000 = 12500 2

25000 = 2500 10

3000-2500=500

500 = 0.04 12500

B

3000 = 1500 2

3000 = 600 5

2000-600=400

400 = 0.27 1500

C

12000 = 6000 2

1200 =1500 8

2000-1500=500

500 = 0.33 1500

0

20000 = 10 000 ,2 •

20000 = 2000 10

4000-2000=2000

2000 = 0.20 10,000

E:

40000 = 20,000 2

40000 = 4000 10

8000-4000=4000

4000 = 020 20,000

A

25000 = 12500 2

25000 = 2500 10

3000-2500=500

~=004 12500

27

Methods for Comparing Investment Alternatives Thus the ranking of the proposals are C, B, D, E and A.

Example 11 : A limited company is considering the purchase of one of the two machines with following details: Find the best choice by rate of return method: Machine X

Life

Machine Y

3 years

Capital Cost

3 years

As.

1,00,000

As.

1,00,000

Earnings after tax 1st year

As.

80,000

As.

20,000

2nd year

As.

60,000

As.

70,000

3rd year

As.

40,000

As.

1,00,000

Solution: Now Average annual cash inflow for the two machines is Machine A = 80,000 + 60,000 + 40,000 = Rs. 60,000

3 M h' B - 20,000+70,000+1,00,000 - Rs 3 00 ac me 3 . 6 ,3 . . f or A = 100,000 D epreclatIon 3

3 3333

. . 100,000 DeprecIatIon for B = = 33333 3 Average investment for both the machines is R ' . f or'j\ = 100,000 s. D epreclatlOn 2 = 50,000. Hence from (19) rate of return for A = 60,000 -33333 = 0.53 50,000 rate of return for B = 63300 - 33333 50,000

=0.60

(b) Time Adjllsted rate of return method: According to National Association of Accountants, America, "Time adjusted rate of rehlrn is the maximum rate of interest that could be paid for the capital employed over the life of an .investment without loss on the project."

28

Methods for Comparing Investment Alternatives

There are many other names of this method viz. Discounted rate of return method, Internal rate of return method etc. This method is particularly useful when the rate of return on investments is not known exactly. The method consists of following steps: (i) Find the ratio of cost of investment and annual cash-in flow. (ii) For the value obtained in (i), find present value factor from

Pwfs table for the given period. In the case of uneven cash-inflows, trial and error method can be used. The method is illustrated by the following examples: Example 12 : An investment of Rs. 12000 provides the annual cash inflows of Rs. 2000, Rs. 3000, Rs. 5000 and Rs. 6000 respectively in 1st, 2nd, 3rd and 4th years. Find Time adjusted rate of return.

Solution: Here there is an uneven cash inflow. So we shall apply trial and error method to find time adjusted rate of return. First of all we find average annual cash-inflow = 2000 + 3000 + 5000 + 6000 = 4000

4 Hence Investment = 12000 =3.0 A verage cash inflow 4000 In Pwfs table, we find that in the row of fourth year, the value 3.0 lie in the column of 12%. Hence at first iteration the time adjusted rate of return is found to be 12%. Now at this rate of return, we can calculate the present value of cash- infllows for different years in the following tabular form: present value factor =

Year

Cash inflow

Pwf at 12%

Present Value in Rs.

1

2000

0.8929

1785.80

2

3000

0.7972

2391.60

3

5000

0.7118

3559.00

4

6000

0.6355

3813.00

Total

11549.40

29

Methods for Comparing Investment Alternatives

It can be seen that with rate of return to be 12% the total amount recovered in 4 years is Rs. 1 1549.40, which is less than the total investment of Rs. 12000. So the time adjusted rate of return should be somewhere between 12% and 13%. The following are the drawbacks of rate of return method: (i) It fails to give full effect to the time value of money, especially in cases where investments are made at different periods of time or when income from investments is not likely to accrue at a uniform rate. (ii) The method does not recognize the true return on capital investments.

In both these techniques no account is taken of the time at which the earnings are made.

Example 13 : Bajaj Auto Parts Ltd. is screening projects for capital expenditure. They have only Rs. 1,00,000 for investment. The following proposals have been submitted: Project

Investment

Cash Flow

EconomiC life

Rs.

Rs.

years

A

31,300

6,000

10

B

97,400

20,000

20

C

98,075

25,000

10

D

27,200

4,000

15

If cost of capital is 20%, please recommend projects according

to: (a) Pay-back period method

(b) Rate of return meth'Od (c) Present value index method. Solution: (a) Pay-back Period method: Amount investment Pay back period = Annual Cash inflow The pay-back period for each project can be calculated in the following tabular form:

30

Methods for Comparing Investment Altemativeb

Project Amount invested Annual cash inflow

Pay-back period

3(300 --=52 6000 .

A

31,300

6000

B

97,400

20,000

C

98,075

25,000

98075 25:000 = 3.92 years

0

27,200

4000

27,200 - - = 6.80 years 4000

97400 ~

years

= 4.87 years

The pay-back penod for project C 1S least. Hence 1t 1S recommended. (b) Rate o/Return Method: Assuming Depreciation to be linear and the zero scrap value for each project, the depreciation and average investment values for each project can be calculated in the following tabular form : Project

Amount invested I

A

31,300

15650

3130

B

97,400

48700

4870

C

98,075

49037.50

9807.50

0

27,200

13600

1813.34

Average investment 1/2=AI

Average Depreciation D=II economic life

Now using formula, R = Ra teof retum=

Annual Cashi in flow - Depreciation 100 x Average investment

Thus for Project A : R =

Project B : R =

6000-3130 x 100 = 18% 15650

20,000 - 4870 x 100 = 31% 48700

Pr' C· = 25,000-9807.50 xl00=31% oJect . R 49037.50 Project D : R =

4000 -1813.34 x 100 = 16% 13600

Methods for Comparing Investment Alternatives

31

The rate of return is same for Project Band C being 31 %. Any of these can be recommended. (c) Present value index method: From formula, Present va1ue In d ex =

Present value of future income al Initi investment

Here salvage value is assumed to be zero. The present value of future income

=Cash inflow (Pwfs -t%-r) P.V.1. for Project A

=

6000 (Pwfs-20%-10) 31300

= 6000 x 4.1925 = 0.80

31300 P.V.1. for Project B =

20000 (Pwfs - 20% - 20) 97400

--~-~--~

= 20000 x 4.8696 =0.99 97400 P V I f p . C 25000 (Pwfs-20%-10) . . . or rOJect = 98075 = 25000 x 4.1925 = 1.07

98075 P.V. I. for Project D =

4000 (Pwfs - 20% -15) 27200

= 4000 x 4.6755 =0.69 27200 The present value index of future income is maximum for project C . Hence it should be recommended.

***

Chapter

3

** REPLACEMENT ANALYSIS The problem of replacement is an everyday phenomena. It is experienced in systems where machines, individuals or capital assets are the main job performing units. It is a common phenomena that performance / efficiency of a fixed asset in a system deteriorates with time. The remedy is either to replace the fixed asset with some new fixed asset or to restore the level of performance by some sort of maintenance. Also, there comes a stage where maintenance of any fixed asset becomes so much expensive that it is more profitable to replace the fixed asset. Thus there is a necessity to formulate a most economic replacement policy which is in the best interest of the system. The major reasons for replacement are: (i) Deterioration: Decline in performance due to wear and tear indicated by increase in maintenance costs; reduction in product quality and rate of production, increase in labour costs, loss of operating time etc. (ii) Obsolescence: It may be due to advancement in technology. This reduces profits, impairs competition, causes loss in the value of machinery. (iii) Inadequacy: Equipment's capacity may not be sufficient to meet the demand or it is not able to increase the production rate to desired level.

Replacement Analysis

33

(iv) Working conditions: Causing unsafety to workers and leading to accidents, making the environment noisy and smoky etc. (v) Economy: The existing units have outlived their effective life and it is not economical to continue with them. (vi) The existing units breakdown, perished or destroyed all of

a sudden. Some special characteristics of replacement are: (i) replacement reduces maintenance costs but it involves a high average capital cost. (ii) many people feel that an equipment should not be replaced

until it is physically worn out. But this attitude is never in the interest of the organisation. On the contrary the equipment's must be constantly reviewed and updated, otherwise these may become obsolete. Replacement Models and Their Solutions:

The study of replacement is some kind of application mostly concerning comparison of alternative replacement policies. The various factors relevant to replacement analysis can be divided into two main categories; namely, (i) Technical: Deterioration, Obsolescence, Inadequacy. (ii) Financial: Initial cost; operating costs; labour costs, material costs; maintenance costs, salvage value, insurance etc.

A well designed replacement policy should compare thoroughly an existing equipment with its possible replacement. In order to make a sound economic comparison strategy all the factors should be converted into costs. The different types of replacement problems can be broadly classified in following situations: (i) Replacement of Items Whose Efficiency Deteriorates with Time: The simplest replacement model in such cases is one where the deterioration rate is predictable in terms of increasing maintenance costs and decrease in salvage value with time. The expenditure on replacement items is considered here as cost of replenishment in inventory analysis and maintenance costs are like holding costs. There are two methods to find appropriate solution in this case viz.

34

Replacement Analysis

(i) delermination of cost per unit of time and (ii) present value concept representing time value of money.

Replacement ofitems that fail completely and are expensive to be replaced: In such situation the items are assumed to have relatively (ii)

constant level of efficiency until they completely fail. Here replacement strategy is formulated in anticipation of failures due to which probability of failures are considered in analysis. A policy is formulated to balance the wasted life of items replaced before failure against the costs incurred when items completely fail. (iii) Staff replacement problem.

Replacement of Items Which Deteriorate with Time: In this situation the efficiency is measured as the discounted value of all future costs associated with each alternative e.g. the maintenance cost of a machine always increases with time and at some stage maintenance cost becomes so large that it is more economical to replace the machine by a new one. The criteria evolved in such cases can be broadly divided in three categories namely, (i) Replacement of items whose maintenance cost increases with time, and (a) the value of money remains same during the period (b) the value of money changes with time. (ii) Criteria of present value for comparing replacement

alternatives. Case (i) Replacement of fixed asset whose maintenance costs increases with time. A. The value of money remaining same during the period.

Here we use the following notations : C

Purchase price of the item.

S

Scrap value of item taken to be same over time.

g (t) :

Maintenance / running cost at time '1'.

Now g (t) can be discrete or continuous ftmction of time. In the case of g (t) to be discrete we can use the summation sign to calculate the total maintenance cost in a given perioa otherwise integrals can be used e.g. in some given period 'n' the total maintenance cost will be

35

Replacement Analysis n

M(n) =

L g(t), when t is discrete t=O

and

Jong(t) dt, when t is continuous.

Thus the total cost incurred on the item in some period n is given by Total cost =cost of the item + total maintenance cost in period 'n' - scrap value = C + M(n) - 5 Thus the average cost incurred per year on the item is given by C+M(n)-S G(n) = ----'-~­ n

Now it is advisable to replace the item when G (n) is maximum. Without going into the mathematical treatment it can be seen that G (n) will be minimum when and

9(n)

<

G(n-1)

G(n)

<

g(n+1)

So we get the following replacement criteria in this case. Do not replace the item if the next year maintenance cost is less than the average cost of the previous year and replace the item if next years average cost is less than the maintenance cost of next year i.e. when Average Cost is least.

The method is explained by the follOWing examples:

Example 1 : The cost of a machine is Rs. 6100 and its scrap value is Rs. 100. The maintenance costs are found to be : Year Maintenance

Cost in Rs.

1

2

3

4

5

6

7

8

100

250

400

600

900

1200

1600

2000

When should the machine be replaced?

Solution: Here C = 6100, 5 = 100 and the maintenance costs are given at discrete values of time~ The total average costs in different years can be calculated in the following tabular form:

36

Replacement Analysis Cumulative value of (2) Year

g(n)

M(n)

(n) (1 ) 1 2 3 4 5 6 7

(2) 100 250 400 600 900 1200 1600

(3) 100 350 750 1350 2250 3450 5050

(4) 6100 6350 6750 7350 8250 9450 11050

C+M(n)-S n i.e. col. (4)/col(1) (5) 6100 3175 2250 1837.50 1650.00 1575.00' 1578.57

8

2000

7050

13050

1631.25

C + M(n)-S G(n) =

"Average cost is minimum. Hence the machine should be replaced at the end of the sixth year.

Example Z: A manufacturer finds from his past records that the costs per year associated with a machine with purchase price of Rs. 5000 are as given below: Year(n) Running cost g(n) Scrap S(n)

1500 3500

2

3

4

5

6

1600 2500

1800 1700

2100 1200

2500 1000

2900 500

7

8

3400 4000 500 500

Determine the optimal replacement policy:

Solution: Here C =5000 and 5 (n) =scrap value is decreasing with time. So the value of C - 5 will change with time in this case. The calculations can be done in the following tabular form. Year (n)

S(n)

C-S(n)

(1 ) 1 2 3 4

(2) 3500 2500 1700 1200

(3) 1500 2500 3300 3800

.

g(n) Cumulative g(n) = M(n) (4) 1500 1600 1800 2100

(5) 1500 3100 4900 7000

Col(3)+(5) C+M(n) - S(n)

G (n) col(6)/(1)

(6) 3000 5600

(7) 3000 2800

8200 10800

2733 2700

37

Replacement Analysis 5

1000

4000

2500

8500

13500

2700

6

500

4500

2900

12400

16900

2816

7

500

4500

3400

15800

20300

2900

8

500

4500

4000

19800

24300

3037

'minimum

The average cost G (n) is minimum in 5th year. Hence 5 years is the optimal replacement interval. Example 3 : A truck owner has three trucks, two of which are two years old and the third is one year old. The cost price, operating costs and resale value of these trucks are same as given below: Year Running

1

2

3

4

5

6

7

8

cost

1000

1200

1400

1800

2300

2800

3400

3400

Resale Value

3000

1500

750

375

200

200

200

200

The cost price is Rs. 6000/-. He is considering a new type of truck with 50% more capacity than one of the old ones at an unit price of Rs. 8000/- . He estimates that the running costs and resale price for the new truck will be: Year Running costs Resale price

2

3

4

5

6

7

8

1200

1500

1800

2400

3100

4000

5000

6100

4000

2000

1000

500

300

300

300

300

Assuming that the loss of flexibility due to fewer trucks is of no significance, and that he will continue to have sufficient work for three of the old trucks, what should his policy be?

Solution: First of all we have to calculate average total cost for each of the two types of trucks. On the basis of the calculations as illustrated in Example 23 the average total cost for each of the category will be Years (n)

Average Cost for Type I 4000

5200

New Type The following observations

2

3350

4350

are made from these

3

2950

3833

calculations. (i) The minimum

Replacement Analysis

38 4

2756

3600

average total cost for both

5

2700

3540

type of trucks corresponds to 5th year. Thus the

6

2717

3616

7

2814

3814

replacement policy should

8

2962

4100

be after every five years for each one of them.

Now for 3 old trucks 2 new trucks will be required, since the capacity of new truck is 50% more than the capacity of old truck. The minimum Average cost/year for 3 old type trucks will be Rs.3 x 2700 = Rs. 8100

and that for two new type trucks will be Rs. 2 x 3540 = Rs. 7080

Hence it is desirable to replace 3 old trucks by two new type trucks as the minimum average cost with a fleet of two new trucks comes out to be less. Now the decision of when to replace can be made by preparing the following table: Total Annual Cost of Old Trucks Year

Average Annual Total cost

1

4000

2

2700

3

2150

4

2175

5

2475

6

2800

7

3400

8

4000

Average total cost of 2 year old trucks

Average cost of one year old truck

Total average cost of 3 old trucks

=4300 2 x 2175 =4350 2 x 2475 =4950 2 x 2800 =5600 2 x 3400 =6800 2 x 4000 =8000

2700

7000

2 x 2150

2150

6500

2175

7125

2475

8705

2800

9600

3400

11400

The annual average cost for two large trucks is Rs. 7080. We can see that total costs for smaller trucks will not exceed than for the large trucks until the third year from now. Thus all three small trucks should be replaced by larger ones after two years from now. B. The value of money changes with time.

39

Replacement Analysis There can be two situations in this case,

(a) the value of money decrease at a constant rate 'd'. 'd' is known as depreciation ratio or discounted factor. Here we want to find the optimum value of time at which the item should be replaced. If d is the per unit depreciation rate, t.hen the present value of one unit of money after a period oft years is given by 1/(1 +dt

(b) the manufacturer takes a loan at some given interest and agrees to pay in a prescribed number of fixed installments. Then we want to find appropriate period of making the repayment of loan. Case (a) Let the maintenance costs in X years be C 1,C 2 ... , C x respectively, A, the purchase price of the item and' d' be the per unit depreciation value. Then the present value of the total expenditure with a X-yearly replacement policy is given by G(X) =

(A + ~Cjdi-l)/ (l-d

X )

Then the following criterion can be used for optimum replacement policy: (i) Do not replace if the operating cost of next period is less than the weighted average of the previous costs. Where weights are 1, d, d 2, ........•••••.. respectively. (ii) Replace if the operating cost of next period is greater than the weighted average of the previous costs.

Example 4 : N.K. Ltd. pays Rs. 10,000 for its automobiles. Their operating and maintenance costs are about Rs. 2500 per year for the first two years and then g~ up by approximately Rs. 1500 per year. When such cars be replaced? The discount rate is 10% per year.

Solution: Here discount rate i =0.1 and the depreciation ratio d =_1_=0.9091 1 +0.1

= A = 10,000. The value of G (X) can be calculated in the tabular form page 226.

40

Replacement Analysis Now Cs > G (4) and C4 < G(3)

Hence the optimum length of time to hold the machine before replacing it is 4 years. Replacement of Items that Fail Completely and are Expensive to be Replaced. It is a common characteristic that the probability of failure of any item in a system increases with time. The system may be such that the whole system may breakdown if any item fails. This breakdown implies loss in production, idle inventory, labour and other units of the system. The nature of item which needs replacement may be such that immediate replacement is not available. Thus there is a necessity of formulating some appropriate replacement policy in such cases. There are two main strategies: (i) Individual Replacement Policy: Whenever any item fails, it should be replaced immediately. (ii) Group Replacement Policy: All items are replaced after a certain period p inspite of these being in working order with a provision that if any item fails before this time p it can be replaced immediately. This approach decreases the probability of breakdown in the system.

Such policy requires following two fold considerations, namely, (1)

the rate of individual replacement during the period.

(ll) the total cost incurred on individual and group

replacements during the chosen period. The period for which the total cost is minimum is taken to be optimal. The following information is required in this procedure: (A) probability of failure at different periods of time. (B) loss incurred due to these failures. (C) cost of individual replacements. (0) cost of group replacements.

The following criteria should be used:

41

Replacement Analysis

Group replacement should be made at the end of tth period if the cost of individual replacement for tth period is greater than average cost per period by the end of period t and one should not adopt a group replacement policy if the cost of individual replacement at the end of (t-1)th period is not less than the average cos t per period through time (t-1).

Example 5 : A Computer contains 10,000 resistors. When any resistor fails, it is replaced. The cost of replacing a resistor individually is Rs. 1/- only. If all the resistors are replaced at the same time, the cost per resistor would be reduced to 15 paise. The percent surviving say S (t) at the end of month and P(t) the probability of failure during the month tare t

0123456

S(t)

100

P{t)

97

90

70

30

15

0

0.03

0.07

0.20

0.40

0.15

0.15

What is the optimum replacement plan?

Solution: The whole problem can be divided into two parts. 1.

There is a policy of individual replacement.

2.

There is a policy of group replacement.

It should be noted that no resistor survives for more than 6 months. Thus a resistor which has survived for 5 months is sure to fail during sixth month. We assume that the resistors failing during a month are replaced just at the end of the month.

Let Ni denote the number of resistors replaced at the end of ith month. The different values of Ni can be calculated in the following way: No =

Number of resistors in the beginning = 10,000.

N} =

Number of resistors being repliiced by the end of 1st month.

=

Number of resistors during the 1st month X probability that a resistor fails during 1st month of its installation.

=

10,000 300.

x

0.03

42

Replacement Analysis N2

Number of resistors replaced by the end of second month. =

(Number of resistors in beginning X probability that these fail in 2nd month) + (Number of resistors replaced in first month X Probability that these will fail during second month) N OP2 +N IP I

= =

709 N OP3 + NIP I + N 2P I

N3

N4

10,000 x 0.07 + 300 x 0.03

10,000 x 0.20 + 300 x 0.07 + 709 x 0.03

= =

2042

-

NoPs + N IP3 + N 2P2 + N 4P I

= =

10,000 x 0.40 + 300 x 0.20 + 709 x 0.07 + 2042 x 0.03 4171 NoPs + N IP4 + N 2P3 + N 3P2+N4P I

Ns

10,000 x 0.15 + 300 x 0.40 + 709 x 0.20 + 2042 x 0.07 + 4171x 0.03 =

N6 = =

2030 NoP6 + NIPS + N 2P4 + N 3P3 + N 4P 2 + NSP I 10,000 x 0.15 + 300 x 0.15 + 709 x 0.40 + 2042 x 0.20

+ 4171 x 0.07 + 2030 x 0.03 =

2590

It can be seen from above calculations that Nj increases up to fourth month and then qecreases. It can also be seen that Nj will later tend to increase and the value of Nj will oscillate till the system acquires a steady state.

The expected life of each resistor is =

~~Pi' where "t is

the month and Pi is the corresponding

probability of failure. =

1 x 0.03 + 2 x 0.07 + 3 x 0.20 + 4 x 0.40 + 5 x 0.15

43

Replacement Analysis

+ 6 x 0.15

=

4.02 months

Average number of replacements every month N (mean age)

10000 4.02

=2487.5 -~488-resistors. Hence average cost of monthly individual replacement- policy

=Rs. 2488/-(the cost being Rs. II - per resistor). Now let us consider the policy of group replacement. End of month

Total cost of group replacement in Rs. 300 x 1 + 10,000 x 0.35

Cost/month in Rs. 3800.00

= 3800 2

(300 + 709) x 1 + 10,000 x 0.35 = 4509

2254.50

3

(300 + 709 + 2042) x 1 + 10,000 x 0.35 = 6551

2183.66

4

(300 + 709 + 2042 + 4171) x 1 + 10,000 x 0.35 =10722

2680.50

5

(300 + 709 + 2042 + 4171 + 2030) x 1 + 10,000

6

x 0.35 = 12752

2550.40

15442

2557.00

Hence the minimum cost per month is obtained by group replacement of all resistors after three months with an average cost of Rs. 2183.66 per month.

***

Chapter

4

** FARM MANAGEMENT

With the advent of green revolution in India, there has been shift from the traditional system of subsistence type of farming to the new market oriented commercial type of agriculture. The change is being brought about by the employment of scientific and technological advances. Some of the seed are seed of high yielding varieties, fertilizers, plant protection chemicals, new implements and equipment's, improved cropping system, improved water management and use etc. The changes in input use entail the expenditure of larger sums of money to purchase the inputs and consequently have increased the demands for additional funds and sources of credit to finance the agricultural operations. Farming is changing from a way of life to a business-oriented agriculture. With this change, farmers are favoured with new opportunities and possibilities but are faced with more complex problems of farm organization and operation and are in need of greater management skills to cope with the changes. Farmers need information on various physical and biological relationship involved in crops and livestock production and also need information on price trends, credit availability and government programmes and policies.

Farm Management

45

Farm Management Deals with Managerial Input: With the increasing need of managerial input for modern agriculture, 'Farm management' as a subject has gained immense importance among the subjects related to agricultural production. Although the farm is an economic and social institution developed over many centuries, the scientific management of farm as a business is relatively new. Because of its recent origin, the term farm-management is understood in various ways by different people. There are many definitions of farm management but to understand as to what this term actually means there can be expression as blow: "Farm management is the science which deals with rational decisions on the use of scarce farm resources, having alternative uses to obtain the maximum profit and family satisfaction on a continuous basis from the farm as a whole and under sound farming programmes." Farm management science as compared with other fields of agricultural science has many important features. This is a practical and integrating science which is profitability oriented and has macro:approach considering farm unit as a whole. Farmmanagement is the field of agriculture science which is primarily and basically related to human being and its concern with crops and livestock is only secondary. For successful farm management there is need on the part of farmEr to possess ability and capacity to make correct decisions. Nielson has elaborated the decision making process by proposing following eight functions. 1.

Formulation of goals or objective of the farm;

2.

Recognition and definition of a problem or opportunity;

3.

Obtaining information-observation of relevant facts;

4. Specification and analysis of alternatives; 5.

Decision making-choosing an alternative;

6.

Taking action;

Farm Management

46

7.

Bearing responsibility for the decision or action taken.

8.

Evaluating the outcome.

Farm Planning an Effective Tool to Help Farmer make Better Production Decision: At the micro-level efforts have been directed primarily to extending new inputs, such as fertilizer, irrigation, improved seeds and new techniques of production viz, improved methods of sowing, manuring, fertilizing and irrigation to the farmer. Very little has been done to improve the managerial ability of the farmer. In other words, there has been greater emphasis on providing farm people with new information and inputs rather than m helping them apply these to their own situations. Farm planning aims at providing such help to the farmer. Farm Planning as Related to Credit : In under-developed conditions "farm planning" is considered to provide a method by which the farmer with limited available assets can be made credit worthy and thus be able to obtain the needed production supplied and other capital needs In other words, the farm plan provides the farmer with the technical possibility of achieving additional yield and eventually guarantees additional incomes. This additional income forms a source of credit which enables the farmer to borrow funds from institutions to buy mater also needed for production increase. In this case, the plan is regarded as planned repaying capacity for loans. Concept of Farm Planning: In farm planning the fundamental concept is to look at the farm as a single operating unit. The kit of the farm planner should include the micro-economic principle, technical knowledge pertaining to different aspects of agricultural science, and information relating to the farm and farmer. The job of a farm planner is to use these information's to help the farmer to ~ake changes in the: (i) Crop and livestock enterprises on the farm-selection of a product-mix, (ii) inputs used on the farm-selection on an input complex,

47

Farm Management

(iii) techniques of production-choice as to how to produce and (iv) marketing procedures choice as to when, where and how to market farm products and purchase farm inputs. Several economic models, presented in the following table, are available to a farm planner for generating answers to these questions, either separately or simultaneously; Economic Models for Farm Planning Models based on perfect knowledge and certainty

Models based on imperfect knowledge i.e. Models for risk and un-certainty.

1.

1.

Production function models:

Modified programming models.

(a) without any resource restriction 2. Diversification models. (b) with resource restriction 2. Budgeting models:

3. Probabilistic models. 4. Game Theoretic models

(a) Conventional budgeting models (i) Partial budgeting model (ii) Whole farm budgeting model (b) Linear programming model

Here we shall concern ourselves only with conventional budgeting models. Farm budgeting is a method of analyzing plans for the use of agricultural resources at the command of the decision-maker. The portion of the farm business analyzed may range from a particular organisation to the total farm business. The farmer is generally called "Partial budgeting" and latter "Complete budgeting". The technique begins with assessing the present organization of the farm and proceeds to working out alternative farm plans. The final phase of budgeting is normally the computation of an estimated return of a nature relevant to the problem considered. Following five steps are generally followed in conventional budgeting procedures; (i) existing farm resources are inventoried (ii) the systems to be budgete,d are selected (iii) the technical coefficients of production are specified

Farm Management

48

(iv) prices for inputs and products are specified and (v) costs and returns are calculated. Farm Planning and Budgeting Let us assume that a farmer in Jaipur District owns a one hectare of unirrigated land, one pair of bullock, and one Buffalo. The farmers family consists of 6 members with 3 adult members, mainly engaged in farming. (A) Resource Restrictions (constraints) 2009-2010 Resource

Season/Period

Quantity

(i)

Land

Kharif

0.8 hectare

(ii)

Land

Rabi

0.2 hectare

(iii)

Human labour

3 adults male

(iv) Cash to meet crop expenses. Rs. 200 00

The cropping pattern followed during 2009-2010 is given in table-1 During the Kharif Maize for is grow his family consumption. Table No. 1

Crop/Season

Area in hectares

Kharif

Rabi

Maize + Urd

0.6

Groundnut

0.2

Fallow

0.2

Gram

0.2

The farmer has all the necessary farm implements, however he hires human labour whenever necessary at the peak season period. The soil of the farm is loam without the irrigation facilities, Table 2

Cost and Return from Cropping Pattern Crop/Season

Area in hectares

Yield of main product

Yield of by product

0.6

4.2 Q.M.

12.00

1.5 Q.U.

1.00

Gross returns

Total Net cost returns

Kharif Maize + Urd

624.00 425.00 574.00 385.00

49

Farm Management 1009.00 Groundnut Fallow

0.2

1.6

1.5

0.2

-

.-

0.2

1.5

1.5

Aabi Gram

335.00 256.00

-

79.00

-

-

285.00 119.00 166.00 1629.00 800.00 819.00

1.00

In the month of May, 81 the farmer constructed a pacca well on his farm which can command only 0.9 hectares of land. The water quality is good and adequate water is in the well. The farmer has also purchased necessary equipment's for irrigation purpose. Selection of Activities:

Keeping in mind the resource constraints given in table-I, the land acreage is to be allocated on the basis of maximum net returns, per unit area from different crops. Physical Norms for Important Crop of the Region Table-3 Items

1.

Crop Varieties Maize Local

Maize Hybrid

Groundnut Local

Groundnllt Improved

Wheat Hybrid

Gram Hybrid

N

28

60

20

80

20

P

-

40

60

40

40

-

-

-

100.00

-

12000

100.00

130.00

Fertilizer if' (Kg)

K

-

2

Plant protection in (Rs.

3

Seed in (Kg)

30

20

100

100

100

75

4.

Human labour in man days

70

110

50

90

120

64

5.

Bullock pair days

19

30

11

12

30

16

6

Yield of main products in aIls

7.00

30.00

800

1500

3500

1500

Price of Inputs and Output Price of inputs (As.)

Output prices (As.)

N@As. 3/- Kg.

Wheat@As. 125/- quintal

P@As. 2/- Kg.

Gram@As. 170/- quintal

50

Farm Management

Seed:

Maize@Rs. 120/- quintal

Maize local @1.5/Kg.

Urd@Rs. 250/- quintal

Maize Hybrid @4.00/Kg.

Groundnut@Rs. 200/- quintal

Groundnut local @2/- Kg. Groundnut improved @4/ Kg. Urd local @3 5/Kg.

Enterprize Budget Table 4 (in Rupees) item of expenditure

Maize •• Local

Maize Groundnut Hybrid Local

Groundnut Improved

Kharif pulses (Urd)

Wheat HYV

Grar.1 Improved

100

60.00

60.00

240.00

60.00

III

120.00

0000

00.00

00.00

100

120.00

10000

130.00

•• With one Improved practice Fertilizer N

84

P K Planet Protection

Seed

45

III

200

400.00

70.00

250.00

150.00

550

250

450.00

165.00

600.00

320.00

Human labour

350

Bullock

228

360

132

144.00

120.00

36000

192.00

707

1350

5lI2

1294.00

49500

1630.00

93200

3535

6750

29.10

74.50

24.75

81.50

4660

Total cash expenditure

742.35

1417.50

611.10

136850

519.75

171150

978.60

Yield of main products

840.00

3600.00

1600.00

300000

2000.00

437500

2550.00

Yield of by products

28000

1200.00

00.00

520.00

150.00

Gross return

1120.00

480000

1600.00

3000.00

200000

4895.00

2700.00

Net returns

377.65

238300

98900

2632.00

1570.00

3184.00

1722.00

Total

.

Interest on working

caprtal @ 10% for 6 months

Plan for 0.9 hectare of Irrigated Farm 2010-2011

In his alternative plan for the year 2010-2011, the farmer would like to grow 6.00 quintals of maize and quintals gram 1.5 for his family consumption in kharif and rabi seasons respectively. These activities are called predetermined activities, which the farmers plan to undertake irrespective of their profitability.

51

Farm Management TableS Resource A.

B.

Kharif land (hectares)

Rabi land hectares

Total available

1.00

0.9

(i)

Kharif crop Maize hybrid.

0.2

Grouudnut

0.8

Rabi Gram

0.1

Wheat H. Y. V.

0.8

Table-6 Cost and Returns from Cropping Pattern. Area

Yield of Yield of main product qtls

Gross by product

Total Net returns returns. cost.

Kharif Maize

0.2

6.00

18.00

900.00

283.50

616.50

Groundnut

0.8

12.00

12.00

2520.00

109480

1425.20

Gram

0.1

1.5

1.5

285.00

97.86

187.14

Wheat

0.8

28.00

42

3920.00

1369.20

2550.80

7625.00

2845.36

4779.64

Rabi

1.9

Comparison o/Suggested Plan with the Existing Plan

Table No.7 indicates that the cost and returns from the existing plan will be increased by implementing the suggested plan. The total net returns of Rs. 819.00 in the existing plan increase to Rs. 4779.64 in the alternative plan, which is an increase of about 57.6 percent. This increase in net return is due to the conversion of unirrigated area into irrigated area and the adoption of improved technology of the selected enterprises.

52

Farm Management Table No. 7 Existing plan

1.

Kharif Maize + Urd Local Groundnut Local

2.

Rabi Gram

Area in hectare

Net return

0.6

574.00

0.2 0.2

Suggested plan Area in hectare

Net return

Maize Hybrid

0.2

616.50

79.00

Groundnut Improved.

0.8

1425.20

166.00

Gram Improved. Wheat

0.1

187.14

0.8

225080

1.90

4779.64

H.Y.V.

1.00

819.00

Improved Designs of Bullock Cart For Farm Use In recent years bullock cart has become main nude of transport for goods as well as people. Even in the villages where there are no all whether roads, the bullock cart transport patiently, the moving goods from village to nearest towns. The bullock cart is very important mode of transportation in our Indian economy. This is because of two important reasons. First, the system continues to be the most dependable and cheapest mode of transport in a majority of villages. This would remain so since a cheaper substitute to the bullock cart has yet to be devised. Secondly, in the present situation of increase in fuel prices, truck and railway are not economical for carrying all the goods produced in villages. Inspite of the importance of bullock cart, proper attention has not been given for improving the design of these carts to achieve better efficiency and overall rural development. It is the time we give, the farmers a good transport vehicle with better payload, less drudgery to the bullocks, less/ damage to our highways and metal roads and less road accident. There are 13 million carts haJ.lling 70% of the rural goods traffic. Aggregate investment in the animal drawn transportation system is estimated at about Rs. 3,000 crores. This system transports about 10,000 million tonnes of goods every year.

Farm Management

53

Improved Designs: With the aforesaid background in mind the two improved designs for the bullock cart has been developed. One which is developed by Punjab Agriculture University, Ludhiana. and another which is developed by Research Center for improved Agricultural Implements, Mahatma, Phule Krishi Vidhyapeeth, Pune is known as Jyoti bullock eart. The special features of the improved designs are given as below: 1. Pneumatic Wheels: Pneumatic wheels have been suggested in place if wooden wheels. The wheels for this purpose may be taken from un-serviceable vehicles.

2. Hand Brake: At present there is no provision for stopping the cart under unfavourable driving conditions. The hand brake provision suggested for the improved design operates mechanically and is similar to 'bicycles' brakes. It is located on right hand side near the sitting place. 3. Lights: Both front and rear lights have been provided in the design. The lights are simply kerosene oil lamps. 4. Rear Support: The rear support is made adjustable. It can be folded during unloading operation and thus facilitates in time and labour saving. 5. Forage Box: A forage box of 0.57 cubic meter capacity (1.5 m x 0.6m xO.6m) made from wood has been provided in the rear portion of the cart. The farmers may keep forage for their bullocks in the forage box during long journey. 6. Sitting Place: A cushioned seat made from coconut fibbers have been provided for comfortable sitting. The seat is adjustable and it can be adjusted in two positions as shown in the drawings. 7. Personal Belonging Box: This is provided for putting the blankets, food, tools etc. The size of box is 75 cm x 45 cm and located in the front portion of the cart just near the sitting place.

The cart can handle grains up to a capacity of 25 quintals by normal health bullocks. The cost of the cart having all the above features comes around Rs. 3000- only. It is easily fabricated by a village artisan.

Farm Management

54

]yoti Bullock Cart (Improved design) :

In this cart taper roller bearings readily available in the market are used in place of cast iron bush bearings, width of steel rim of the wooden wheel is increased from 25 and 50 mm to 60 mm. On the steel rim solid rubber tyre is fitted to minimize damage caused to roads. Rubber tyres are used out of used tyres of truck. Capacity of chassis is increased 2.5 times by providing extension of pipe frame to the traditional wooden chassis of the indigenous cart. Cushions are provided to the yoke where bullocks are hitched to the cart. Tipping arrangement is provided for quickly (;:,.nptying the loaded cart. Self engaging brakes are provided to the wheels. The brakes are so designed as to engage when bullocks lean back for controlling the speed of cart on steep down grades of the road. For this at the junction of yoke and beam of lever is provided Bullocks try to pull back the yoke when cart moves on the downgrades of the road. The cable attached to the other cud of the lever will then try to engage the brakes. Hand brake is also provided to operate it in case of emergency. For using the cart as transport vehicle a platform is provided on the extended portion of the chassis for sitting the passengers. Excluding the above provisions to the cart, rest of the portion of the cart is just like a traditional cart. Comparison Between Existing Indigenous Bullock Cart and Jyoti Bullock Cart. S.

Item

Different Indigenous bullock carts found in various areas.

Jyoti bullock cart

No.

1.

Dia of wheel, cm

115,120,124,136,148

133

2

Hubdia, cm

23.5, 28.5, 29, 30

25.5

3.

Hub length

28,32,33,40

35.0

4

Iron tyre width, mm

50

60

5.

Solid rubber lyre

No.

Yes from used truck lyres

6

Bearing and its tyre

No.

Taper roller bearings

7.

Brake

No.

(a) Expanding shoe type operating automatically due to rear movemnetof yoke on the neck of the bullocks. (b) Emergency hand brake.

55

F,) rm Management .;

9.

Chassis dimensions (a) Length, cm

200,207,224,226

Lower292 , upper210

(b) Width, cm

32,90,102, 105

Lower·98, upper 153

Volume,cubicmeter

1.05,1.07,1.08

1.29+1 .31=2.6

10. Load carrying capacity Kg . 500·800

(1) 2 tonnes on highway

11 . Cost Rs.

3000/·

(2) 1 ton on farm road . RS.2200/·

Farm Management

56

Improved Design of Bullock Cart

Scale-l ern = 80 ems. Isometric view of the Bullock Cart 1. Front Support

2. Bullock Neck Holder

3. Sitting Place

4. Hand Brake

5. Front Light

6. Hori Zontal Sport

7. Vertical Support

8. Personal Belonging

9. Pneumatic Tyres

10. Plat Form

11 . Forage Box

12. Rear Light

13. Rear Support

Housing for Cattle An efficient management will be incomplete without a well planned and adequate housing for cattle. Houses for animals are necessary and should be as little as house like as possible, but should be designed in a way to give protection from rain, drainage winds, excessive heat, cold and dampness. Properly planned house reduces tr..e labour charges and increase the profit of the cattle owner. Selection of Site: While selecting a site for the construction of cattle-shed, following points should be kept in mind: 1.

Select a site at a higher elevation to give slope for the drainage of rainwater and the cattle yard water. Avoid low lying areas and proximity to places of bad odour.

2.

Care should be taken to avoid fertile soil for cultivation. Choose an area which have rocks beneath, this will reduce the cost of foundation work.

3.

Efforts should be made to locate the long axis of the building in north-south direction to derive maximum benefit of the sun.

4. Building should be easily accessible and should have sufficient supply of fresh, clean and soft water. 5.

Surrounding should not be infested with wild animals and

6.

On exposed sites, attention should be given to the use of

existing trees as wind breakers or planting of quick growing trees if none is present.

Fann Management

57

The most common practice in this country's to tie the cow with chain or rope on a kachcha floor. The animals move too far in, and out of the standing space, defecating all around and even trampling and wasting the feed. In advanced countries, three systems of stalling dairy cows are in general use: 1. Cow house System: in this system the cows are housed and milked in the same building. There are separate stalls and stanchions for every in divid ual cow. 2. Milking House or the Lounging Barn System : cows are housed in cow sheds but milked in a special milking parlour. In lounging barns the animals remain loose and are offered roughage's. 3. The Open Air or Bail System: no housing is provided, instead the cows live continuously in the fields in movable enclosures, where they are also milked. In this system the expense on permanent building is avoided and the fertility of the soil is maintained. This system is not suitable under Indian conditions as sufficient fallows or pasture lands are not available throughout the year.

Cow sheds can be arranged in a single row if the number of cows are small, say up to 16, or in a double row if the herd is large. In double row housing, the stable should be so arranged that the cows face out or face in Preference should be given to face out system as it provides ample space behind the animal for milking and cleaing operations, chances of spreading diseases are less, animals get more fresh air, it is easy to supervise milking operation, and it is easy to detect diseases or any change in the hind quarters. Floor: should be of some impervious material which is easy to clean and is not slippery. Paving with bricks or grooved cement concrete floor will serve the purpose Surface should be laid with a gradient of 1" to 1 1,1" from mangers to excreta channel 65 to 70 sq. ft. of floor space is sufficient for an adult cow. Walls: should have smooth surface which will not allow lodgement of dust and moisture. In plains, walls should be about 4- .

5 feet in height and pillars provided to support the roof. The open space in between the pillars will serve for light and air circulation.

58

Farm Management

Roof: Roof of the barn may be of asbestos sheet or tiles. Corrugated Iron sheets with aluminum painted top will also serve the purpose. The height of the roof, at the sides, should be 8 ft. and 15 ft. at the ridge. A good building should provide about 800 cu ft. air space per eow. Mangers : Cement concrete continuous mangers are best to prevent feed wastage. Mangers should have 1'- 4" height in front and 2W to 3' height in back. Width should be kept between 21h-3'. Alleys :The central walk should be 5W wide and should show a slope of 1" from center to the gutters. The feeding alley in face out system may be 3 feet wide. Gutter: should be 2' wide with a gradient of I" for every 10' length. Doors: Single row cow shed should have 5' wide and 7' high door. In Case of double row shed the width should not be less than 9 feet. Stalls: The length may be kept as 5W-6' and width as 2'-214'. The above mentioned housing system suits little to the village conditions because of it's cost and labour requirement. Loose Housing: It is the most suitable, economic and efficient system of housing under Indian farm conditions, in this system animals are kept loose except for milking and treatment periods. The system is preferred over other system because of the following:

(i) Cost of construction is low. (ii) Structure can be expanded without much charges. (iii) Animals in heat can be detected easily. (iv) Animals feel more comfortable. (v) Provides optimum exercise to animals (vi) Better management can be practiced,

Farm Management

59

Space Requirement: Floor space per animal (Sq. ft.) Covered area

Manager length

animal (inches)

Open area

Cow

20-30

80-100

20-24

Buffaloes

25-35

80-100

24-30

Young stock

15-20

50-60

15-20

Pregnant cows (Pen)

100-200

180-200

24-30

Bulls (Pen)

120-140

200-250

24-30

Cattleshed for 20 Cows: A covered shed measuing 40 x IS ft. with an uncovered loafing area of 40 x 3S ft. would be sufficient to accommodate 20 cows. For young calves, we need to provide fully covered houses with good ventilation as they need protection against extremes of weather. Under this plan, we should have a fully covered space of 10 x 15 ft. size for the calves having facilities to provide feed and water to the animals. The boundary wall of the cattle-shed should be S' in height. In side, along the 40' length, there would be a 2~ ft. wide feeding manager. A water trough of the size 8' x2~ x2~ may be constructed on opposite side in the loafing area. Near the manger, under the roofed shed 9' wide floor should be paved with bricks. Beyond that, there should be an open unpaved area (40x3S) surrounded by S' wall with one gate. A plan for such a house along with the plan for calves shed and their sections are shown In the fig. 1 & 2. It will be preferred if the animals face north while eating under the shed, this will provide the animals protection against-northerly chilly winds when they are sitting. The roof may be of corrugated cement sheet or asbestos sheets. Cement concrete roofing or use of slabs (Pati) may be recommended when first floor is to be used as storage system for fodder etc. Calve Shed :

On one side of main cattle shed there shall be fully covered shed of 10'x IS' to accommodate young calves. This may also serve as calving pen under adverse climate conditions. Attached to the covered areas there should be a 20'x 10' open loafing area.

Farm Management

60

In this way, both cattle shed and calves shed will need in alISO' x 50' area. Person with limited resources can build kachcha boundary wall with the provision of chhappar shed. There should be a modest source of clean and fresh water as the daily water requirement per animal for drinking and washing operations, is estimated at 300 liters. Material requirement for the construction of cows shed and calves shed for calculating the cost, the rates prevailing in the local market may be taken into account) 1. 2. 3. 4. 5. 6. 7.

8.

Material M. S. pipe 4" M. S. angle iron A. C. sheets

Quantity 127 ft. 240 kg. 45 4000 60 bags 50 c. ft. One Two

" class bricks Cement J sand Door 4'x6W Gate 4' wide

Labour: 1. 2.

Mason Helper

60 rnanunits. 200 rnanunits.

3.

Skilledman (mazdoors)

400 rnanunits.

***

Chapter

5

**

PRE-FABRICATED IRRIGATION CHANNELS

Production in agriculture may be increased either through more area under crop production or by better use of existing resources of production. Also, with the limit on area to be brought under cultivation emphasis rests on efficient utilisation of resources. Irrigated area in our country is about 24.6% which could be increased without much investment on new projects, if proper utilisation of existing surface and sub-surface water is achieved. Water management, therefore, involves improvements in "projectwater management" and "on-farm water management" aspects. Let us examine water use status on a typical farmer's field with 22500 liters of water pumped per hour, (average discharge of a 5 hp pump). About 30% water is lost in unlined channels due to seepage and around 3% gets lost through evaporation. Of the rest water, 35% is lost because of uneven fields, and poor control practices. Thus, Only 9562,5 liter of water is beneficially used by the crops. The situation in various irrigation command areas is equally dismal. Water utilisation in an irrigation project area is depicted in table 1. It is obvious that with reduction in seepage losses in main canals and distributries. On-farm water losses tend to increase due to extra availability of water and lack of appreciation of judicious water-use by farmers in such areas.

62

Pre-fabricated Irrigation Channels Table 1 : Water Utilisation in Command Area of An Irrigation Project

S.

System

No

Losses %

Loss Ditches in the

Total Utilisat-

Main

Distri-

canals

butories

(field)

field%

%

loss

ion%

1.

Whole system unlined.

15.0

7.0

22.0

27.0

71.0

29.0

2.

Only main canals lined.

4.0

8.0

25.0

30.0

67.0

33.0

3.

Main canals & distributries lined.

4.0

2.0

26.0

32.0

64.0

36.0

4.

Whole system lined.

4.0

2.0

6.0

42.0

54.0

46.0

5.

Whole system lined + levelling of fields/sprinkler irrigation

4.0

2.0

6.0

6.0

18.0

82.0

Lining of irrigation channels, thus, can play an important role in bringing more area under drop production with little investment in our agriculture. Briefly, advantages of lining irrigation channels are as under: (a) Seepage losses are reduced. Excessive seepage resulted saline and alkaline soils in Punjab, Utter Pradesh, Haryana, Bihar and parts of Rajasthan states. (b) Repair and maintenance of channel is less and labour

requirements are low. (c) Aqatic weeds are eliminated resulting in more water for crops. (d) Damage by rodents is reduced. (e) For the same discharge, lined channels occupy less land area than unlined channels. Common Lining Materials For Irrigation Channels: Different lining types of materials are in use ranging from farmers practice to an efficient cement/ chemical lining. Selection of the material depends on investment capacity of the farmer,

Pre-fabricated Irrigation Channels

63

availability of the material, useful life and cost of lining. Some of the materials/practices, are classified below:

1.

Clay Linings: (a) Mixing clay along with irrigation water. (b) Underlying 2.5 em thin clay layer at 15 em depth and sides

in earthen channel and compacting the ditch, (c) Soil cement linings in different ratios.

2.

Hard Surface Linings: (a) Stone masonry lining (joined with lime/ cement mortar) (b) Brick mrsonry lining (joined with lime/ cement mortar)

(c) Baked clay tiles (joined with lime/ cement mortar) (d) Cement concrete linings: (i) In-place casting (ii) Pre-fabricated channels (iii) Semi circular pipes

(iv) Shoterete lining (v) Coal tar (bitumin) lining

3.

Linings from Chemical Materials: (a) Polyethylene (Black) sheets.

, (b) Alkathene sheets. Cement concrete linings:

Cement concrete linings are becoming popular because of their longer life and ease of preparation. However, recent scarcity of cement has given a jolt to speeding use of concrete channels. In place casting of concrete channels is economical in areas served by tube well irrigation or state owned canals (for trows higher than 0'028 cum/ sec.) However, pre-fabricated channels have popularity amongst farmers as they cost less and can be prepared by themselves. Table 2 illustrates specifications of various sections in use, with preference for 6 and 10.3 lit/ see sections depending upon the water resources. Bigger section:s being bulky pose problems of damage in transportation.

64

Pre-fabricated Irrigation Channels Table-2 Specifications of Common Channel Sections

S No.

Available water discharge htres/sec

SpecWicallons. ems. Width To bottom plnside inside

out

n

side

sIde

CosV Cost of thickness meter. Rs. I1e BottOut Rs. Insta- mould side om Prep. lIatlon As.

height

1.

6 0 (5 hp pump)

150

12.5

20.0

15.0

175

2.5

2.5

4.90

3.65

Il!O.O

2.

10.3 (5-7hppump)

25.0

22.5

:nO

15.0

17.5

2.5

2.5

528

4.02

140.0

3.

29 2 (canaJltube well area)

32.0

26.0

38.0

23.0

28.0

3.0

5.0

1170

8.70

100.0

4.

43.6 (canal area)

35.0

31.0

43.0

27.0

33.0

4.0

6.0

13.l!O

10.56

175.0

Preparation of Per Fabricated Concrete Channels: (a) Cement, sand (free from clay) and small aggregates (1 cm long) in 1:2; 3 ratio are thoroughly mixed.

(b) Inner sides of outer mould and outsides and bottom of inner

mould Ere brushed with old and used engine oil for easy removal of the mould upon setting of cement. This practice is repeated after preparation of 6-8 pieces. (c) With minimum (workable) amount of water usually 25 liter in one cement bag) the concrete mixture is prepared. (d) The outer mould (two sides joined with links, fig 1) is set on a flat ground, in the shade, and the bottom of the channel is prepared by pouring the concrete_ Uniform spread (2.5 cm thick) should be achieved_

Pre-fabricated Irrigation Channels

65

(e) Now, inner mould is set in and sides of the channels are easted by pouring concrete in equal amounts on both sides (to avoid sliding of the mould) in 2-3 operations. Uniformity is achieved by constant taming of concrete mix with iron bar. Extra concrete is taken off.

(f) After 45-50 minutes and slight taping of the outer mould

with a mallet, inner mould is taken out, carefully. (g) Hinges of the outer mould are lessened and outer mould is separated, leaving the shaped concrete channel as shown in fig. l.

Curing and Installation of Pro-Fabricated Channels: The channels, so casted, are dried in the shade for 2-3 days and i water sprinkled over for curing. After this time the sections may be! kept in water stilling basin of the farmer for 10-15 days for final curing. The channels are installed on a well compacted earthen bund. Sections are laid side by side and a space of 1 cm is left for joints. The bund may be given approximate slope (0. 2-0. 5%). The joints are made of cement mortar (1:2 mixture). Curing of the joints is done

Pre-fabricated Irrigation Channels

66

by blocking the channel with earth on both sides and water allowed to stand for 3 days. A thin slurry of cement water is brushed on inner sides and bottom of the channel for smoothness of the section. Various water distribution structures should be incorporated in the installation. Economic Analysis and Feasibility: The cost of pre-fabricated channels will differ from place to olace depending upon the labour rates and-availability of materials. However, estimates at Udaipur with one labour casting 16 meters/ dayoflO.3liters/sec section is given in table 3. Various components in cost estimates are (i) labour in preparation and installation of channels (ii) materials in preparation and installation. Preparation cost per meter is Rs. 5.28 and installation of the same on a bund with soil support on both sides, at 0.2% slope comes to Rs. 4.02. However, if the labour component provided by the farmer is not considered and sand and aggregates are brought from the nearby river /nalahbed, the cost of preparation is reduced to Rs. 3.46 per meter. Table 3 : Cost estimates for 40 meter prefab channels (10.3 lit/sec.) Particulars

No./Qty.

Rate/Unit Rs.

(a)

Rs.

Preparation of cement concrete channels. (i)

Cement bags

(ii) (iii)

138.50

5 Nos

27.70

Sand

0.4 cum

35.00/cum

14.00

Aggregates

0.54 cum

48.60/cum

26.25

(iv) Labour

2.5 man days

7.00/day

17.50

(v)

-

-

Oil

(vi) Rent for moulds

4 moulds

5.00 10.00

Subtotal (b)

Amount

211.25

Installation of channels: (i)

Cement bag

1 No.

27.70

(ii)

Sand

0.2 cum

35.00/cum

(iii)

Labour

18 mandays

7.00/day

126.00

Sub Total

160.70

27.70 7.00

67

Pre-fabricated Irrigation Channels (c)

(i)

Cost /meter (a)

5.28

(ii)

CosVmeter (b)

402

(iii)

Total cosVmeter

9.30

Cement concrete channels of specifications as given in table 1 can be used in situation as obtained under various discharges. In command areas, however, there has been a tendency to use brick lined channels in preference to bigger pre-fab channels and in-situ lining of concrete (5 em thick). Such sections are very much in use in Rajasthan canal and Chambal command areas (fig. 2). For the sake of comparison, economics of brick lined section (0.07 cum/sec) is presented in table 4. Table 4 : Cost estimates of brick channels (70 lit/sec) per running meter. S.No.

Unit

Qty

Rate Amount (Rs.)

1.

Earth work

Item

10 cum

0.76

32.00

2.43

2.

Dressing of bed and side slope

10 cum

1.72

3.50

0.60

3.

Cement concrete foundation (1 : 4 : 8)

1 cum

0.05

124.30

6.22

4.

Brick work in cement mortar (1 :4)

1 cum

0.133

254.10

33.80

5.

Cement plaster 1 sqm

1.20

6.20

(1 : 4)

Total Add. 5% miscellaneous

7.44 50.49 2.53 53.02

Feasibility of Pre-fab Channels:

Extensive work on demonstration and installation of pre-fab channels (6 & to.3lit/sec) around College of Agriculture, Jobner (Jaipur Distt.) and Udaipur has shown ado-Ptability and preference for these channels by the farmers on account of longer life (20 yrs) and ease of maintenance. A recent study conducted on well irrigated farmers of Jaipur distt. by the team of College of Agriculture, Jobner for various categories of the farmers, resulted cost-benefit ratios of 1.19,2.54,2.17 and 3.31 for small, semi-medium, medium and large

Table 5 : Cost-benefit-ratios of adoption of pre-fab channels in Jaipur District. Type of farm

%seepage loss(sandy to sandy loam soils)

Capital outlay on lining of channels per farm (Rs.)

Length.of unlined channels

Annual %increase in %increase maintenance irrigated in cropping intensity on lined area channels (100 m) Rs.

Small (0-2 ha)

21.33

2188.46

249.0

29.58

3.6

27-41

2249.98

256.0

30.41

6.16

26.08

2496.08

284.0

33.74

14.76

2.17

20.85

4869.11

554.0

65.82

18.07

3.31

Benefit cost ratio at 10% rate of interest

Remarks

7.14

1.19

Cost/meter

19.1

2.54

Rs.8.55

Semi medium (2-4 ha) Medium (4-10 ha) Large (10 ha and above

69

Pre-fabricated Irrigation Channels

farms, respectively with percentage increase in irrigated area of 3.6,6.16,10.4'1 and 9.33 for the same categories by adoption of prefab concrete channels ( 6 lit/sec). Salient results of this study are presented in table 5. Installation of such channels by the farmers is quite a paying proposition as percentage increase over existing returns had been 11.8. 12,49,6.37 and 11 for small, semi-medium, medium and large farms. Total benefits per annum for such categories were Rs. 335 22, Rs, 703.82, Rs. 669.14 and Rs. 1956.53 due to saving in irrigation bill (Rs. 275.02 Rs. 571.17, Rs. 419.25 and Rs 36502 respectively) and increase in crop production had been Rs. 60.20, Rs. 132.65. Rs 174.89 and Rs. 1591.51 respectively. However, due to some capital outlay on lining of irrigation channels, farmers may not be coming forward despite of the gains. Scarcity of cement is another bottleneck in extensive use of" re-fab channels by the farmers, Banks and other credit, institutions can play an important role by advancing loans and formulating projects for channel lining. Efforts of various developmental agencies could be pooled for procurement of materials and installation of such channels. For small farmers up to 12% rate of interest such channels are feasible whereas for other categories interest, rates up to 20% result in profitable proposition as evident in table 6. Table 6 : Net Benefit Cost Ratios At Different Rates of Interest. Type of farm

Rate of interest 10%

12%

14%

16%

18%

20%

1. Small

1.19

1.64

0.92

0.83

0.75

0.68

2. Semi-medium

2.54

2.24

1.98

1.77

1.60

1.46

3. Medium

2.17

190

1.68

1.51

1.36

1.24

4. Large

3.31

2.90

2.57

2.30

2.08

1.89

Conclusion: Pre-fab concrete channels (6 lit/sec, and 10.3 lit/sec) prepared from 1:2:3 ratio of cement, sand and aggregate are economical and can be easily adopted by the farmers. Small farmers should be charged a lower rate of interest (up to 12%) by the banks and other credit institutions, so as to popularize judicious use of water by the farmers. This could be arranged through subsidies etc. Saving of

70

Pre-fabricated Irrigation Channels

water through such channels will reflect higher crop production and better returns of capital in Indian agriculture. Fisheries In Rural Development Our country is blessed with rich and variegated inland fishery resources. Through application of modem technologies the scientific management of reservoir fisheries can generate self employment and thus improve socio-economic conditions of fishermen and fish farmers. The high yields that are now possible along with the fish seed trade provide direct and indirect employment to the unemployed and underemployed, particularly in the rural areas. Further, being labour intensive, fish culture in itself has the potential to check the influx of rural population to over crowded cities in search of jobs. Agriculture made man change his aptitude from a wandering tribe to a well settled being. If man had taken the fish culture in the manner he looked the agriculture perhaps he would have consolidated his position on land providing him greater choice & certainty of his aquatic demand at a lesser cost. What prevented him from giving due recognition to this immense potential of water resources on land could be a subject of debate in the years to come. Table 7 : Inland Water Resources of India and Rajasthan and Their Stocking Needs Resources (Water spread area)

Present production of fish seed/yield

Total need of fish seed (fingerlings) Expected yield

2,700 kg long Rivers

1 billion

16 billion

1,12,000 km long irrigation canals

8 lakh tonnes

128 lakh tonnes.

12 million

325 million

.105 lakh tonnes

1.7 lakh tonnes .

INDIA

2.9 million ha. of reservoirs,

1.6 million ha. of ponds & tanks 2.6 million ha. of brackish water.

Rajasthan: 31akh ha.

)

Pre-fabricated Irrigation Channels

71

There is an urgent need to develop specific programmes for creating employment upgrading income of fish farmers. Exploitation of fishery potential is an integral part of the rural development. Rajasthan with its reservoir resources and fairly higher productivity appears to be on the there should of BIl'_e Revolution. Rajasthan fishery being mostly a capture type of reservoir fishery can get a tremendous boost, if bank schemes are formulated and institutional finances are arranged for the unexploited and under exploited waters. To start with, some level of subsidy for supporting the venture would be necessary, but later on the projects will depend on their inherent economic and financial viability. The integrated reservoir fisheries projects should be aimed to provide a package of practices such as water management, development of seed fish farms, storage facilities, constituting fishermen cooperatives, ancillary industries development, marketing research and training etc. In view of the above, irrigation and fisheries should go together and be viewed as complementary programmes for construction of reservoirs From the very beginning of the planning of irrigation projects, the requirement of fisheries should be fully built in. Good fish is a product of healthy fish seed and to establish a flourishing fish industry the procurement of quality fish seed is essential. The fish seed farms are important to increase the production of fish as well as to serve as a training cum demonstration farms for prospective farmers. The establishment of fish seed farms and fish culture in long seasonal ponds have many folds, purpose, impact and benefits such as: Purpose

: Fish seed production, self employment, increased income.

Components : Farm construction, hatchery management and seed production. Impact

: Fish seed supply to fish farmers, gram Panchayats, fishermen cooperatives, source of employment for landless labours and unemployed youth.

72

Pre-fabricated Irrigation Channels

Benefits

: Solving protein deficiency, generate income and emplo:rment in rural areas.

The Following Data Indicate a Cost Benefit Ratio of one Hectare Fish Seed Farm Capital cost

In Rupees.

(a) Cost, of land

23,000 m2 )

10,000

Total

38,000

2.

Cost of nets, hapas and other equipment:

6,000

3.

Operating cost:

(b) Cost of construction of farm (6000 (c) Cost of construction of shed

3,000

(a) Cost of breeder: 60 sets

1,400

(b) Pituitary gland: 200 nos

400

(c) Feeding charges:

300

(d) Preparation of nursery ponds

550 Total

4.

2,650

Establishment charges: (a) Manager: 1

@

(b) Fishermen: 2

4,800

Rs. 400/- p. m.

@

200/- p. m. for 6 months.

(c) Seasonal collies: 3

@

Rs. 7/- per day

2,400 1,265

(d) Watchman: 1 @ Rs. 200/- for 12 months.

2,400

(e) Other contingencies and miscellaneous expenditure.

1,000

Total

11,865

This fish seed farm requires 60 sets of breeders; conservative estimation of success is 50%. Each set will yield 2.00 lakhs of eggs. Total eggs obtained 30x2.0 lakhs: 60.0 lakhs. 70% fertilized eggs i. e. 421akhs. 80% hatching-33.60 lakhs spawn. Farm hatchlings to fry stage at about 30% survival: 10 lakhs fry. Total cost of 10 lakhs seed at Rs 4,000/ - per lakhs = 40,000. " Expenditure and Income Statement:

Expenditure: 1.

Depreciation on cost of construction : including shed @ 10% (on Rs. 13.000/-)

1,300

73

Pre-fabricated Irrigation Channels 2.

Depreciation on cost of nets, hapas and other equipment's @ 30% (on Rs. 60001-)

1,800

3.

Interest on capital @ 12% (on Rs. 44.0001-)

5,280

4.

Operational cost

2,650

5.

Establishment charges

11,865

22.895

Total

Income: 1.

Sale proceeds of 10 lakhs fry :

2.

Sale proceeds of spent brooder

200

3.

Miscellaneous receipts from grass vegetables etc.

200

40,000

Total:

40,400

Net profit (Rs. 40, 400 - 22,895)

=Rs. 17,505.00

Economics of composite Fish culture in one hectare pond. Fingerlings

I

I

Catla

Aohu

Grass Carp

500

500

500

I Common Carp

Silver Carp

625

1250

Mrigal Gourami

625

75

No. / As.

5075 1 500 ,1.

Cow dung 2500 kg Rs. 200

~

INPUT

/"

I 1 ha water I Inorganic Manure 1700 kg Rs. 2370

Artificial feed oil cake and rice bran 2400 kg. Rs. 1500

Labour incidentals and depriciation cost of Nets 400

OUT PUT at the end of one year 4210 kg of fish @ Rs. 8/- Per kg. Total income-Rs. 33,6801Net income- Rs. 25.1101-

***

Chapter

6

ee PURCHASING METHODS

One of the important problems in the control of production is that of having the required material on hand when needed. In ideal conditions material would arrive from the sources, whence it is purchased, just when it is needed and in the desired quantity. Such ideal conditions can rarely be realized, and usually a sufficient amount of raw material must be carried in stores, the storeroom acting as a reservoir to equalize the variations between the plant and the sources of supply. It is the primary function of the purchasing department to make all purchases of material and supplies as required, and it is the primary function of the storekeeping department to guard and care for all purchased materials and to ensure that they are issued only on the proper authority and in the correct amounts. Purchasing and storekeeping are, therefore, closely connected. Included in these functions also are the receiving of purchased goods and their inspection before acceptance. In comparatively small companies all four of these functions are usually conducted as one department under one head. In large plants purchasing is an independent function and receiving and inspecting are usually combined with storekeeping. In very large enterprises receiving and inspecting are sometimes organized as an'independent function,

Purchasing Methods

75

Organization of Purchasing Department:

The position that the function of purchasing may occupy in the company organization depends upon the size of the plant and upon the degree to which general policies enter into its operation. In small companies it is not uncommon to find purchasing under the supervision of the treasurer, stores, of course, being under the direction of the shop superintendent. In companies of moderate size the purchasing agent is usually responsible to the factory manager. In very large companies, consisting of several plants that are separated geographically and in which general policies are important, there is usually a general or central purchasing organization to direct policies and to make such contracts as affect all of the plants, with a local purchasing agent at each plant to care for routine matters. The best arrangement will, therefore, depend somewhat upon circumstances, but in any case responsibility for all purchases should be centralized, and purchasing by several persons or departments should never be tolerated, as it always leads to loose, extraVagant ideas and methods, higher purchase prices, and needless waste. The opportunity for dishonesty is also much increased. A good purchasing agent is always a valuable man; and as the size and complexity of a business increase, his value rises. It is axiomatic that he must possess the business training and natural commercial instinct that will make him a keen student of market conditions and a judge of values. It is equally important that he be able to systematize his department so that it runs smoothly in connection with the other departments, serving them quickly and well. If, in addition, he is well informed on the technical and practical side of the industry, his efficiency will be increased many fold. For these reasons a Clan promoted from the shop or engineering department will, all other things being equal, make a better purchasing agent than one promoted from the clerical force of the oftice. Purchasing, however, involves a knowledge of business methods and forms, of which shop men and engineers are, unfortunately, seldom will informed; hence, purchasing agents are usually recruited from the clerical force.

76

Purchasing Methods

The internal organization of a purchasing department will vary with the size of the enterprise. In the small plant a purchasing agent with an assistant or two may suffice; in the large enterprise the department must be large and consequently organized with care. Figure 47 shows an organization suggested by P. M. Marshall for a large enterprise with several branches that are separated geographically. It is assumed in this plan that the volume of business, both at the central purchasing division and at each departmental division, is large enough to permit of specialization. In each division, therefore, the work of purchasing is functionalized under three sections, namely, buying clerical, and service. The buying section does all the purchasing, this work again being separated into classes and a specialist assigned to each class. The clerical section performs all clerical work and keeps all records. The service section follows up all orders, conducts relations with other departments, and makes all necessary adjustments. Such a highly developed department is, of course, necessary and possible only in very large organizations. Sources of Supply: A major function of the purchasing department is to keep fully informed concerning sources of supply of all type materials. Viewed broadly, all industrial effort is concerned with the transforming of natural resources into useful forms and the transportation of the same to the places where they are needed. As each increment of labour is bestowed upon the material while it passes through the process, it rises in value. Thus, coal is mined in one place; iron ore in another. Both are transported to a convenient place, arriving there worth a few cents per hundred pounds. By means of the coal the iron is there transformed into pig iron worth perhaps 1 cent per pound. This pig iron may be transformed in the same plant into steel rails worth 1% cents per pound, or it may be again transported to an engine works and made into steam engines worth 20 cents per pound. Or it may be shipped to a crucible steel works and made into crucible steel bars worth 16 cents per pound, and these steel bars may be transformed elsewhere into watchsprings worth many dollars per pound. This is true, in a general sense, of all the products

Purchasing Methods

77

of industry, material values being, in the main, accumulated labour values, the value of the original material in its natural state often being a negligible part of the mark~t value. In some cases the transformation of the raw product into useful form is accomplished in one plant. Thus, table salt, kerosene, and similar commodities may each be made in a single reduction works and placed directly upon the market. In most cases however, this is not so, most market products being the result of several distinct stages of manufacture, each stage separated widely by character and geographical distance. This is so from the nature of the case and from the complexity of modern manufacturing. The man who smelts pig iron would not be expected to produce, also, all the finished products into which it enters; in fact, he may be compelled to supply a widely diversified field of industry in order to secure the quantity necessary to manufacture pig iron economically. These general conditions apply to all those who in tum transform pig iron into other forms and equally again to those who in turn use these other forms for other purposes.

What, then, appears to one manufacturer as finished product appears to some other manufacturer as raw material, and the extent to which any manufacturer may depend upon other branches of industry varies widely. In very few instances is he entirely independent of other lines of industry. It is a fundamental requirement, therefore, that the purchasing department have full and accurate knowledge of the material requirements of the plant and of the sources of supply of these requirements. This latter information is obtained from personal knowledge, from records of transactions already consummated, and from trade catalogues, "buyers' guides," and other publications containing such information in condensed form. A well-organized purchasing department will have this information carefully classified and indexed so as to make it readily available. The materials that enter into any given finished product are, in general, of two kinds: direct and indirect; and even though a manufacturer may control the direct material from its natural sources to the market, he must, in most instances, depend on other people

,78

Purchasing Methods

for many of his indirect supplies and his tools of production. If, however, the required quantity of any material, direct or indirect, becomes great enough, it may pay the manufacturer to extend his control of that particular material a little further back toward the natural sources. Thus, a growing concern may not have enough demand for castings to operate a foundry; but as the business increases, it may pay to build one, even though no reduction in price is so obtained, in order to control the supply of castings and thus facilitate deliveries. If the quantity increases so that foundry work can be prosecuted as economically as in the foundries from which castings were formerly purchased, the profit formerly paid these foundries is thereby saved. The electrical manufacturing companies in this country depended originally on other sources for their porcelain and mica products, and small companies still do so. As the quantities incident to great growth have appeared, some of the larger electrical works have put up their own porcelain works and have installed presses for making mica products. Some have even put in wire-drawing plants, not so much with a view, perhaps, of obtaining lower priced wire as for convenience and better control of deliveries. The importance, therefore, of the control of the several streams of material coming into an industrial plant will depend on their relative bearing on questions, of economy of manufacture, or convenience as affecting delivery of finished goods. It may be highly important to control a large stream for financial reasons. It may be no less important to control a very small one because of its effect on deliveries. The lack of a small detail will hold up the delivery of a machine as effectually as will a larger one, and thus control of the sources of supply may vary from the simple case where all materials are fully controlled to the other extreme where nothing but assembling is carried on, the finished parts coming from many factories ready to be assembled. The first extreme is rare, but many cases of the latter are to be found. Purchase Requisitions:

The demand for materials grows naturally out of the needs of the business and cannot, therefore, originate with the purchasing

Purchasing Methods

79

agent. In a shop devoted to general repairs, the requisitions for materials would, most naturally, originate with the foremen in charge of work, since they will know better than anyone what is wanted. In a shop building new work to order only, such as an engine works, these material requisitions for direct material would originate in the engineering department, though they should pass through the storekeeper's hands before going to the purchasing agent in order to check off material on hand. In a shop manufacturing standardized articles, as knives, watches, etc., a material requisition would naturally originate in the stores department, which is the reservoir that feeds the factory, and here also would originate, always, the requisitions for all indirect and expense material. In a shop doing all three of these classes of production, therefore, material requisitions might originate from several sources; and just as it is necessary to centralize the authority and responsibility of the purchases based on these material requisitions, so it is absolutely necessary to fix definitely the authority and responsibility for originating these requisitions. In a factory that is well managed this power is limited to responsible men, and the requisitions in many cases must be countersigned by a higher official as a check on irregularities. Where production is fully controlled, the planning department will, as a matter of routine, issue such information concerning the material needed as will be necessary both for the stores department and for the purchasing department in obtaining the proper material at the proper time. The purchase requisition should specify accurately the character and amount of the material needed, the time when it is required, the place where it is to be delivered, the purpose for which it is to be used, and any other information needed to identify it fully with its purpose. The requisition should be signed by the person responsible for its issuance so that any necessary adjustments may be taken up with him. Routine of Purchasing:

A full discussion of the problems of purchasing and of the printed forms and documents used in purchasing is beyond the scope of this chapter. Only those features which are of general

80

Purchasing Methods

interest will be noted. If the items called for by the purchase requisition are not important, the buyer to whom it is referred may place a purchase order with some reliable vendor with whom a regular business is conducted. If, however, the amounts involved are large, he may ask for quotations from a number of vendors. On the basis of the bids received he will place the order to best advantage. It is in this connection that good department records are of great importance, for it is not sufficient that the bidder's price be right but the buyer must be assured of his reliability in the matter of meeting delivery dates, quality of material furnished, etc., and past experience may show that the lowest bidder is not desirable from, these viewpoints. The purchase order will necessarily vary widely in form depending upon the business, but, in general, it should include all information necessary to make misunderstandings impossible. It should bear an identifying number, the date of issue, the name of the vendor to whom it is sent, a full description of the article desired and the quantity thereof, the date of delivery at the plant, shipping directions, prices and terms of payment, and the name of the company making the purchase, with the signature of the purchasing agent. Quite frequently the purchase order has an acknowledgment form attached to the purchase order which the vendor signs, detaches, and mails to the purchasing agent as an acknowledgment that the order has been received. The buyer usually sends a duplicate copy of the purchase order to the receiving and inspecting departments and sometimes to the requisitioner of the material as a check on accuracy. Skilful purchasing involves following five principal features, namely: Price. 2. Quality. 3. Quantity. 4. Time of delivery. 5. Verification of goods purchased. 1.

1. For a given quality and quantity of material the securing of low prices becomes a commercial matter depending on a knowledge

Purchasing Methods

81

of the sources of supply, transportation facilities, market conditions, discounts, and similar considerations that apply to all purchasing. Price, however, is not always the only factor that must be considered, for, as will be seen, an effort to obtain low purchase prices may result in high manufacturing costs, though it is fundamental that other things being equal, the lowest possible prices should be obtained. 2. It is obvious that the judgment of the purchasing agent as regards the quality of materials required increases with his knowledge of the trades and processes for which he buys. In the buying of many indirect or expense materials such as oil, waste, stationery, etc., it is customary in many plants to trust to the judgment of the purchasing agent. In fact, this is true in many cases of much of the direct material. But as an ind ustry grows more complex and the scientific knowledge on which it is based becomes more important, the purchasing agent must depend more on the expert in each line for instructions as to the quality of material required. In electrical construction, for instance, the quality of many materials is of highest importance, and the characteristics must be carefully specified to the purchasing agent. Many large companies keep wellequipped experimental laboratories for determining the best qualities of material; foundries now buy their iron by chemical specification; and careful managers specify the character of their supplies, such as coal and oil. Best results will, therefore, be obtained when the special buying ability of the purchasing agent is reinforced by the expert knowledge of the specialist who knows the characteristics desirable in the material under consideration. Where necessary, therefore, the purchase requisition should be accompanied by complete specifications, and the purchasing agent should be guided strictly by these in making purchases. Any other method will be found to be wasteful. 3. The temptation to buy large quantities of material is always strong for two reasons: (1) Lower prices are obtained as the quantity to be purchased increases, and (2) a large stock on hand ensures prompt service to the shop and consequent quick deliveries. But here again the judgment of the purchasing agent should be reinforced by expert knowledge and advice. There is no money in ordering

82

Purchasing Methods

several years supply of anyone article, storing it, and thus tying up considerable capital and losing the interest thereon simply for a small saving in price. The quantity ordered, therefore, should have a reasonable relation to the prospective output of the factory. Mr. Frank Parrish, Supervisor of Inventories of the United States Steel Corporation, is quoted as estimating inventory carrying charges for average warehouse stocks as 25 per cent per annum, divided as follows: Storage facilities ......................................................... 0.25 Insurance .................................................................... 0.25 Taxes .......................................................................... 0.50 Transportation ............................................................ 0.50 Handling and distribution ........................................... 2.50 Depreciation ............................................................... 5.00 Interest ........................................................................ 6.00 Obsolescence .......................................................... 10.00 25.00

Furthermore, before placing purchase orders for large quantities of stock, particularly special stock, careful inquiry should be made as to prospective changes in design that may render such stock obsolete, an occurrence only too frequent in an industry that is in a state of development. In large works a great purchasing advantage can be obtained by standardizing, as far as possible, articles of a similar character used by different departments, thus decreasing the variety and increasing the number of each kind purchased. This principle should be observed from office lead pencils to the largest common supplies and tools purchased. 4. The time element is a most important one in purchasing. It is essential that all material for a job arrive so as to be fabricated in time to avoid delay in assembling the completed product. Yet a contract might be taken for machines involving the use of tons of copper, say, and requiring a year for completion, the copper not being needed till near the end of the construction. Evidently the purchasing agent, working in connection with a good planning department, can save considerable money by means of well-

Purchasing Methods

83

arranged schedules of delivery. The same thing can be accomplished for material used constantly, such as coal, by making long-term contracts but with periodic deliveries and payments. In other cases, again, the purchasing agent is often justified in paying a high price for a quick delivery if it will save great delay in the factory or secure a remunerative contract because of early shipment. 5. The verification of purchased goods is usually conducted by the receiving department which is, in general, a branch of the stores department and is, therefore, discussed among the problems of that department. Market Purchasing:

The routine methods of purchasing, are those in general use where it is the purpose simply to satisfy the manufacturing needs at the proper time and at the best prices of the existing market. There are many cases, however, where it is possible to satisfy these needs without strict reference to the requirements of the manufacturing program and, by taking every advantage of market conditions present and future, make great savings in purchasing. Such a procedure is called market purchasing. There are three sources of information from which prices may be forecast: (1) the many published statements of price movements, (2) special advises furnished by private statistical bureaus for remuneration, and (3) whatever statistical data the purchasing department may gather from its own experiences. A competent purchasing agent should be able by a careful study of such statistics to forecast the trend of market prices and thus make advantageous purchasing contracts. If, for instance, such studies show prices to be low but with an upward tendency, contracts for material at the low price and extending some time into the future will be advantageous. Again, if prices are high with a tendency downward, close buying will be advisable. Statistical data presumably reflect changes due to supply and demand. There are however, other factors that may exert a large influence upon the policy of purchasing. Labour troubles, congested conditions in transportation facilities, and many other movements in the industrial field all tend to affect prices. Furthermore, market

84

Purchasing Methods

movements in fields other than the one in which the purchasing agent is directly interested must be kept in mind. Thus, market movements in basic industries such as steel and copper, the number of unfilled orders, and the stocks of material on hand in these industries are indicative of future prices in other lines. Unemployment and import and export statistics may also be of service in evaluating future market prices.

In some industries where the manufacturing processes do not change materially, where the cost of production is small compared with the cost of the material, and where large quantities of some basic commodity are used, purchasing is often conducted without much reference to immediate factory needs. Thus in the textile industries and in some of those industries which use large quantities of copper, where the cost of the raw material is a large part of the total cost, it is often good purchasing policy to buy large quantities when the market price is low without any reference to the immediate manufacturing program. Such purchasing is known as speculative purchasing. Obviously such purchasing cannot be successfully carried on without a comprehensive knowledge of all market conditions; and although, no doubt, there are industries in which it has a proper place, it should be avoided as far as ordinary manufacturing is concerned. Such methods tie up large amounts of money and in many forms of production are likely to upset the manufacturing program and to leave large quantities of unusable material on hand owing to changes in design or policy. Purchasing Contracts: In ordinary commercial purchasing the purchase order and a written acceptance are considered all that is necessary, it being assumed that the mutual interests of purchaser and vendor are sufficient to ensure good faith on both sides. Usually this is true, though when business declines suddenly, the practice of cancelling orders is all too common. In very large and important undertakings dependence is not placed upon the purchase order and its acceptance, but a written contract is drawn up binding both parties to the fulfilment of their share of the transaction. Thus the Federal government contracts for practically all materials, supplies, and

Purchasing Methods

85

services rendered to it by those doing business with it. In important contracts the bidder is required to deposit with his bid a certified check for a specified amount as a guarantee of good faith and performance. This practice is not uncommon in private practice where the work is of considerable magnitude. Many companies that use large quantities of basic materials such as pig iron, coal, coke, etc., have found it very desirable to contract for the entire supply of such commodities for a considerable period of time. Usually the schedule of deliveries of the commodity is worked out to fit into the manufacturing program and incorporated into the contract. The advantages of such an arrangement are that the purchaser obtains reasonable assurance of a supply of material during the contract period, he is protected against excessive price fluctuations, and, in general, he is able to secure low prices because of the large quantities contracted for. The vendor also enjoys corresponding advantages that ~re obvious. Frequently it is not possible to fix a flat price for long-term contracts, and in such cases the price may be fixed with reference to lowest market quotations or by quotations in some selected periodical. These contracts are of many kinds varying widely with the circumstances. It should be noted, however, that these contracts may not be broken by either party with impunity, and they should, therefore, be drawn with care so that they are fair and binding and include all necessary stipulations. In important cases, especially where the contract fixes penalties for nonperformance, it is advisable to have legal advice before signing the contract.

Chapter

7

**

STORES CONTROL

Under ideal manufacturing conditions the raw materials would be used as fast as they arrive at the factory, passing directly through it, and the finished goods would be shipped to customers as fast as it was turned out. Such conditions are almost impossible to attain, though they may be approached in some of the simple continuous process industries. In most manufacturing companies the raw materials are used in varying quantities at varying times, and sales are likewise intermittent and varied. For these reasons, and also because purchasing and transportation are facilitated by quantity, provision must be made for storing such quantities of raw material as will ensure prompt service for these varying demands. Where sales are varying and goods must be made in advance of sales, similar provision must be made for caring for finished goods, in order to ensure prompt delivery to customers. In shops that make goods to order only, as a shipbuilding company, this last feature would not be important. Unworked material is usually known as stores, and the space where it is housed is known as the storeroom stores department. The storeroom is, in effect, a reservoir between the incoming materials and supplies and the factory proper, equalizing the varying supply and demand. Finished goods ready for shipment is usually called stock, and the place where it is stored is called a stock room. The

Stores Control

87

stock room is, in effect, a reservoir between the factory and the selling department equalizing the varying demand of the customers and the varying output of the shop. In small factories the storeroom and stock room may be one and under the control of the same official, but there is a major difference in their functions; and as plants grow in size, separation becomes almost inevitable. In order to obtain the advantages of manufacturing a large number of pieces of one kind it is often necessary to finish large numbers of parts of machines or other goods and store them, drawing them out for final assembly in completed goods as the business requires. In fact, in some companies carrying on semicontinuous manufacturing, the quantities are so large that it is necessary to store them between successive operations, especially if the materials involved are valuable. In many cases, also, the same part is used in different kinds or sizes of goods that come through the factory at different times, and repairs and supply parts always demand a stock of standard finished parts on hand. The storeroom may, therefore, also act as a reservoir to equalize inequalities in the manufacturing processes of the company by storing so-called finished parts, and in some cases a special section of the storeroom called the finished-parts storeroom is set aside especially for this purpose. A distinction is sometimes made between finished parts made by the factory and those purchased. Thus bolts, screws, or any other element that is purchased and used directly in the goods are, strictly speaking, finished parts and are sometimes called purchased finishe~ parts to distinguish them from manufactured finished parts. The distinction is, however, somewhat academic and not of practical importance, provided the cost of each goods is accurately determined. The storeroom may be said, therefore, to care for following three classes of material: 1.

Stores, or raw material that is to be fabricated into goods, consisting largely, therefore, of direct material.

2.

Supplies, or indirect material, such as oil, waste, etc.

3.

Finished parts, or goods, fabricated, but not fully assembled.

The stock room in its fully developed form will care only for finished goods, that is, fully fabricated and ready to be shipped. In

88

Stores Control

large organizations this department comes, naturally, under the shipping clerk. In such cases the stock room may carry many finished parts for convenience in supplying repair parts. In smaller concerns the stock room, storeroom, shipping and receiving rooms may be under one man and in one room. But as factories grow in size, these different functions should be separated in the interest of efficiency. Storeroom Organization:

The storeroom is usually organized under the superintendent of planning, and the chief stores clerk is responsible to him. It will be obvious that since the stores constitute a service function, the exact manner of this, organization will depend upon the size of the com pan y. In companies of moderate size a single storeroom centrally situated will serve all needs, but in a very large company with many buildings housing diverse activities it is frequently economical to establish branch storerooms throughout the plant at convenient. locations. And in large companies with factories separated " ~\geographically it is obvious economy to have storerooms at each plant even though the purchasing may be centralized. Storeroom Methods:

The necessity and the advantages of a well-organized storeroom are not always fully recognized. Managers who would look with horror upon a financial system that would permit the easy extraction of small sums of money from the office safe often look complacently upon storeroom methods that permit the tmauthorized withdrawal of valuable material from the stores, wastes due to excess material drawn, and losses due to valuable material unaccounted for, out of all proportion to their care of the cash in the office till. Managers who would look most carefully into the tying up of money in securities permit the investment of large surns in raw material with little thought as to the relative amount invested, the possibility of how long it may remain so tied up, or the depreciation that it may suffer while so invested. Yet material represents value as truly as the money in the office safe, though this is not always appreciated. Any saving in material is as effective as a saving on the pay roll. Money tied up in material is crystallized capital and while in this

Stores Control

89

form is inactive. Clearly, the amount so invested should be carefully scrutinized, and its total kept as low as proper service of the factory will allow. The major business of the storeroom is to anticipate the needs of the factory in the most effective and economical manner possible. In order to accomplish this it must fulfil the following functions perfectly: 1.

Issue requisitions on the purchasing department for the most economical amount of the right kind of material for delivery at the most advantageous time.

2.

Check all material received as to quality and quantity.

3. Store all material in a safe and convenient manner. 4.

Issue materials and supplies in the exact amounts needed and at the exact time requ:ired.

5.

Maintain exact records of all receipts and issues and of all balances on hand.

The work of the stores department is, therefore, closely connected with that of the purchasing department on the one hand and with the shop and cost system on the other. In small business the storeroom and purchasing department are often included in one department.

Item 1 : The origin of purchase requisitions will vary with the character of the industry, but usually all requisitions originating outside the storeroom should be passed upon by the storekeeper so as to ensure the use of material on hand before ordering more. For this reason all requisitions are drawn on the storeroom in some organizations, the storeroom alone requisitioning the purchasing department. The problem presented in obtaining material for repair work or for special work done on order is comparatively simple, since the quantity and quality are here fairly definite in character, the question of time, however, being often of great importance. If the work is of large magnitude and is to extend over a considerable period of time, a careful planning, by either the engineering department or the planning department, of the time schedule on which materials

90

Stores Control

should be delivered is almost essential to prevent premature and over investment of funds. In the case of repairs, on the other hand, quickness of delivery is usually an essential. The problem of anticipating the needs of a large.company that is manufacturing standardized goods of several kinds and many sizes is a more difficult problem, including as it does the consideration of the quantity of raw material that should be carried in all stages of fabrication from raw material to finished goods. Among the leading considerations that must be given weight in deciding what stock of goods shall be carried in the several stages of production the following may be noted: 1. The demand for the particular part or combination of parts. 2.

The saving that may be effected by manufacturing in quantity.

3.

The interest on the capital tied up in material in process of manufacture and in facilities for storing and caring for it.

4.

The time required to obtain raw material and to assemble it into completed goods from various stages of fabrication.

5.

The probability of change of design and consequent depreciation of raw material, finished parts, or completed goods.

To make the interrelation of these considerations Clearer consider a hypothetical problem of manufacturing a complete line of alternating-current transformers. The demand for the smaller sizes of transformers, or, say, up to 100 kilowatts, is large though varying; very quick deliveries are essential; the voltages are moderate; and the design will be assumed to be fairly stable. These small sizes would be in continuous manufacture, or they would, at least, be passed through the factory in large lots, finished completely, and put in stock. To facilitate delivery some stock of these sizes would also be carried in branch sales offices. Complete sets of special winding machines and other labour-saving devices Vv ould be developed so as to take advantage of quantity in reducing shop costs. Anticipation of the demand for raw material in this case is comparatively simple, care being necessary only to see that the supply of any material does not get so low before ordering that

Stores Control

91

production is held up and care exercised, on the other hand, that the amount ordered is not so excessive as to tie up too much capital or to run the risk of any of it becoming obsolete through changes in design. This case represents in a general way the problem of continuous processes of all kinds. Now, in general, the demand for a given class of goods lessens as the size of the unit increases. Transformers from 100 to, say 250kilowatt capacity would probably not be in such demand as the smaller sizes and would not be carried in branch-office stocks. The demand may also vary with the season. The yearly demand, nevertheless, is such that they can be economically put through the shop in large lots, the size of these lots and the proper times for authorizing their production requiring careful consideration to keep the investment as low as is consistent with prompt delivery. A good equipment or special tools might also be warranted for these sizes, though they may not be in continual use. Transformers of, say, SOD-kilowatt capacity may present a very different problem. Here the demand may be so small that it may not be advisable to put large lots through to completion and stock, because the interest on the money so tied up would more than equal the saving made by production in quantity. Yet the time required to manufacture these larger sizes may be prohibitive from the standpoint of the salesman, and, therefore, it may be good policy to make up and stock some of the parts that require the longest time to produce. Thus the copper coils may be wound and insulated and carried as finished parts, thus also providing spare parts for repairs. A limited amount of sheet steel for building up the laminated cores might also be carried among the finished parts. The cast-iron casings or any steel or malleable-iron castings that require time to obtain might be carried in the raw-material supplies, labour being expended only on such parts as would greatly facilitate delivery when orders to assemble these sizes were received. The outfit of special tools for these sizes would also be very limited and carefully considered. In the case of still larger sizes not even finished parts of any kind would be justifiable, and only such raw materials as require a

92

Stores Control

considerable time to obtain would be carried. Thus, certain special sizes of copper strip might be justified, though usually special material of any kind should be avoided, if possible, since, if rendered obsolete for any reason, it depreciates very rapidly and is, in general, useless for other purposes. No special tools might be justified for these larger sizes because of the small quantity demanded. In still larger sizes and perhaps for higher voltages it may be that not even raw materials should be c'1rried. The more difficult engineering problems involved, the possibility of changes in design, the varying requirements to be met in the field would perhaps make all anticipation of materials hazardous and out of the question. The problem has passed from the extreme case of the continuous industry to the other extreme where the goods must be made to order and material ordered as needed and not anticipated. The relative sizes assumed above are, of course, hypothetical but entirely possible. The principles involved are, however, universal. The question of the quantity and form in which material shall be carried is not a simple one or one that can, in the general case, be decided by anyone man. The storekeeper can easily handle the extreme cases. In the cases that approach continuous production it is simply a matter of considering the stock bins as hoppers feeding the factory. Minimum limits can be set to each bin or other storage that will serve as a warning to order more quantity material. Maximum limits may be set, based on the sales demands that will prevent over investment. In the other extreme where work is done to order, the problem is specific as to quality and quantity and the important element is the time relation. But between these extremes the combinations are complex, and an intelligent solution can be reached only by the joint efforts of the storekeeper, the salesman, the engineer, the financier, and the tool-maker. Item 2 : When the vendor ships goods to the purchaser, he mails the purchaser an invoice, or list of the goods. This invoice is sent to the receiving department which is usually a part of the stores department; and when the goods are received, they are checked against the invoice and purchase order in order to ensure fulfilment of the purchase order before sending t~e purchased material to the stores or to fabrication. This checking at the receipt of the material

Stores Control

93

includes the quantity and quality of the shipment, the price, terms, and freight charges. Any discrepancies are referred to the purchasing department for adjustment. In many lines of work a visual checking is sufficient, but again it may be necessary to inspect the material as to chemical or mechanical characteristics, in which case an inspection department fitted with laboratory apparatus may be a necessity.

Item 3 : It is axiomatic that all type of materials should be stored in places where they will be safe against deterioration or pilfering. They should also be stored in a convenient and systematic manner and so that they can be delivered quickly to the shop. In large works branch storerooms are a necessity, for reasons of both convenience and economy. If the stores are extensive, a book, plan, or written record of some kind showing the location of stores is imperative to guard against the delay and confusion arising from the 1055 of experienced employees who carry such matters in their heads. The . same remarks apply to pattern and other storage problems. A carefully planned systematic way of storing tools, patterns, and materials of all kinds is an important feature of good management. A well-developed stores system also necessitates a system of identifying nomenclature so that the location of all material is easily found. The physical arrangement of storerooms and the methods of placing material in bins, racks, etc., will depend upon the character of the plant. Item 4 : In former times, when shops and factories were small, materials and supplies were stored on open shelves and each workman helped himself to what was wanted. The custom still prevails in small plants, particularly where the stores are such as are of no personal value to the workmen or where they consist of indirect material and form a very small part of the material cost. There are, no doubt, many cases where it would cost more to employ a storekeeper than he could save by his watchfulness, but in most cases it pays to put all stores under a good storekeeper, give him needed facilities to keep the stores properly, and then hold him responsible for wastes and losses as far as the stores are concerned. It is common experience that workmen cannot, in general, be trusted to draw either direct or indirect material from stores without

94

Stores Control

great waste, both as to the quantity drawn and as to its economical use. Furthermore, loose methods of issuing materials are always likely to lead to dishonesty and pilfering. The first method of checking these difficulties was to put the responsibility on the foreman. Under this system each foreman is furnished with an order book and no article can be issued from the storeroom except on the authority of the foreman's order which describes the material required, the amount needed, and the order number to which it is to be charged. Indirect material is ordered in the same way; in many cases the foreman also notes the order number to which the expense material is to be charged, this number usually being the order number on which the workman is, at that time, employed. The unfairness of such a method of distributing expense material is obvious. The orders issued by the foremen are taken up by the storekeeper and are his authority for the issuance of the material and also the basis of material costs. The advantages of such a system are its simplicity, flexibility, and quickness. No delays are experienced in getting the material from tRe stores to the factory floor. This method responds instantly to emergencies, either in production or in the shop repairs. There are many places where it is adequate, particularly where the force of men is small, the foreman intelligent, and the stores of no value to the workman personally and where the number of orders issued daily is small and the accounting consequently easy. As departments become larger, on the other hand, it is not good practice to use a busy foreman for this purpose. His time is more valuable for other purposes, and he will not do it well if he pays the attention that he should to the more important problems of production. He may, of course, be given clerical help, but this, again, is a palliative only, as the system falls down for other reasons. As shops grow in size, the problem of cost keeping becomes rrlore and more important and, in most instances, when the problem of drawing material becomes too great for the foreman, it is high time to consider better methods of cost keeping. This leads naturally to the preplanning of work and the use of the production order. Under these modem methods full bills of

Stores Control

95

material are prepared in the engineering department, in the planning department if there is one, or by someone in the office of the superintendent. These bills of material give full information regarding the quality and quantity of the material and the order number to which it is to be charged. They are made in multiple, one copy going to the foreman with the drawings and other directions for the work and constituting his authority to draw the material. One goes to the store keeper and constitutes his authority for issuing the material specified, serving also as the basis of costs. The accuracy of the method is manifest. If properly operated it prevents unnecessary drawing of direct material, fixes responsibility and authority definitely and in such a manner that errors or irregularities can be instantly attributed to those responsible. Most important of all, it permits of more accurate costs than are attainable under the older methods. The method is not flexible, however, and emergencies must be cared for by modifications of the plan. Small jobs would cost too much if passed through a system of this kind. It does not take account of expense material and supplies. For these reasons it is customary to give a foreman or other official power to issue emergency requisitions to care for these special conditions. Thus, in an emergency repair job brought into the shop on Saturday afternoon or an imperative repair job on the shop powerhouse on Sunday, when the machinery of the planning department is not running, this official would issue the requisitions, subject to the approval of the proper authorities when the office and storeroom open up again. Emergency methods must always be provided, in any wellorganized system, to prevent inflexibility destrOying its usefulness. It is the fear of this inflexibility which often leads superintendents and foremen charged with the duties of production to oppose new systems that savor of "red tape" because although they may cure certain evils, they may do so at the cost of convenience and ~lexibility. This particular defect in all systems deserves careful .... consideration in installing them, and it is in making modifications of this kind that the manager shows his true ability in organizing. Expense materials and supplies such as oil and waste cannot, of course, be handled on production orders. They may be issued on

96

Stores Control

the foreman's order, but in no case should the foreman assign the order number to which they are to be charged unless classified standing order numbers have been provided for this purpose. Standard supplies, such as oil and waste, are often given out at assigned times only and in definite quantity to each man. Extra quantities may be drawn at other times by special order only.

Item 5 : It is obvious that if the stores department is to anticipate the needs of the factory, it must keep a fairly accurate record of all material and supplies. If a planning department exists, this need is accentuated, since skilful planning cannot be carried on without accurate record of materials on hand. The extent and detail necessary in such records will, of course, vary greatly with the type of business. In the case of continuous processes or of manufacturing approaching a continuous process, where the material for the most pClrt moves from the storeroom directly through the factory without interruption, the storeroom bins and racks may be considered as reservoirs in which the material should never fall below or rise above certain economical limits that have been fixed by the considerations already discussed. Many methods are available for making intelligent use of such maximum and minimum limits. The simplest is that which may be called observation of limits. Usually only two limits are set, the maximum and the minimum, though sometimes a lower or danger limit is also set for the purpose of indicating that orders for a fresh supply of material must be rushed. To keep account of the material a printed form is attached to each bin or rack; and as· material is withdrawn, the storekeeper deducts the amount taken away, thus keeping a continuous record of what is left. When the amount falls to the lower limit, an order is placed that will bring the amotmt up again to the maximum. Balance-of-stores Ledger: In more highly developed systems of production, the stores records are kept by a head storekeeper or his clerical assistant on a card system or in a loose-leafledger ruled especially for this purpose, and known as a balance-of-stores ledger the complete control of production and the accurate prediction of the schedule of productive

Stores Control

97

processes depend to a certain degree on the control of materials. The required information concerning material is recorded on these ledger sheets in the following manner. Each ledger sheet records the transactions in one part or item only. There are four main vertical divisions, namely, l-Ordered; 2-On Hand; 3-Apportioned; and 4- Available. If entries are properly made, the sum of divisions 1 and 2, that is, the amounts ordered and on hand, will always equal the sum of divisions 3 and 4, that is, the amounts apportioned and available, and the distribution of all stores recorded upon the sheet may be seen at a glance. To illustrate the procedure let it be assumed that on February 11 there were on hand 1,500, lh- by 4lh-inch bolts. Being on hand they were also available, and entries to this effect were made in these columns. The balance of stores shown by the four division columns was then 0 + 1,500 =0 + 1,500. On February 12, 600 bolts were apportioned to production order 760. The entries made were as follows: 600 was added to the Apportioned column, 600 subtracted from the Available column, and the balance was 0 + 1,500 = 600 + 900. This l>ransaction, however, brought the available amount below the minimum allowable quantity as shown at the top of the sheet; consequently an order was placed for 4,000 bolts, which is also the predetermined quantity to be ordered. Ordered material is considered as available, due allowance being made for time of deliveries; hence 4,000 is added to both column 1 and column 4, making the balance 4,000 + 1,500 = 600 + 4,900. On February 15, the material issue of production order 760 to which 600 bolts had been apportioned was presented by the move man to the stores, and these bolts were issued and this amount subtracted from both column 2, On Hand, and column 3, Apportioned. The balance then was 4,000 + 900 = 0 + 4,900. On February 16, 75 bolts were returned to stores, it having been found that the material issue of production order 760 was that much in excess of actual requirements. This number was, therefore, added to both column 2 and column 4 and the balance then stood 4,000 + • 975 = 0 + 4,975.

Stores Control

98

On February 17, the 4,000 bolts that were ordered on February 12 were received. This number was, therefore, deducted from column 1 and added to column 2. The balance on that date was, therefore,

o+ 4,975 = 0 + 4,975. In column 2 provision is also made for pricing the bolts both for unit cost and also for total cost. This serves as a memorandum of the value of the inventory and also provides the information for evaluating the material issue for the benefit of the cost department, from time to time the actual quantity on hand is checked by actual count against the quantity recorded on the ledger. This is indicated by drawing a vertical line in volume 2 down to the date at which this checking was performed. Visual Balance of Stores:

In such companies that manufacture a standardized goods, where the variety of stores is not very great and the quantities fairly large, a visual balance of stores may be operated to advantage. In a N.K. Computer Ltd. actual board is about 15 feet long and 6 feet high. Through a series of corresponding notches at the top and bottom of the board, pairs of strings are carried completely around the board so that they can be moved at will. The right-hand string of each pair is made up of two parts, one white and one blue, knotted together, the knot serving as an indicator. The left-hand string of each pair is made up, also, of two parts, one white and one red, knotted together in a similar fashion, the knot serving again as an indicator. These knots will be referred to as the blue knot and the red knot respectively. Each pair of strings indicates for one part as follows: 1.

The amount of raw material on hand.

2.

The amount of finished or partly finished parts in process.

3. The point where raw material should be ordered. 4.

The point where new manufacturing orders should be issued.

5.

The amount of raw material on order.

6.

The total inventory of finished parts, parts in process, and raw material in stores for any given machine part.

Stores Control

99

To illustrate the method of operation, consider the pair of strings on which the blue knot and red knot are indicated. The horizontal markers 1,2,3,4, and 5 are made of coloured ribbons and are placed on the board at the desired level as indicated by the scale at the extreme left. The lower ribbon indicates the danger limit for finished parts and'is so placed that if, when the blue knot falls to that level, a new manufacturing order for finished parts is placed with the factory, these parts would be available by the time the blue knot reaches zero. It is not advisable, however, to work so closely to the limit, and, therefore, ribbon 2 is placed somewhat above ribbon 1 and indicates the minimum limit to which the supply of finished parts should be permitted to fall before placing a new manufacturing order. The distance between ribbons 1 and 2 represents a cushion or reserve to provide for emergencies and should never be too large, as this increases the inventory value, which should be kept as low as possible, compatible with safety in production. A certain amount of time must be allowed to the planning department for issuing manufacturing orders, bills of material, etc. This time is represented by the distance between ribbons 2 and 3. There should also be a limit to the number of parts on hand, and this limit is set by ribbon. 4. The distance between ribbons 4 and 2, therefore, measures on the scale the size or number of the lot to be made on new manufacturing orders. The height of the red knot measures the total inventory of finished stores, parts in process, and raw material, all in terms of numbers of finished parts. The distance between the red knot and the blue knot, therefore, measures the amount of raw material on hand. The ordering point for new material is indicated by ribbon 5 and is set as far above ribbon 2 as will permit the stores and purchasing departments to obtain new material by the time it is needed. By means of auxiliary clips attached to the strings and coloured marker buttons shown at the left it is possible to visualize all the conditions shown on the balance-of-stores sheet. Control boards based upon the Gantt chart that are adaptable to the control of stores, etc., are now manufactured commercially.

100

Stores Control

Control of the Inventory : Materials in stores, in process of fabrication, and in the form of 'finished stock are, for the time, crystallized capital and not infrequently represent a large part of the capital investment. Although it is essential, therefore, that the material needs of the company be adequately provided for, it is equally important that this form of capital investment be kept at a minimum value. Under older and cruder methods of management this value was known, with any degree of certainty, but once a year when a visual inventory was taken of the entire plant; in fact, this method, still prevails in many plants. In taking such an inventory all assets are evaluated and all material measured, weighed, or counted, and priced according to the judgment of those taking the inventory, with a view to finding the current value of the business. Usually this means a total suspension of work for several days, and it always makes a serious interruption of the work, though it does give a good picture of the state of the business.

It will be clear, however, that if stores have been issued only upon proper orders and if the balance-of-stores ledger is accurately kept, it will be a continuous inventory of all material in stores. And since the cost of all material is also placed upon these ledger sheets, they also record the cost value of all material in stores. Whether this value or the present market value or a depreciated value shall be placed upon such an inventory is a matter of judgment upon the part of the management. It is customary, where a continuous inventory of this kind is kept, to check the actual amount in each bin or rack against the stores ledger whenever an order is placed for additional material, so that verification of the stores ledger is in constant progress. Many managers are not satisfied, however, with such a clerical inventory and, although using it for ordinary accounting purposes, insist upon a periodic visual inventory. An analogy is found in banking where book values are always verified by periodic counting of all assets on hand. The cost ledger shows at all times the values of all material in process of fabrication. Finished goods or stock is recorded in a stock ledger not unlike the stores ledger. The value of all fixed assets such

Stores Control

101

as land, buildings, machinery, etc., is recorded in a plant ledger. These several ledgers, therefore, if accurately kept, constitute a complete continuous inventory of the physical assets of the enterprise. The relation of stores, material in process, stock, and the three corresponding ledgers in their relation to the main ledger are shown graphically in Fig. 55, where production is visualized as a flow from left to right of the diagram. The stores act as a reservoir between the market for supplies and the factory; the stock room acts in a similar capacity between the factory and the market for sales. The stores ledger registers the level of the value of the stores; the cost ledger registers the accumulated values of materials in process; and the stock ledger indicates the value of the finished goods on hand. It is obvious that the methods, blanks, forms, etc., that may be used advantageously in storeroom and stock room work will vary widely with the business and conditions, as indeed they necessarily must in all business organizations. The methods suggested in the preceding paragraphs have been included more to explain the problems met in handling material than to advocate them as the best for all cases. They are, however, in successful use in many places.

Although it is essential that the necessary stores shall be on hand when needed, it is just as essential that no more stores shall be carried than is necessary. The maximum and minimum quantities of all materials should, therefore, be determined with care. In many cases these limits can be set only by experience and careful observation, and such observation will often result in a great reduction of inventory. A number of efforts have been made to determine mathematically the most economical number of pieces that should be produced at one time, taking into account probable sales, cost of setting up the machinery of production, interest upon the investment in stores, etc. Professor Ralph C. Davis has developed a very complete and fairly simple solution of the problem as follows: LetQ

=

the most economical number of pieces to be manufactured.

102

Stores Control

A

=

total cost of preparation for manufacturing, setting up, etc.

M

= =

rate of manufacturing expressed in pieces per year.

S C'

rate of consumption by sales per year. unit cost per piece. current rate of interest.

RI

= =

R

=

quantity of material in stores when order for new material should be placed.

R2

=

reserve material held in stores for emergency purposes.

F

=

R - convenience. Rl

I

quantity of material necessary to manufacture the lot of parts.

It should be noted that, in general, R2 = R - RI . If, however, no reserve is considered necessary, R = RI and ordering would begin

when the material on hand was just sufficient to manufacture a lot of parts. If, however, material can be obtained quickly and if the withdrawal of material is gradual so that ordering and receiving of new material may proceed coincident with the manufacturing of the same, R may be less than RI and R2 is then a negative quantity. The value of F, furthermore, will be greater or less than unity depending upon whether R is greater or less than RI . Then according to the demonstration of Professor Davis,

Q=

fA

V"K'

where K is a constant whose value for different values of F is as follows: F

K

F

1.25

K

103

Stores Control 0.50

C'I 2S

1.50

0.75

M+O.5S)C'I ( 2MS

2.00

(

M +S)(M +2S))C'I 2M 2S

3.00

(

M +S)(M +4S))C'I 2M 2S

1.00

To explain the use of the equation, assume that the rate of sales S = 30,000 per year and that where the machinery of production is set up, parts can be manufactured at a rate per year of M = 150,000. Let C' = $20, I = 0.06, A = $1,000, and assume that conditions are such that no reserve is needed; hence R = Rl and F = 1.0. Then K= (M+S)C'I=( 150,000+30,000 !"OxO.6=0.000024 2MS 2 x 150,00 x 30,000

r

Hence

Q=~=

1,000 = 6 455 pieces. 0.000024 '

This would be about 4 months' supply, and it would require about 2 weeks to produce the lot of goods. This discussion indicates that for lowest unit cost the quantity to be manufactured varies as the square root of the preparation costs. This appears to be corroborated by other similar discussions. The effect of preparation costs upon unit costs as discussed in Art. 31 and as illustrated in Fig. 4 should be noted. It will be seen that this influence is very great when the number produced is small, decreases rapidly as the number is increased, and becomes negligible when the number produced is very large. It should be noted also in this regard that in solving the Davis equation the unit cost is assumed from preceding records. If this cost has been obtained

104

Stores Control

from manufactured quantities not markedly different from the value of Q, the solution may be considered satisfactory. If, however, this cost has been obtained from much larger quantities than Q and particularly if Q should be a moderately small quantity, a rise in manufacturing costs might result if the quantity represented by Q was put into production. In other words, the quantities must be such as to be well away from that portion of the curve (Fig. 4) where the rate of change of curvature is very great. The Davis equation is simple and easy for application; and considering that all such expressions rest partly, at least, upon certain assumptions, such as the rate of interest, the unit cost of production, and the yearly rate of sales, it is probably sufficiently accurate for most cases. Professor F. R. Raymond has developed fully the theory of economical lot sizes in his book "Quantity and Economy in Manufacture," and the reader is referred to this volume for a very exhaustive treatment of the subject. Economical Use of Material:

The material wasted around a factory may be a serious source of loss, particularly if the material has high intrinsic value as in the case of copper and brass. These wastes may be due to many causes. It is not always possible to specify exactly just how much of a certain material is needed for a job; and, if a liberal amount is drawn, that left over after the completion of the job is seldom returned to the storeroom but collects on and under benches and in out of the way comers. In certain kinds of work, as in punch-press processes, the material left after the punched parts are removed is often as great as or greater than the parts themselves; and if the material is valuable, care should be taken to recover it. In all cases systematic and constant effort should be made to collect and store all scrap so as to recover as much value as possible and also to keep the shop or factory clean. In nearly every storeroom will be found old material for which there is no apparent use. This comes usually from two sources. The first is over ordering of material for special jobs. Special material is always a hazardous investment, and care should be taken that no

Stores Control

105

more is ordered than will give the minimum margin of safety. The second most important cause is a change in design. The engineering department can save a great amount of money by carefully considering the question of material. The standardization of parts and the use of the same part as often as possible keep down the value of the inventory, and great care should be taken that no change in design is made that will leave raw material, finished parts, or completed machines in danger of obsolescence. Obsolete material, raw or worked, depreciates very rapidly, completed machines often being worth less than the original cost of the materials of which they are composed. Before scrapping such material, however, a report should be sent to the manager, approved by all parties concerned, giving the inventory value, scrap value, and loss, with the reasons and responsibility for such loss clearly determined. The wasteful use of indirect materials and supplies is another source of great loss, especially in large plants. As before'noted, it is a difficult problem to specify accurately and supervise intelligently the drawing of expense material from the stores. The cost-keeping system, however, that furnishes accurate records of all expense material is a powerful means of regulating these expenditures. The purchasing of expense material best suited to the needs of the plant and its economical handling and use are a fruitful field of study for the works engineer, and his labour will be greatly expended by well-kept records of performance.

***

Chapter

8

**

CREDIT SYSTEM

The term credit may be defined broadly or narrowly. Speaking broadly, credit is finance made available by one party (lender, seller, or shareholder / owner) to another (borrower, buyer, corporate or non-corporate firm). The former may be a pure lender (a financial institution or a private money-lender), a seller supplying goods against the buyer's promise of future payment, or a shareholder/ owner of a corporate/non-corporate firm making funds available to the company viewed as a separate entity. More generally, the term credit is used narrowly for only debt finance. In this chapter, we shall also use the term in this sense. Thus defined, credit is simply the opposite of debt. Debt is the obligation to make future payments. Credit is the claim to receive these payments. Both are created in the same act of borrowing and lending. This act is a special kind of exchange transaction, which involves future payments. In an exchange transaction, to every sale there is an equal purchase since, by definition, sale and purchase are two sides of the same transaction. Similarly, in a credit transaction, the amount loaned is equal to the amount borrowed (and the interest paid is equal to the interest received). At any time, the total volume of debt is equal to the total amount of credit. Credit is a stock- flow variable. At any point of time there is a certain amount of credit (of anyone kind or all kinds) outstanding.

107

Credit System

It is a revolving stock. Once a loan is repaid, the amount received

can be advanced to the same party or some other party or parties. Any increment (decrement) in the stock of credit per period represents a positive (negative) flow of credit per period. Credit should be carefully distinguished from money. Even bank credit is not the same thing as money. Their nature and functions are not the same. Money is an asset of the holding public. It is a liability of the banking system (including the RBI) and the government. However, it is not all the liabilities of the banking system that are money, but only those that serve as media of exchange, namely currency and the demand deposits. Bank credit, on the other hand, is a liability of the borrowing public (or the government) to banks and an asset of banks. Then, money serves as the commonly accepted medium of exchange and the unit of account. Bank credit itself does not serve as bank money. What serves as bank money (in the narrow sense) is the demand deposit of a bank on which cheques can be drawn in the settlement of payments. Bank credit only allows the borrower a claim to such a deposit (or bank money) up to a certain sanctioned amount, All this will be discussed in sORledetail separately.

.

Then, bank credit is only one form of credit. In a modem economy, there exist several other sources of credit as well. Collectively they constitute the financial system. In a credit economy, that is economy with borrowing and lending, each spending unit (whether a household, a company, or the government) can be placed in anyone of the three categories: deficit spenders, surplus spenders, and balanced spenders, according as its total expenditure is greater than, less than, or equal (owned or internal) receipts, respectively. We shall have several occasions to use these terms or concepts in the book. The major function of credit is to relax the constraint of balanced budgets. As we shall study later, it is through this chief function that the financial system is able to promote savings, investment, better allocation of resources and growth in the economy. It is also worth remembering that if credit is not well managed, it can cause inflation or deflation and unemployment. It can also lead to malutilisation of resources,

108

Credit System

excessive concentration of income and wealth in a few hands, and exploitation of the weak and the poor. What is a Financial System: A financial system should be distinguished from a payments system. Earlier we had defined the latter as the set of institutional arrangements through which purchasing power is transferred from one transact or in exchange to another. The payments system is, thus, concerned with payments in cash. The financial system is much broader than a payments system in that it covers both cash and credit transactions importantly, the financial system is a set of institutional arrangements through which financial surpluses (or commands over real resources) in the economy are mobilised from surplus units and transferred to deficit spenders. The institutional arrangements include all conditions and mechanisms governing the production, distribution, exchange, and holding of financial assets or instruments of all kinds and the organization as well as the manner of operation of financial markets and institutions of all descriptions. In concrete terms, financial assets, financial markets, and financial mstitutions are the three main constituents of any financial system. Financial assets or claims are generally subdivided in the two heads of primary (or direct) securities and secondary (or indirect) securities. The former are financial claims against real-sector units. The examples are bills, bonds, equities, book debts, etc. They are created by real sector units as ultimate borrowers for raising funds to finance their deficit spending. The secondary securities are financial claims issued by financial institutions or intermediaries against themselves to raise funds from the public. The examples are such diverse financial assets as the-Reserve Bank currency, bank deposits, life insurance policies, units, lOBI bonds, etc. In the present day Indian economy important financial assets are currency, bank deposits (current, savings, and fixed), post office savings deposits, life insurance policies provident fund contributions, bonds (government and corporate bills, hundis, corporate shares (ordinary and preference), units of the UTI, company deposits, compulsory deposits, deposits with investment

Credit System

109

companies/trusts, nidhis, chit funds and similar other organizations. The list is not meant to be exhaustive. Nor is any asset listed above homogeneous. Thus, currency includes both coins and paper currency notes, which are further of different denominations. Ordinary share or bonds of-no two corporations are identical. Nor are any two insurance policies. The products of the financial industry are truly heterogeneous. We have already studied about currency, bank deposits of various kinds and post office savings deposits in the previous chapter. We shall study more about other financial assets and various financial institutions and markets operating in India in later chapters. In a modem industrial economy a wide variety of financial institutions, more popularly called financial intermediaries (FIs) have grown. We shall study about their role and common services and features in the next pages. FIs are generally classified under two main heads: (a) banks and (b) non-banks or non-bank financial intermediaries CNBFIs). The dichotomous classification shows the special position banks occupy in a country's financial structure. Financial Intermediaries:

Financial Intermediaries (FIs) are institutions or companies that mediate or stand between ultimate lenders and ultimate borrowers or between those with budget surpluses and those who wish to run budget deficits. The examples are banks insurance companies, unit trusts (or mutual funds), investment companies, provident funds, etc. The central function of all FIs is to collect surpluses (savings) of other economic units and to lend them on to deficit spenders. Both the surplus units and the deficit spenders belong to the real sector of the economy. Their principal economic activity is to buy and sell productive factors and current out put, whereas the principal economic activity of financial institutions is the purchase and sale of financial assets. We know the distinction between primary securities and secondary securities. The former are bought by both surplus realsector units and FIs. When surplus units buy these securities, they

110

Credit System

are said to provide direct finance to ultimate borrowers. A part of the total surpluses of surplus units is provided to deficit spenders in this way. But this is only a part of the story in a modern moneyusing system. A large and growing part of the savings of individual units are now placed in secondary securities and thereby make them available to ultimate borrowers. The ultimate lenders are still . the surplus units. But they lend to ultimate borrowers indirectly through FIs and not directly. Therefore, in such cases the finance given by th~m is called indirect finance. I

Thus the FIs are dealers in securities. What they buy are primary securities, what they sell ere secondary securities. By absorbing primary securities in their asset portfolios and producing secondary securities to finance them, they virtually transmute primary securities into secondary securities. The essence and the success of financial inter mediation lie In this asset transformation. This is the alchemy which only the FIs possess,.; They alone are able to produce securities that are in general far more acceptable to surplus units than the primary securities produced by deficit spenders. The latter themselves can not produce financial claims that meet as welUhe asset preferences (in terms of risk, liquidity, convenience, etc.) of the wealth-holding public as the secondary securities manufactured by the FIs. The latter embody innovations in financial technology whereby disparate asset debt preferences of lenders and borrowers are reconciled and satisfied to the satisfaction of both the parties. One simple example of the asset transmutation role of the FIs will throw further light on it. Consider a farmer who wants a crop loan against his promissory note supported by .the crop sown in his field. The local village moneylender has been the traditional source of finance to him. But an urban, household will not be willing to lend to the farmer because of high risk and inconvenience involved. Normally, there will be no point of contact between the two in the first Instance. It will be different with a bank (or a cooperative credit society). The bank may be having several such borrowers among its customers and organizational links and staff to service such loans. The urban household may be operating a savings account with this bank and thereby entmsting a part of its

Credit System

111

surpluses to the bank. The bank will be lending a part of the saving~ of the urban household to the farmer. Yet the urban household does not care so long as it has confidence in the bank's ability to pay cash on demand. Thus, the secondary security in the form of savings deposits has enabled the bank to mobiles savings of households which can be used to lend even to a distant farmer who could not otherwise borrow directly from an urban household on the strength of his own promise to pay. Gains to Lenders and Borrowers : Talking generally, why do surplus units prefer to lend to FIs rather than directly to deficit spenders? In other words why do they prefer secondary securities to primary securities? The major advantages to ultimate lenders are summed below: (1) Low Risk : Other things being the same lenders are interested in Minimising all kinds of risk of capital and interest loss on loans or financial investments they make. These risks may arise in the form of risk of default or risk of capital loss on stock market assets. Such risks on secondary securities are far less than on primary securities for individual lenders. How FIs are able to reduce such risks even though they themselves hold primary securities will be explained later. Besides government regulation of the organization and working of major FIs helps in reducing risks of their creditors. Any strengthening of the financial system that goes to inspire public confidence in it reduces further any psychological risk suffered by lenders. (2) Greater Liquidity: FIs offer much greater liquidity on their secondary securities to their lenders. Consider a few examples. Demand deposits of banks are perfectly liquid. They can be drawn upon without notice, Banks allow even time deposits to be drawn upon subject to certain condition involving only some loss of interest. They, of course, always stand ready to lend against them. Units of the UTI can be sold back to it. Savings embodied in life insurance policies are not equally liquid, but loans can always be arranged against them from banks or the LIC itself. Primary securities do not carry any of these features, because primary borrowers need funds for agreed periods to finance their expenditures. For reasons to be

112

Credit System

explained later. FIs can offer much greater liquidity to their creditors, and yet lend on a much longer term to their debtors. (3) Convenience: Secondary securities sold by FIs are easy to buy, hold, and sell. The information cost and transaction cost involved are very low. Banks run b:.:anches in all urban areas and several semi-urban and rural areas. The deposits they sell are standardised and information about them easily available. So the choice about bank deposits, life insurance policies. UTI units is not as difficult as about (say) corporate equIties (primary securities). Mueh, however, depends on the quality of cpstomer service provided by the FIs. which in the case of public sector FIs in India is deplorably poor. This has hampered greatly the growth of financial inter mediation in the country.

(4) Other Services: Each of the FIs specialises in selling special kinds of secondary securities and other services associated with them. Thus, banks specialise in selling deposits with particular features. In addition, they transfer funds, collect cheques for their clients, offer safe-deposit vaults and most important of all are the dominant lender. All these and several other services attract the public to banks and induce it to hold deposits with them. The UTI sells units (shares) of a balanced asset portfolio of marketable corporate securities to the investing public.

The LIC collects long-term savings of the public by selling life insurance. These other services can be had only when particular kinds of secondary securities carrying them are bought. Borrowers also have a preference for Fls due to the following reasons: 1.

Fls have big pools of funds so that big individual demands for funds can be satisfied only by the FIs.

2.

There is much greater certainty of the availability of funds with the FIs at the all times.

3. The rate of interest charged by the Fls is generally lower than that charged by other lenders: and 4.

Regulated Fls do not fleece small borrowers in the manner moneylenders do. On the contrary as a matter

Credit System

113

of official policy, banks and other official lending agencies are required to give small borrowers preferential tr~atment both in the grant of credit and in the rate of interest charged by them. The actual implementation of policy leaves much to be desired. Economic Basis of Financial Intermediation: In view of the above the question arises how are the Fls able to offer better financial facilities both to the lenders and borrowers? What is the economic basis of their success or of the financial alchemy whereby they purchase and hold primary securities which are much riskier and far less liquid than the secondary securities they sell as their liabilities to the general public and yet earn handsome profits on their activities? The answer will help us understand better the source of social gain accruing from improvements in financial technology. The true economic basis of financial intermediation lies in the economies of scale in portfolio management and in the law of large numbers. This is explained below. (1) Laws o/Large Numbers: Banks, insurance companies, unit trusts, and all other FIs operate on the assumption, supported by statistical law of large numbers, that not all the creditors will put forward their claims for cash at the same time. Add to this the fact that if some creditors are withdrawing cash, some others (whether old or new) are paying in cash. Besides, FIs receive regularly interest payments on loans and investments made and repayments of loans due. Fortified by this knowledge, banks keep in cash only a small fraction of even their demand liabilities and invest or lend the rest* For the same reason, unit trusts can also afford to keep most of their funds (liabilities) invested in securities and yet offer to buy back all· the units the unit-holders like to sell at any time. Life insurance companies also operate on the actuarial fact that a determinable fraction of lives insured will actually expire in a normal year, so that they need keep only an estimated fraction of their total life funds in cash and near cash and the rest of them can be invested on long-term basis. Thus FIs can afford to manufacture liabilities

1

114

Credit System

(secondary securities) that are far more liquid than the primary securities they buy as earning assets.

(2) Economies a/Scale in Portfolio Mill. , ~t'l1lellt : The average size of the asset portfolios of banks, insurance companies and other organized sector PIs is quite large in value. So these FIs can reap several economies of scale in portfolio management which improve significantly their net rates of return from their asset holdings. These economies accrue in the following main forms:

(a) Reduction of risk through portfolio diversification: Lending/ investing is always risky. It carries risk of default and of capital loss on marketable assets. One common way of reducing risk is through pooling of independent risks by placing funds in a diversified portfolio. There by what the investor may lose in a few directions may more than make up in other directions. But for adequate diversification the size of the portfolio must be reasonably large, otherwise the cost of portfolio management will become excessively high. An average wealth owner cannot afford the degree of portfolio diversification and the resulting reduction of risk an average FI can. Then a large FI can schedule maturities of its loans to match anticipated outflows and thereby safeguard its liquidity. (b) Professional Management : The large size of the asset portfolios to be managed allows FIs to employ professional managers who are well versed in the complexities of modem finance in appraising loan proposals in evaluating investment opportunities in monitoring their loans and investments in analyzing consequences of market and other developments for the health of their businesses. Individual wealth owners cannot afford the cost of professional management and other support staff. They do not in general have the expertise, time, or even the desire to manage financial asset portfolios comprising of primary securities.

(c) Indivisibility's and market imperfections: Some loans and investments are of very large size individually. Average household wealth owner cannot handle them. In certain cases even FIs have to come together in consortia, pool their resources and spread their risks to finance them. The per rupee administration cost of large loans borne by FIs is quite low.

Credit System

115

In certain cases, such as purchase of treasury bills or placement of call funds, only sums above a certain minimum amount too large for an average householder are accepted by the borrower to save transactions costs. Thus FIs with large asset portfolios can earn interest ever, on very short-term funds and construct the maturity structure of their assets as desired. Small asset holders cannot do so.

(d) Other cost economies: Because of the large volume of business the fixed C05t of establishment, cost of information and various transactions costs are lower per unit of transaction to a FI than to an average household wealth-owner. FIs and the Economy: FIs playa very important role in the functioning of a modern complex economy, in promoting economic development and in the working of monetary credit policy. This role inheres in the separation of saving and investment, so characteristic of modern capitalist economies. In most cases savers are different from Investors. In India the bulk (75 to 80 par cent of the total) of savings is done by households. About half of it is invested directly by them in physical assets but the rest is committed to financial assets. In industrially developed western economies the proportion of financial investment of household savings in much higher. Corporate firms and the government are everywhere net deficit spenders. Financial assets are the vehicles through WhiC:l the savings of surplus spenders are mobilised and allocated among deficit spenders. Some part of this mobilisation allocation is accomplished through primary securities acquired directly by the savers. But the bulk of financial savings is handled by the FIs. The more numerous, varied, well organized, geographically well distributed and efficient the FIs that is the more developed the financial infrastructure of an economy, in general, the more economically developed will also be that economy. This is discussed in the next section. Functions and Importance of the Financial System: The financial system helps production capital accumulation and growth by (i) encouraging savings, (ii) mobilising them, and

116

Credit System

(iii) allocating them among alternative uses and users. Each of these functions is important and the efficiency of a given financial system depends on how well it performs each of these functions.

Inducement to Save: Savers require stores of value to hold their savings in. The financial system promotes savings by providing a wide array of financial assets as stores of value, aided by the services of financial markets and intermediaries of various kinds. For wealth holders, all this offers ample choice of portfolios with attractive combinations of income, safety and yield. With financial progress and innovations in financial technology, the scope of portfolio choice has also improved. Therefore, it is widely that the savings income ratio is positively elastic with respect to both financial assets and financial Institutions. That is, financial progress generally induces larger savi.tgs out of the same level of real income. As stores of value, financial assets command certain advantages over tangible assets (physical capital, inventories of goods, etc.) : they are convenient to hold or easily storable, more liquid, that is, more easily encashable, more easily divisible, and less risky. The pecuniary yield from money is zero. But, as a generalized means of payment, it gives convenience yield to its holders and users. Non-money financial assets yield money returns to their holders. In addition, some of them render other specific services as well For example, life insurance policies also provide cover against risk of loss of life over the currency of the policy. Corporate equities serve as a hedge against inflation. A very important property of financial assets is that they do not require regular management of the kind most tangible assets do. Factories, farms, and shops need to be run by their owners in order to earn income. Owners of financial assets are completely absolved of this responsibility, so that they can devote their full time and energy to whatever other pursuits they like to follow. Owners of financial assets are only the ultimate (or indirect) owners and not the immedia te (or direct) owners (except for equity shareholders) of tangible assets. The latter are the borrowers of funds who are

Credit System

117

responsible for the actual management of tangible assets. They assume all the risks of production. Thus financial assets have made possible the separation of ultimate ownership and management of tangible assets. In the case of corporations even the immediate owners, the shareholders, do not run the management. This separation of savings from management has encouraged savings greatly. With the availability of financial assets as stores of value, the public can save and hold its savings in these assets without the necessity of converting these savings into tangible assets and then managing these assets. On the other hand, management can be professionalised, that is, the management of tangible assets can be entrusted to professional managers (without requiring them to own these assets), which improves productivity. Savings are done by households, businesses, and government. Following the official classification adopted by the Central Statistical Organization (C50). Government of India, we reclassify savers into the household sector, domestic private corporate sector and the public sector. The household sector is defined to comprise individuals; non-Government non-corporate entities in agriculture, trade and industry and non-profit making organizations like trusts and charitable and religious institutions. The public sector comprises central and state governments, departmental and nondepartmental undertakings, the RBI etc. The domestic private corporate sector comprises non-government public and private limited companies (whether financial or non-financial) and cooperative institutions. Of these three sectors, the dominant saver is the household sector, followed by the domestic private corporate sector. The contribution of the public sector to total net domestic savings is relatively small. Savings by households are done for several reasons. The motives to save may be to provide for known future need.s( such as old age, education and marriage of children, the desire to own property, to buy high-value consumer durables, or simply to satisfy the urge to grow wealthy. The motive may also be to build up capacity to meet better uncertain future needs such as sickness or accident, that is, to

118

Credit System

provide for the rainy day. Household and business savings also arise due to lack of synchronisation between income stream and expenditure stream, the latter following the former. Different kinds of financial assets are required and have come to be produced to meet diverse needs and preference of differed, categories of savers. Yet there is vast scope for introducing known kinds of financial assets not yet available in India such as shares or deposits of building societies that specialise in giving loan finance to their members for constructing residential houses, for developing mortgage market, for innovating with new kinds of financial assets, and in making available more widely, especially in semi-urban and rural areas, the financial assets which are already being produced, such as life insurance and UTI units. For improving further the financial system's influence on the public's willingness to save, measures should be taken to reduce the risk of default and market riskiness of financial assets, to improve their liquidity and rates of return, and to maintain price stability to avoid real-value depreciation of monetary financial assets. It may be noted in passing that not all tangible assets are inferior to financial assets as passive stores of value. By a passive store of value we mean something which does not require regular management as does a farm or a factory. Important examples of such tangible assets in the Indian context are gold and silver ornaments or bullion. They are attractive stores of value for the public. This is especially so during periods of inflation when the real value of most financial assets (except equity shares) goes down and gold and silver appreciate in money value along with inflation. Some time this appreciation is greater than the average rate of inflation, making these precious metals highly attractive stores of value. This again emphasis's the importance of price stability.

Mobilisation of Savings:

Financial assets separate the act of saving from the act of real (physical) investment. Savings are done by millions of individual households and firms. They may be in large or small amounts, long term or short term. All these individual savings need to be collected

Credit System

119

or mobilised before they can be spent by deficit spenders. A financial system is a highly efficient mechanism for mobilising savings. In a fully monetised economy this is done automatically when, in the first instance, the public holds its saving~; in the form of money. However, this is hot the only way of instantaneous mobilisation of savings. Other financial methods used are deductions at source of the contributions to provident fund and other savings schemes. More generally, mobilisation of savings takes place when savers move into financial assets, whether currency, bank deposits, post office savings deposits, life insurance policies, bills, bonds, equity shares, etc. Financial assets are broadly divisible into two categories: (a) primary securities; and (b) secondary securities. The former are securities issued by the ultimate borrowers such as bills, bonds, equity shares, company deposits, etc., while secondary securities are securities issued by financial institutions (also called financial intermediaries) such as banks, insurance companies, etc. When the public buys primary securities, it makes its surpluses available directly to deficit spenders. It represents direct mobilisation as well as allocation of credit, though it is also through the mediation of financial assets and markets. When the public buys secondary securities, it entrusts its savings to financial institutions who allocate it further among competing borrowers. This represents financial inter-mediation. A part of saving does not go through the financial system. It is that part which is invested directly by savers in tangible assets, whether houses, businesses, or precious metals. For financial planning and control institutionalization of savings is important, because it is easier to control lending/ investing policies of financial institutions than of millions of direct lenders or direct investors in physical assets. Allocation of Rinds:

Another important function of a financial system is to arrange smooth, efficient, and socially equitable allocation of credit. Moneylenders and indigenous bankers have been providing finance to their borrowers since long. But their finance suffers from several defects. With modern financial development, new financial

120

Credit System

institutions, assets and markets have come to be organized, which are playing an increasingly important role in the provision of credit. In the previous sub-section, we have already spoken about direct purchase of primary se.~urities by the public. Such direct lendings by the general public have been made possible by the organization of stock markets and marketable financial assets, such as corporate bonds and equities. Besides, there are banks, insurance companies, and other financial institutions. They serve as financial intermediaries between the ultimate lender and the ultimate borrower. They mobiles savings of the former by selling their own liabilities (deposits, insurance policies, etc.) and make these funds available to deficit spenders at their own risk. So, many savers find the secondary securities of financial institutions much more acceptable than the primary securities of all sorts of borrowers. The allocative role of financial institutions is very important. Only corporations can go to the stock market for raising funds through public issue of equity shares and bonds. Even there the support of financial institutions as buyers of securities is important. But non-corporate borrowers cannot issue marketable liabilities. Therefore, they depend on bank finance or private finance. In the market for funds there Is generally credit rationing. This makes the availability of credit important to all potential borrowers. Financial institutions (subject to the policy of the government and the RBI) determine how institutional finance will get allocated among various sectors of the economy and among competing borrowers. In the allocative function of financial institutions lies their main source of power. By granting easy and cheap credit to particular companies, they can shift outward the resource constraint of these firms and make them grow faster. On the other hand, by denying adequate credit on reasonable terms to other firms, financial institutions can restrict the growth or even normal working of these other firms substantially. Thus, the power of credit can be used highly discriminatory to favour some and to hinder others. Realizing this early in the day, all important business houses in India had either started or otherwise controlled individual banks and/or insurance companies. For the same reason, all major financial

Credit System

121

institutions, called picturesquely as 'commanding heights' of the economy, have been either nationalised or set up in the public sector from the very beginning. Thereby the direct control of financial institutions by business houses has been eliminated. But these houses do continue to enjoy substantial influence on the actual credit allocation by these institutions. Organized credit to weaker sections is still inadequate. Serving Production, Trade, and Investment: All the above services of savings promotion, mobilisation, and allocation are essential for production, capital formation and growth. Investment obviously requires that there is corresponding amount of saving. If at individual firm level all investment were to be financed by Internal savings only, the aggregate rate of investment in the economy will be pitiably small, because a major portion of savings Is done by non-investors. What the financial system does is to break the straight jacket of internal finance (or balanced budget). It places at the disposal of entrepreneurs resources saved by others. This enlarges greatly the aggregate rate of investment. The financial system enlarges greatly the aggregate rate of savings and their mobilisation by offering savers a wide variety of financial assets to suit their needs and preferences. There is a comparable service offered to investors (and producers) to induce them to absorb the savings the system generates. As borrowers they are facilitated to produce a wide range of financial liabilities to suit their needs and preferences. Thus, for example, they can borrow short term or long terra, issue bills or bonds, ordinary shares, or preference shares, bonds may be convertible into equity shares, or not. Then corporate shares are limited liability documents that is the liability of a shareholder is limited only to the face value of shares he holds. The sources of funds are also several: open market, banks, insurance companies, indigenous bankers and moneylenders, trade credit, etc. All this brings into contact a much larger number of ultimate borrowers and ultimate lenders than would be possible otherwise. It bears repetition to say that this promotes specialisation of the functions of saving and investment. Those who have the capacity and willingness to save, but not to

122

Credit System

undertake production, may only save and entrust their savings to others, either directly or indirectly through financial intermediaries. These other persons may have both the competence and willingness to organize production but may not have enough resources of their own to make the required investments. The financial system makes it possible for them to make use of their entrepreneurial skills by providing them credit* Apart from encouraging investment, this makes possible b~tter use of scarce entrepreneurial and technical skills in the country. A well developed financial system is able to mobiles and allocate all kinds of savings, howsoever small or short term. This helps in the maximum utilisation of savings. It also facilitates flow of savings throughout the economy and thereby the flow of funds in directions where returns are presumably highest. This supposedly helps in the maximization of returns from resources. Production requires various kinds and amounts of capital (funds) : long term capital for making fixed investment in physical plant (land, buildings and machinery); medium term capital for buying other tools and equipment: and short term working capital to finance current operations of business. Shortage of any kind of capital with any firm can hurt badly its productive activity and growth. The financial system helps firms in raising funds for meeting its various requirements. Of course, every firm must have some equity funds of its own to start business. For big projects requiring large amounts of capital, no single firm or house is usually in a position to raise all the required finds internally. It has, therefore, to depend upon outside sources. Even in the case of big corporations, promoters equity is usually a small proportion of total equity capital. The rest of the equity capital and all long term debt capital are raised in the open market by the public issue of shares and bonds. Thus, a corporation is not only a new for a of business organization, more importantly, it is a financial innovation which makes it possible to collect financial surpluses of far-flung surplus spenders through open-market sale of shares and bonds. Small firms suffer greatly from the paucity of funds. Their needs for credit are met inadequately and at very high cost.

Credit System

123

In usual discussions there is a presumption that mobilisation of surpluses and their allocation among deficit spenders by a financial system are always to the good of the country as a whole. This is not necessarily true. The financial system can work to the detriment of savers in a variety of ways. Public sector monopoly and official regulation to help in the process. For example, the deposit rates of banks can be kept artificially low, the deposit rates of insurance companies can be kept artificially high and their bonus rates to policy holders deplorably low. On the lending side, too, the financial system (at least in parts) can be a vehicle of exploitation of the weak and the expropriator of the small, as has been largely true of moneylenders credit. Small borrowers can be starved of bank credit and big borrowers surfeited with it. Excess credit to government to finance its ever growing deficits is a major source of inflation and all its ills and inequities. Thus, the equity of financial system cannot be taken for granted.

Chapter

9

** KINDS OF CREDIT

Credit is not one homogeneous good or asset. It is of many kinds. To understand better the nature, scope and complexity of credit and its problems, we look at the several kinds of credit. There is no unique method of classifying credit. It can be, and need to be, classified in more than one method, each way specializing in only one aspect or dimension of credit. Thus, we classify credit from five different angles: (a) source, (b) end-use, (c) users, (d) term, and (v) cost. The problems of credit need to be studied from each of these angles. Sources of Credit :

In the present-day Indian economy credit is supplied by a wide variety of sources. These sources may be conveniently classified as in Figure 1. Sources of Credit

I

I

I

Banks

I

RBI

Institutional I

I

Non-institutional

I

I

Non-Banks Moneylenders (e.g. LlC) and Indigenous Bankers

I

Other Banks

I Commercial

I

I

.

C o-operatlve Figure 1.

I

Open Market

I

Sellers (Trade Credit)

125

Kinds of Credit

Each source can be further subdivided into various sub-classes. Here, we are presenting only a skeletal picture of them. The End-uses of Credit: Real credit is a scarce resource. Therefore, its proper allocation among competing uses and users is of great importance for the attainment of whatever social objectives a country sets before itself. Credit is required and used, less or more, in all spheres of economic activity. So, we may classify credit by its end-use by way of major areas of economic activity. This is done schematically in Figure 2. This provides the basis for the distinction between agricultural credit, industrial credit, export credit, etc. The classification in Figure 2 is neither rigorous nor exhaustive. Its categories are not necessarily mutually exclusive nor their boundaries well-defined. Yet some such broad classification is essential for evaluating the prevailing credit arrangements in the country and for any meaningful credit planning. This is because the credit needs, their nature and the problems, of organizing credit supply are likely to differ from one sector to the other, according to their own structural features. End-Uses of Credit Production

Consumption

I

Current Production

Fixed Investment

Agriculture

Industry

Construction Trade and others

II

/

I Cottage

Small

Large

Domestic

Foreign

Scale

Scale

Trade

Trade

~

Food

Figure 2.

~

Non-Food Expoerts Imports

126

Kinds of Credit

The above sectors of economic activity can be cross-classified in a number of ways. One cross-classification adopted by the FBI for regulating the allocation of bank credit is that between the priority and non-priority sectors. Another cross-classification is that between rural urban credit. It is based on the location of economic activity. The categories of rural credit and urban credit are selfexplanatory. The end-use classification of credit is particularly important for evaluating the allocation of credit from a particular source. For example, this is particularly important in the case of commercial bank credit as these banks are the lacgest single source of institutional credit in India. For comprehensiv~ credit planning: the end-use classification of non-bank institutional credit will also be important. This knowledge, however, will only be a first step in credit planning. Bust also develop social criteria for the optimal allocation of credit know the factors responsible for the prevailing allocation of credit, identify the difficulties involved in changing this allocation and the remedial measures necessary for the realization of the desired allocation of credit. The Users of Credit : The classification of credit by its users is not common. But this (dimension of credit allocation, especially of the allocation of institutional credit, is of much social Importance. The most important proclaimed social objective of the rationalisation of major commercial banks has been to reallocate bank credit in favour of the weaker sections of the community. This kind of social concern relates to the users of bank credit and not to the nature of its use. The Term of Credit : Yet another dimension of credit is the length of time for which it is extended. The term of credit is important for both the borrower and the lender. A borrower needs credit for various uses, some of which will pay themselves back over a short period and some over a medium or a long period. For example, the loan taken by a manufacturer to buy raw materials for his products can normally be repaid after a short period. The actual time-length will depend

Kinds of Credit

127

upon the time-length of the production-sale cycle, that Is, the time it takes to manufacture the raw materials into finished products sell them, and realize the sale proceeds. On the other hand, the credit taken to install a machine will normally pay itself back over the expected life of the machine. Suppose this life is 20 years, which is a long period by common reckoning. Then, the manufacturer will need long term credit for buying the machine. Similarly, in agriculture, a farmer needs short-term credit for buying seeds and fertilizer for a crop and long-term credit for making permanent improvements on land. The former will pay itself back once the given crop is harvested and sold, the latter will pay itself back over a long period so long as the improvement lasts. From the lenders side, too, the term of credit is important. For financial institutions that raise funds by issuing their own liabilities to the public, the determining factor is the nature of t.~eir liabilities: whether they are short-term liabilities or long-term liabilities. For example, a commercial bank raises funds by selling deposits of various kinds to the public. Most of these deposits are short-term liabilities. Only time deposits of a maturity of more than a year are medium-term liabilities. Therefore, such a bank generally prefers to make short-term advances. On the other hand, life Insurance companies get long-term funds. The Insurance policies which they sell are, in general, for long periods. Therefore, they can afford to lend for long periods. They also prefer to do so in order to ensure steady interest income from their investments and to keep the task of reinvestment of funds to the minimum. This, task will increase manifold if insurance companies make only short term investments. Similar considerations held regarding the expected time-lengths of the financial surpluses of surplus spenders and the credits expected by them. The financial industry is a service industry. It's raison d' etra lies in servicing the real sector, which is responsible for the production and distribution of real goods and services. The real system for its efficient working needs credit of various time-lengths. The financial system has to see how best it can meet these needs without endangering either its own health or that of the real system it is supposed to serve. For this, the financial system devises ways

128

Kinds of Credit

and means whereby short-term funds can be transformed into longterm funds and vice versa. We cannot go into the intricacies of all the financial devices for the aforesaid transformations. But one general point does need to be made. In financial matters liquidity is very important. In one sense, it refers to the ability of a debtor to meet his obligations on time. Almost always, it means his ability to pay cash, when due, whatever his net worth position. That is, liquidity of a debtor is different from his solvency. The latter is only concerned with the question of the net worth of a debtor, whether it is positive or not. It is possibly that a debtor rna y have positive net worth, but not all his assets may be perfectly (or even highly) liquid. This brings us to the second sense in which the term liquidity is used. In this sense, liquidity is property of an asset. This property refers to the ease with which an asset can be converted into cash on demand (or short notice) without loss of value. In short, the liquidity of an asset refers to the degree of its encashability In this sense, money is perfectly liquid. Time deposits of banks and short-term marketable assets are highly liquid. Corporate bonds though liquid, are much leas so. Hence there arises a need for enchasing imperfectly liquid assets before payments due can be made. And such needs can frequently arise for individual units on account of unforeseen developments.

The financial system provides a mechanism whereby particular kinds of non-money financial assets (such as bills, bonds, equities, etc.) can be converted into cash. The system does this through stock markets where marketable financial assets are bought and sold openly. The existence of stock markets (and other financial mechanisms to be discussed later in the book) allows creditors to make longerterm loans even when their matching liabilities are of shorter maturity. For, in time of need, they can tum to the market for meeting their needs for cash through sale of some of their non-cash assets. Of course, they run the risk of making capital losses through such sales. But it is better than being not in a position to meet their obligations to pay cash to their creditors, or letting the, opportunity

Kinds of Credit

129

of making higher profits by making longer term advances in vestments slip by. The efficiency and success of a financial institution depends among other things on how well it can combine the twin considerations of liquidity and profitability. Term vise credit is usually divided into three broad classes: (i) short-term credit, (ii) medium-term credit, and (iii) long-term credit. Short-terra credit is usually for a year or less. (In agriculture, it goes even up to 18 months). Medium-term credit is for more than a year, but less than ten years. Long term credit then is for ten years or more. In actual practice, however, borrowers may and do use short term credit for financing durable investments and long term credit for meeting working capital needs. For short term credit and long term credit are not water tight-compartments. They all are liquid funds that can be used in any manner except that it is not prudent to finance long term investments by short term credit. But there may be some delay in the receipt of long term funds. In the meantime, short term funds may be used for long term investments. Then, continuous renewals of short-term credit converts it into virtual long term funds, though the borrower does run the risk of nonrenewal of short-term credit.

Cost of Credit :

The cost of credit is another dimension of credit. It varies over a wide range for different classes or borrowers and for credit from different sources. There are no hard and fast r~les for classification of credit by cost. Following common usage, we may suggest only a broad three fold classification: (a) cheap, (b) dear, and (c) usurious, Cheap, dear, and usurious are relative terms. Their numerical measures in rates per cent per year cannot be specified for all situations. Two complicating circumstances are specially noteworthy. One is the premium for any risk of default the other is the expected rate of inflation. Quoted rates of interest are gross rates which include provision for both in addition to the pure rate of interest for the loan. And the provisions for the two llforesaid factors may vary greatly over time, space, and the circumstances governing borrowing and lending. Then an element of usury, small or large

130

Kinds of Credit

may also be prese,nt, depending on the relative bargaining strength of the lender and the borrower. Thus, several factors will have to be weighed before classifying a particular rate of interest as representing cheap, dear, or usurious cost of credit. But such a judgment is essential in any design of credit policy. Quite often the monetary authorities attempt to achieve policy goals by influencing the cost of credit through policy tools at their disposal. So we read about a deliberate cheap money or dear money policy. More about it later in the book. Financial Markets: A financial system operates through financial markets and institutions. Financial markets deal in financial assets and instruments of various kinds such as currency, deposits, cheques, bills, and bonds, etc. In this chapter we describe briefly the main types of financial markets operating in India. Analytically, financial markets are very much like markets for goods and services. As such they have their own demand, supply, quantities, prices, etc. More important the whole financial system is loose assemblage of credit markets and institutions of various kinds, which differ from each other in various says in organization, functions, size, of individual units on the supply side, geographical coverage, methods of working, cost of credit, type of credit, etc. Some parts of the credit system are more closely connected with each other than others. Within each part of the credit system or within each credit market, there is, in general, greater competition than between any two parts or two markets. Thus, credit markets should not be viewed as constituting one perfectly competitive system, dispensing one homogeneous good (credit) at one uniform price (the rate of interest), but a loose structure of markets dealing in credit of various kinds at widely varying prices and under a wide variety of organizations. Therefore, to understand well the Indian financial system, it is essential to know the main features of its individual parts. Structure of Financial Markets: The structure of financial markets can be studied from different angles, namely, functional, institutional, or sectorial. Accordingly

Kinds of Credit

131

financial markets, institutions and instruments can be classified in anyone or more of these wa ys. The functional classification is based on the term of credit, whether the credit supplied is short term or long term. Accordingly, markets are called money markets or capital markets. The iilstitutional classification tells us whether the financial institutions are organized on commercial or cooperative principles and whether they belong to the organized or unorganized sector. The sectoral classification Identifies credit arrangements for various sectors of the economy: agriculture, manufacturing industry, trade and others. Various classifications are not intended to be water tight or mutually exclusive. Their aim is to give a broad idea of the scope of financial markets, their several dimensions and functions. Combining the first two bases of study, we give a single functional cum institutional classification in Figure 2. Functionally, financial markets are broadly sub-divided under two heads: money markets and capital markets. The former are markets in short term funds; the latter in long term funds. We have interpreted the term money market more broadly to include within its folds also the notional money market of monetary theory. This market is co-terminous with the entire economy. The asset it deals in is money; the demanders are the holders of money (the public) and the suppliers are the government, the RBI and banks. Money itself is acquired in the normal process of selling goods, services, and assets in all markets, as money is the common medium of exchange (in all monetised transactions). There is no special or separate market for money like the ones we have for bills, bonds, or equity shares. In academic discussions of monetary theory and policy whenever the term money market is used, we mean the market for mor.ey as explained above. But in business parlance the term money market is almost always used in the sense of short-term credit market. Structurally, the short-term credit market is divisible under two sectors, organized and unorganized. The organized market comprises the RBI and banks. It is called organized because its parts are systematically co-ordinated by the RBI. Non-bank financial

,.

Financial Markets

I

I

Money Markets

Capital Markets (Lond Term Funds)

I I

I

I The Money Market (National)

Short Term Credit Markets

I Organized

Unorganized

I I

I I

I

I

I

Call Money

Bill Market

Bank Loans

Treasury Bills

Commercial Bills

Hundis

Loans from Indigebous Bankers, Moneylenders and others

Organizd

Unorganized

I I

I I

Stock Market

Loans from Moneylenders and others

Loans from Banks and

Governments Bonds

Corporate

Bonds

I Equities

Fig'dre 3 : Functional cum Institutional Classification of Financial Markets

Kinds of Credit

133

institutions such as the LIC, the GIC and subsidiaries, the UTI also operate in this market, but only indirectly through banks and not directly. Quasi-government bodies and large companies may also make their short term surplus funds available to the market through banks. Besides commercial banks that dominate the organized money market, there are co-operative banks. They are a part of co-operative credit institutes that have a three tier structure. At the top there are state co-operative banks (co-operation being a state subject). At the district level there are central co-operative banks. At local level there are primary credit societies and urban co-operative banks. The whole co-operative credit system is linked with the RBI and is dependent on it for funds. The RBI deals directly with only state cooperative banks. For reasons of size, methods of operation, and dealings with the RBI and commercial banks, only state and central co-operative banks need be counted into the organized money markets the rest (co-operative credit societies at local level) are only loosely linked with it. The unorganized market is largely made up of indigenous bankers and moneylenders, professional and non-professional. It is unorganized because the activities of its parts are not systematically co-ordinated by the RBI or any other authority. Private moneylenders operate throughout the length and breadth of the country but without any link among themselves. Indigenous bankers are better organized on local basis, as in Bombay and Ahmedabad. But this kind of organization is also only a loose association. For the success of monetary and credit policy, the character of the money market is important. The unorganized sector of the market is practically insulted from monetary and credit controls. It is neither subject to reserve requirements, nor capital or investment requirements. It dependence on the RBI or banks for funds is very limited. Therefore, it is not affected directly by (say) the policy of monetary restraint of the economy. The RBI has no control over the quality and composition of credit in this market either. This works as an important limitation to the working of monetary policy in India. But since 1947 the situation is rapidly changing with the fast

134

Kinds of Credit

expansion of banking in the country and the relative shrinkage of the unorganized sector of the money market. There are three main components of the organized sector of the money markets. They are (i) inter-bank call money market (ii) bill market, and (iii) bank loan market. The unorganized sector also has its comparable markets. But its call money market is very small and restricted only to the Gujarati shroffs (one component of indigenous bankers). The other two markets are quite important. The indigenous bills are called hundis, and the hundi market is quite active The indigenous bankers and moneylenders are still the major source of short term loans for the small borrower. The main function of the money market is to provide short term funds to deficit spenders, whether the government or others. It does this mainly by mobilising short term surpluses of both financial and non financial units, including state governments, local governments, and quasi government bodies. Banks do it by'selling, deposits of various kinds, participation certificates, and bills discounted. Then, there are treasury bills sold' on tap' by the RBI. The RBI itself serves as the lender of last resort to the market. Funds have also to be moved between regions and from one place to another according to demand. An efficient and well developed system does it fast and at low cost. Also, it does not allow regional or sectoral scarcities of funds to emerge. The surpluses in some centers or sectors get immediately tramferred to others in short supply. Thereby an even supply of funds and liquidity is maintained throughout theeconomy. For this, banks and other constituents of money market must have an inter-connected network of branches and offices, rapid communication and remittance of funds system and well trained staff. The real economy may also have a seasonal pattern, giving rise to seasonal ups and downs in the demand for funds. In the Indian economy' this kind of seasonality mainly arises from the seasonal character of agriculture and some agrobased industries (such as sugar) and their large weight in the overall economy. Thus, traditionally, the Indian money market has been facing two seasons: busy season from October to April and slack season from May to

Kinds of Credit

135

September. During the busy season the main (Kharif) crops are harvested and marketed and sugarcane is crushed. So the demand for bank credit to traders and sugar manufacturers goes up. During the slack season this demand for funds goes down. The RBI has been following a pro-seasonal monetary policy so that any special stringency of funds does not arise during the busy season which may hurt legitimate economic activity. For some time past with increased double cropping of cultivated land, hefty increases in the output of wheat (a major rabi crop) and autumn rice, growth of perennial industries and a higher proportion of bank credit going to manufacturing industries, the previous seasonal ups and downs in the demand for funds have largely lost their importance. This trend is likely to gain in strength over time. The capital market deals in medium term and long term funds. The importance of such funds for carrying out investment in fixed capital has already been pointed out in Section 2.3. Like money market, the capital market also is divisible into two sectors: organized and unorganized. The organized sector comprises the stock market the RBI, banks, development banks (such as the Industrial Development Bank of India), LIC, GIG and subsidiaries and the UTI. The unorganized sector is mainly made up of indigenous bankers and money lenders, chit funds, nidhis and similar other financial institutions, investment companies, finance companies and hirepurchase companies; and company deposits. The role of the unorganized sector in the capital market is of very limited importance. In the following sections we explain briefly the organization and functions of important specialized financial markets. Call Money Market: This is the most active and sensitive part of the organized money market. It is centered mainly at Mumbai, Kolkata, and Channai, the market at Bombay being the most important. It deals in one day loans (called call loans or call money) which mayor may not be renewed the next day. The participants are mostly banks. Therefore, it is also called inter-bank call money market. The borrowing side is limited exclusively to banks, who are temporarily short of funds.

136

Kinds of Credit

On the lending side, too, there are mostly banks with temporary excess of cash. As special cases, a few other financial institutions like the LIe and the uti are also allowed to place on call their short term funds and earn interest on them. All others have to keep their funds in term deposits of minimum 15 days with banks in order to earn interest. For banks are prohibited from paving interest on deposits made for less than 15 days. Such deposits are treated as current account deposits. In the past, companies (financial or nonfinancial) as well as quasi-government bodies and individuals with large short term surpluses were allowed to place such funds on call with banks. Such money from companies and individuals known as 'house money' used to be an important source of call money for banks. Finance brokers used to act as intermediaries between borrowing banks and lending houses. All this has changed now. From March, 1978 banks have been prohibited from paying brokerage for arranging call loans for them. Among banks, the State Bank of India (SBI), because of its formidable liquid position is always on the lenders' side of the market. It acts as the lender of intermediate resort, whereas the RBI as the country's central bank is the lender of last resort The call advances by the SBI are made against government securities, whereas call loans by all others are made without security (against only deposit receipts of the borrowing banks). Since call loans are made on a 'clean' bast's, the lending banks have to be highly cautious in adjudging the ability of borrowing banks to repay at call. Therefore, as borrowers, smaller banks are always at a disadvantage as compared to larger banks. The call money market operates through brokers who keep in constant touch with banks in the city and bring the borrowing and lending banks together. The main function of the market is to redistribute the pool of day to day surplus funds of banks among other banks in temporary deficit of cash. The business of banking is such that the cash position of banks keeps on changing from hour to hour. As a result of a day's clearing their closing cash position may be vastly different from their opening cash position. Some may end the day with large amount of surplus cash and some with deficit though banks as a whole may be holding the desired amount

Kinds of Credit

137

of cash. Moreover, to-day's surplus cash banks may turn into tomorrow's deficit in cash banks. Therefore: there must be an institutional arrangement for making the surpluses of some banks available to others in temporary deficit for smooth and efficient functioning of the banking system. The call money market provides Just this sort of arrangement. It helps banks economies their cash and yet improve their liquidity by providing them with the facility to borrow on call basis. It also signals such banks as are constantly on only one side (whether borrowing or lending) of the market to put their house in order. For, either they are over stretching themselves in making loans and investments or are not doing enough to buy earning assets. The call money market is a highly competitive and sensitive market. It registers very quickly the pressures of demand and supply for funds operating in the money market. Thus, it acts as possibly the best available indicator of the liquidity position of the organized money market. In adjusting its day to day monetary policy, the RBI, therefore, takes due notice of it. The market experiences some regular seasonal changes. It is normally tighter during the busy season (October-April) than during the slack season (MaySeptember). It is much tighter during the peak of the busy season (April) before the final dates of quarterly tax payments by firms, end on the eve of the floatation of government loans. By its nature the call money rate of interest is highly volatile. The pressures of excess demand push it up easily and of excess supply pull it down equally easily. Thus during 2008-09 this rate at Mumbai fluctuated between the low of 3.5 per cent and the high of 8 per cent per annum, reached on 13 December, 2008. Thereupon, the Indian Banks Association intervened and fixed a ceiling on it at 15 per cent per annum. Thereafter the ceiling rate has been progressively lowered. The current ceiling rate is 10 per cent per annum.

Chapter

10

** TREASURY BILL MARKET

The treasury bill market is the market that deals in treasury bills. These bills are short term (91 days) liability of the Government of India. In theory, these are issued to meet temporary needs for funds of the government arising from temporary excess of expenditure over receipts. In practice, they have become a permanent source of funds, because the amount of treasury bills outstanding has been continually on the increase. Every year more new bills are sold than get retired. Then almost every year a part of treasury bills held by the RBI are funded, that are converted into long term bonds. Treasury Bills are of Two Kinds: ad hoc and regular (or ordinary). Ad hoc means 'for the particular end or cash at hand'. Thus ad hoc treasury bills are issued for providing investment outlets to state governments, semi-government departments and foreign central banks for their temporary surpluses. They are not sold to the general public (or banks) and are not marketable. However, their holders, when in need of cash, can get them rediscounted with the RBI that is sell them back to the RBI. The treasury bills sold directly to the RBI for its keep, by the government are also ad hoes. The treasury bills sold to the public or b~nks are regular or ordinary treasury bills. These are freely marketable. Their buyers are almost entirely commercial banks.

Treasury Bill Market

139

All treasury bills ad hoc or ordinary are sold by the RBI on behalf of the central government. Until July 12, 1965 these used to be sold by tender at weekly auctions. From that date they are made available 'on tap' throughout the week at a rate of discount fixed by the RBI. This change was made to make ready supply of bills available to all investors at all times for investment of their temporary surpluses and also to mop up larger amounts of such surpluses for the government. The latter, of course, has been eager to borrow all the funds offered to it. Bills (of all types) are bought and sold on 'discounted basis'. That is the amount of interest due on it is paid in the form of discount in the price charged for the bill. This price is thus lower than its face (par) value by the amount of interest due on the bill. Technically speaking, the price is simply the discounted (or present) value of the bill and the rate of discount implied (or used) is the treasury bill the RBI buys back bills, it is said to rediscount them, that rate. is, discount them all over again for their remaining lives. Discounting a bill means purchasing it at its discounted value.

When

The treasury bill market in India, as compared to such markets in the U.S.A. and the U.K., is highly undeveloped. There are no

dealers in them outside the RBI who may be willing to buy and sell any amount of such bills at market. The RBI is the sole dealer in them. In the U.S.A. and t\le U.K. treasury bills are the most important money market instrument. These are a very popular forts of holding short-term surpluses by financial institutions, other corporations and firms, because these are free from any risk of default are highly liquid and yield a reasonable rate of return. For the government, these are a very important form of raising funds. For the central bank, these are the chief instrument of open market operations. This is not so in India. The RBI itself is the chief holder of treasury bills, holding about 93% of such bills outstanding (of the value of about Rs. 26,000 crores) at the end of March 2009. All other holders such as commercial banks, state governments, and semi-government bodies hold them in very small amounts. Non-bank financial institutions, corporate and non-corporate firms with short-term surpluses do not invest their surpluses in treasury bills. All this is

140

Treasury Bill Market

because treasury bill (discount) rate in India has been very lowsince July, 1974 it has been kept pegged at the low level of 4.6% per annum, while, in recent years among short-term rates, the Bank Rate of the RBI and the call money rate (ceiling) has been 10% per annum. Business firms with cash credit facility with banks deposit their short-term surpluses in their cash credit accounts to reduce their cash credit outstanding and thereby save interest cost at the prevailing (currently 17.5% per annum) rate of interest. There is also a reasonably active inter corporate funds market whereby corporate units with seasonal funds lend them to other companies at a competitive rate of interest. The very low treasury bill rate has, no doubt, kept the interest cost of treasury bill debt to the government very low. But this has been gained at a huge cost of the economy. First, the low rate has been maintained by converting the RBI into a passive or captive holder of these bills, as the RBI has to purchase whatever ad hoes are sold to it by the government and also rediscount whatever am punt of these bills are presented to its rediscounting window by banks and others. This has led to large-scale 'monetiration of government debt' (that is conversion of such debt into Reserve Bank money), which among other things, bus been the main source of the excessive expansion of money supply and so also of inflation in the economy. Also, due to the low treasury bill rate, the government has been continuously tempted to use the short-term financial instrument of treasury bills as a long term source of funds to it, as already pointed out in the beginning of this section. The low rate has also kept the treasury bill market undeveloped by not attracting nonRBT short-term surplus funds in it. 'It has, therefore, been felt for quite some time that the treasury bill rate should be unfrozen from its artificially low level and made into a competitively attractive and flexible rate (keeping in view its special advantages over other short-term financial instruments) such that it would act as a pace setter for other rates in the money market, enable banks (and others) to adjust to changes in their shortterm liquidity through the purchase and sale of treasury bills, and allow the RBI to exercise control over money market operations.

Treasury Bill Market

141

The treasury bills are a short-term instrument and should be used as such to most only the temporary needs of the government. They should not be used as a cheap source of long-term funds and cannot be so used without taking recourse to the RBI in big way, as has been happening for several years now. Perhaps as a first step in this direction, the RBI has introduced 182-day treasury bills. The first auction for these new bills was held in late November 1986. The response from banks was very good, though the RBI accepted only about 3% of the amount bid at a discount rate of 8.4% per annum. (The rejected bids must have asked for a lightly hire rate of discount). The auction system will restore a degree of flexibility. Commercial Bill Market:

Like treasury bills, commercial bills also have a market of their own. The latter bills are issued by firms engaged in business. Generally, these are of three-month maturity. These are like postdated cheques drawn by sellers of goods on the buyers of goods for value received. An example of typical bill of exchange is given below: Jaipur, 18 May, 2009 Mr. Kapil, Three months after date please pay to the undersigned or order the sum of Rupees Fifty Thousand for value received. Signed: Vibha In the above example Vibha is the drawer of the bill and Kapil is the drawee. The former has sold the latter goods worth Rs. 50,000/ - on three-month credit. The seller may, however, need cash now. So he draws a bill and sends it to the buyer for acceptance. The latter in acknowledgement of her responsibility to make payment on take due date writes 'accepted' on the bill, or arranges to get the bill accepted on his behalf by his bank. The bank charges acceptance commission and assumes responsibility of making the payment if the drawee defaults. Once the bill has been so accepted, it becomes a marketable instrument. On receipt, the drawer can now sell it in the market for cash. Again, a bank normally comes into the picture.

142

Treasury Bill Market

The drawer goes to his bank and gets the bill discounted. This simply means that he sells it for cash to the bank, which pays him the face value of the bill less collection charges and interest on the amount for the remaining life of the bill. The rate of in to rest charged is known as the discount rate on bills. At the time of selling the bill, the seller (drawer) endorses the bill in favour of the buying bank. This makes him liable to meet the bill at maturity should the drawee (or his 'accepting"" bank) fail to do so. Thus, the buying bank is protected against the risk of default. If need be, this bank can later sell the bill to source other bank or get it rediscounted with the RBI. Thus, bills are a very important device for providing short-term finance to trade and industry. These have a fixed term to maturity called seance. This usance is reasonably short for banks to invest their funds in them and reasonably long for the buyers of goods (drawees of bills) to recover the cost of goods from their resale or processing and sale. The latter consideration makes bills selfliquidating. This reduces considerably the risk of default on bills. Moreover, bills are marketable paper, that is, they can be resold any number of times in the money market. They also carry competitive' rate of interest. For all these reasons, banks have a preference for investment in such bills. In the past, several monetary economists were of the view that banks should invest wily In bills. This view is known as the 'real bills doctrine' in the literature. But most economists have regarded it as an extreme view. One good asset should not monopolize the show. Also, during periods of business recession or credit squeeze the expected sales or receipts may not materialize and drawees may find it difficult to honour their bills. Thus, the self-liquidating character of bills is a fair-weather friend. The commercial bills are of various kinds. The bases of distinction among them are many. One distinction is that between modern bills of exchange and indigenous bills. What we have explained above are modem bills. Indigenous bills are called htmdis. Another distinction is that between inland bills and foreign (trade) bills. As the name indicates, the former are used to finance inland trade, the latter to finance foreign trade. It follows that import bills are used to finance imports and export bills to finance exports. A third kind of distinction is that between trade bills and finance

Treasury Bill Market

143

bills. The former are also called documentary bills as they carry with them papers pertaining to genuine trade transactions. As such, they are also known as genuine (trade] bills. Finance bills, on the other hand, are'clean' bills. They do not carry any documents of sale of goods with them, as they do not arise out of any genuine trade transaction. They are only'accommodation bills' drawn and accepted as a device for short-term credit. A large proportion of indigenous bills (hundis) are finance bills. Yet another distinction is that between drawers, bills and drawees, bills. The same bill may be of either kind. It all depends on who presents the bill to a bank for discounting: drawer or drawee. If the former, then the bill is a drawer's bill, if the latter, then the bill is a drawee's bill. Generally, the rate of interest charged by banks on the latter kind of bills is higher than that charged on the former kind of bills This is presumably because when a drawee comes to a bank for getting the bill discounted, it shows that he does not have enough creditworthiness in the eyes of the bill's drawer. A distinction is also made between demand (or sight) bills and time (or usance) bills. The former are payable on demand or presentation, the latter after a definite time period (of say 30, 60 or 90 days) stipulated in the bill. There is a corresponding distinction between purchase and discounting of bills. Discounting pertains to usance bills, purchase to demand or sight bills. Though the demand bills do not allow any credit to the buyer of goods, there Is a time lag between the dispatch of goods and their receipt by the (outstation) buyer, The latter will pay only on receipt of goods. For the period goods ere in transit or have not been taken delivery of by the buyer, the seller will be out of funds. Therefore, he may sell the bill to his banker and get cash. Purchase of demand documentary bills is freely undertaken by bankers on behalf of their customers, subject to a maximum limit granted in each case. Normally, for banks, purchase of bills is an easier operation than the discount of bills, because in the case of demand bills, the banker will have possession of documents of title to goods (such as railway receipt or lorry receipt endorsed in the name of the bank) until payment of bills, whereas in the case of usance bills, possession of goods is transferred to the buyer against

144

Treasury Bill Market

his acceptance. But even in the case of demand bills, banks can be cheated when for example, documentary bills are spurious or unscrupulous lorry operators deliver the goods to the buyer without the lorry receipt. Earlier we had said that in order to make a bill freely marketable, it must be accepted by a bank or some other institution or house of good standing. Normally, the bill should have two good signatures: one that of the drawee and the other that of the accepting bank. This kind of bank's business is called 'acceptance business, and the credit implied in it as 'acceptance credit'. Since acceptance of bills on behalf of one's constituents involves risk of default by drawees, a bank accepts bills only for those of its customers in whose creditworthiness it has confidence and only for the amount it considers safe. This requires a bank to have full credit information on such constituents. In the UK there are specialized liras, known as, ,acceptance houses', who do this kind of acceptance business for commission. In India we do not have such acceptance houses. In the UK the bill discounting; business is also handled by specialized firms, known as discount houses. In India the work also is handled by banks. The bill business, here has not developed so much as to call for specialized institutions to handle it. The following factors have been mainly responsible for impending the growth of a bill market in India: (i) the prevalence of cash credit system as the main form of bank lending, and (ii) the reluctance of the larger buyer in the public and private

sectors to accept the payment discipline involved in the bill market. In addition, the lack of uniformity in drawing bills in different parts of the country; the practice of sales on credit without any specified time limit, usually undertaken to promote sales; and high stamp duty on usance (time bills) have also hampered the growth of bill finance. Keeping in view the usefulness of bills as instruments of credit to both business and banks, their self-liquidating character, and

Treasury Bill Market

145

easier regulation of banks bill finance by the RBI, the latter has been making efforts to encourage the use of bills and develop a bill market mthe country. It has had only limited success so far. Its main strategy has been to induce banks to encourage their borrowers to resort more and more to bill finance. From time to time individual banks fall short of cash. They meet their needs for cash partly from the call money market, partly by selling treasury bills to the RBI, and partly by borrowing from it against government securities. The RBI has offered to make its refinance available to banks against eligible commercial bills as well. This has widened the scope for banks' borrowing from the RBI and acted as a spur for the growth of bill finance in the country. The main features of two specific bill market schemes of the RBI are given below. Old Market Scheme:

The scheme, introduced in January 1952, was a misnomer. It was designed not to develop a genuine bill market in the country but to provide further accommodation to banks on top of whatever borrowing facilities they were already enjoying from the RBI. Under the scheme, the RBI undertook to give demand loans to eligible scheduled banks against their promissory notes supported by the security of bills of their constituents with usance of 90 days or less. The bill could be genuine trade bills or not. The scheme itself did not require them to be genuine trade bills. Instead it permitted banks to manufacture artificially such bills by converting a part of their advances - whether loans cash credits or overdrafts - into usance promissory notes maturing within 90 days. The "banks could easily do so whenever required in concert with their borrowers. Obviously such a scheme could not be expected to encourage banks or their borrowers to switch from the easy system of cash credit to the discipline of bill finance: All that it did was to enlarge further the loan window of th~BI for banks by permitting them to borrow even against their ordinary commercial credit after its conversion into eligible bills. The scope of the "cherne was extended from time to time by making more banks eligible to borrow under it by reducing the minimum eligibility value for bills, and by extending it to export bills with the maximum usance of 180 days.

146

I

Treasury Bill Market

The scheme had provided for only the lodgement of bills as security for advances from the FBI and not for their rediscount with it. Technically speaking, on rediscount the RBI becomes the purchaser of the bill and the selling bank retains only contingent liability of the bill, that is liability only in the event of default. Under the scheme, therefore, the borrowing banks were free to withdraw any of the bills lodged and also to replace them by other eligible bills. The banks were thus enabled to minimize interest charge by borrowing according to their needs and by remitting spare funds to reduce their indebtedness to the RBI. To encourage banks to borrow under the scheme, for some time, the RBI offered loans at a concessional rate of interest and even met half the cost of stamp duty incurred by banks in converting demand promissory notes of their constituents into usance bills. But the scheme did not stake much of an impact. The amount borrowed by banks under the scheme remained a small proportion of the total bank borrowings from the RBI. The villain of the piece was the dominant cash credit system of bank lending which the banks borrowers find much more convenient, flexible, and to their liking. In contrast, bill finance imposes a discipline of making payments when due and supporting their credit transactions with genuine trade transactions. The supporting documents are subject to scrutiny by the RBI and could as well be rejected by it if found unsatisfactory. Most bank borrowers did not find it acceptable. New Bill Market Scheme: Dissatisfied with the old scheme, the RBI introduced a new bill market scheme in November 1970 with the object of developing a genuine bill market in India. It has been modified since then from time to time. We do not go into all the details of the new schema. Only following two main features of it are specially noteworthy: (i) The bills covered under the scheme must be genuine trade bills, i.e. bills which evidence sale and/ on dispatch of goods; (ii) The RBI rediscounts these bills. That is why it is also (and more appropriately) called 'Bills Re discounting Scheme'.

In both the above respects the new scheme is an improvement over the old scheme which covered even improvised usance bills

Treasury Bill Market

147

and did not provide for the rediscounting of even genuine trade bills by the RBI. The bills were used only as security against advances to banks. Under the new scheme also the eligible bills should have maximum usance of 90 days left at the time of rediscount. Banks can get bills rediscounted with not only the RBI but also the LIe, GIC and subsldiaries, UTI, and ICICI but not with private persons. The advantages of a genuine bill market to the banking system and others are soured up below: (1) Normally, bills ore self-liquidating and date of repayment of a bank's advances by way of the discounting/ rediscounting of bills is definite. In contrast, caah credit is not self-liquidating. (2) Bills offer greater liquidity to their holders as they can be shifted to others in the market in case of need for cash. (3) A well-developed bill market helps greatly in evening out liquidity throughout the financial system, as those with short-term surplus funds of whatever duration can invest them in bills of desired maturities and can always hope to unload their holdings of bills to others in the market whenever they need cash. Thus, the short-term surpluses of some become available through the market to meet the short-run deficits of others. Thus, the former do not suffer from the surfeit of liquidity (or cash) and the latter with the lack of it. In the absence of an active bill market banks in need of cash have to depend either on the call money market or on the RBI's loan window. (4) The commercial bill rate is much higher than the treasury bill rate. Therefore, commercial banks and other financial institutions with short-run surpluses to invest find bills attractive not only for their liquidity but also for their return. (5) To the borrower, the cost of bill finance is somewhat lower than that of cash credit because the bills carry the additional security in the form of acceptor's signature are time-bound and can be sold in the market. (6) Extensive use of bills as an instrument of short-term commercial credit and rediscounting of bills by the RBI

148

Treasury Bill Market makes the monetary system highly elastic. Whenever the economy is in need of more cash, banks can get a part of the bills in their portfolios re discounted with the RBI and there by increase the supply of money, The process comes in handy to meet the enhanced needs or busy-season finance. The seasonal expansion-contraction of money supply also becomes automatic and obviates the need for policy actions by the RBI. In the absence of such an automatic mechanism, the HBI has had to intervene actively in the money market to meet the busy-season needs for funds of the economy. We have, however, to remember that this kind of flexibility is hot an unmixed blessing as it can contribute to excessive expansions of money supply.

Stock Market:

The stock market deals in long-term securities, both private and government. It is the most important component of the capital market. The latter deals in long-term funds of all kinds, whether raised through open-market securities or through negotiated loans not resulting in market paper. Open market securities are securities (or market paper) that are bought and sold openly in the market (like marketable goods) and can change hands any number of times. The negotiated loans' have to be negotiated directly (or through a broker) between the borrower and the lender. They appear only in the account books of the lenders and the borrowers promissory notes which are not salable in the market. The scope and structure of the stock or securities market are shown in Figure 1. The stock market comprises several distinct markets in securities. The most important distinction is that between the market for corporate securities and the market for government securities. We shall study them separately in the next two sections. Corporate securities are instruments for raising long-term corporate capital from the public. The stock market organisation provides separate arrangements for the new issues of securities and for buying and selling of old securities. The former it market is known as the 'new issues market' and the latter market as the 'secondary market. Both

149

Treasury Bill Market

kinds of markets are essential for servicing corpor'\te borrowers and investors. Securities Market

I

I

Corporate Securities

I

I

Govnnment (or giltedged Securities)

I

New Issues

Secondary (Old Issues)

I

I I

Organized Stock Exchange

Over the Counter Market

I

I

I Bonds

I

Equities

I

Over the Counter Market

I

I

New Issues

I Secondary (Old Issues)

I

Preference shares

Figure 1. The Structure of Securities Market

New Issues Market:

The major function of the new issues market is to arrange for the raising of new capital by corporate enter-prises, whether new or old. This involves attracting new in-vestibule resources into the corporate sector and their allocation among alternative uses and users. Both ways the role is very important. How fast the corporate industrial sector grows depends very much on the inflow of resources into it, apart from its own internal savings. Equally important is the movement of sufficient venture capital into new fields of manufacturing crucial to the balanced growth of industries in the economy and in new regions for promoting balanced regional development. The new issues nay take the form of equity shares, preference shares or .debentures. The firms raising funds may be new companies or existing companies planning expansion. The new companies need not always he entirely new enterprises They may be private firms already in business, but 'going public' to expand

150

Treasury Bill Market

their capital bases. 'Going public' means becoming public limited companies to be entitled to raise funds from the general public in the open market. For inducing the public to invert their savings in new issues, the services ofa network of specialized institutions (underwriters and stockbrokers) is required. The more highly developed and efficient this network, the greater will be the inflow of savings into organized industry. Till the establishment of the Industrial Credit and Investment Corporation of India (lOCI) in 1955, this kind of underwriting was sorely lacking in India. Instead, a special institutional arrangement, known as the managing agency system had grown. Now it has become a thing of the past. We note its main features for its historical value. The Managing Agency System was a multi-purpose arrangement for promoting new enterprises for raising fixed as well as working capital for them, and for managing them. Managing agents were individual firms, partnerships, private limited or public limited companies. They were owned by Europeans as well as Indian business houses. Daring 1954-55 there were about 4,000 managing agencies which managed about 5,000 joint stock companies out of a total of about 30,000 joint stock companies at work in that year. Most managing agents managed single companies. But big managing houses managed several companies each. Thus, 17 top managing agents managed as many as 359 companies. Then, a majority of big public limited companies were managed by managing agents. The managing agents used to arrange finance for new companies from several sources, namely, direct finance from their own sources, indirect finance from their relatives, friends and associates, subscriptions, from companies under their control (intercompany investments), short term bank credit by extending their guarantees to banks, which quite often were also under, their control. In the absence of financial institutions specializing in underwriting of new issues, the managing agents did playa useful role in promoting new firms and industries. But this was done at too high a price. The whole system was highly exploitative in which companies under management were milched to the utmost in

Treasury Bill Market

151

various ways, directly by way of high managing agency commissions, indirectly as captive buyers from and sellers to other concerns of their individual managing agent and through intercompany investments to suit the interests of these managing agents. It stunted industrial growth of the country, both in terms of the rate of growth and in terms of industrial composition. Basic industries and Industries requiring advanced technology and large capital were shunned and only low-technology traditional industries (like textiles, sugar) 'Nere developed. It also led to extreme concentration of industrial wealth in a few large business houses (now called monopoly houses). The new institutional arrangements for new corporate issues in place of the discredited managing agency system started taking shape with the setting up of the ICICI in 1955. Soon after (1956) the LIC joined hands. The new system has already attained adulthood under the leadership of the Industrial Development Bank of India (IDBI). Apart from the ICICI and the LIC other important participants in the new issues market are the major term lending institutions such as the UTI, the IFCI, commercial banks, General Insurance Corporation (GIG) and its subsidiaries, stock brokers, and investment trusts. Foreign institutional funds from the World Bank and its affiliates. International Development Association (IDA) and International Finance Corporation, are also channeled through the all India term lending institutions (IDBI, ICICI, and IFCI). Managing successful floatation of new Issues involves three distinct services: (i) origination, (ii) underwriting, and (iii) distribution of new issues. The origination requires careful investigation of the viability and prospects of new projects. This involves technical evaluation of a proposal from the technical manufacturing angle, the availability of technical know how, land, power, water and essential inputs, location, the competence of the management, the study of market demand for the product(s), domestic and foreign, over time, financial estimates of projected costs and returns, the adequacy and structure of financial arrangements (promoters, equity, equity from the pUblic, debt-equity ratio, short-term funds, liquidity ratios, foreign exchange

152

Treasury Bill Market

requirements and availability), gestation lags, etc., and communication of any deficiencies in the project proposal to the promoters for remedial measures. All this requires well-trained and competent staff. A careful scrutiny and approval of a new issue proposal by well-established financial institutions known for their competence and integrity improves substantially its acceptability by the investing public and other financial institutions. This is specially true of issues of totally new enterprises. Underwriting means guaranteeing purchase of a stipulated amount of a new issue at a fixed price. The purchase may be for sale to the public or for one's own portfolio or for both the purposes. If the expected sale to the public does not materialize, the underwriter absorbs the unsold stock in its own portfolio. The underwriter assumes this risk for commission, known as underwriter's comI?ission. The company bringing out the new issue agrees to bear this extra cost of raising funds, because thereby it is assured of funds and the task of sale of stock to the public or others is passed on entirely to underwriters. Mostly, underwriting is done by a group of underwriters, one or more of whom may act as group leaders. The group (or consortium) underwriting distributes risks of underwriting among several underwriters and enhances substantially the capacity of the system to underwrite big issues. Distribution means sale of stock to the public. The term lending institutions, the LIe, the UTI and several other financial institutions usually underwrite new issues as direct investments for their own portfolios. For them, there is no problem of sale of stock to the public. But, under the law, a part of the new public issue must be offered to the general public. This is placed with stockbrokers who have a system if inviting subscriptions to new issues from the public. In normal times it is their distributive capacity which determines the extent of the public participation in new issues. During periods of stock market boom the demand for new Issues from the public also goes up. New issues of well-known houses and issues underwritten by strong institutions generally have a good public response. It is the placing of the issues of small companies that continues to be the Achilles' heels of the new issues market. For loosening the grip of

Treasury Bill Market

153

monopoly houses on the industrial economy of the country, it is necessary that new entrepreneurs are encouraged. For this, special efforts need be stepped up further for promoting small issues. There are three main ways of floating new issues: (i) by the issue of a prospectus to the public, (ii) by private placement, and (iii) by the rights issue to the existing shareholders. What we have described above is the first method. The, issue of a public prospectus giving details about the company, issue, and the underwriters is the last act in the drama and is an open invitation to the public to subscribe to the issue. Private placement means that the issue is not offered to the general public for subscription but is placed privately with a few big financiers. This saves the company the expenses of public placement. It is also faster. Rights issue means issue of rights (invitations) to the existing shareholders of an old corporation to subscribe to a part or whole of the new issue in a fixed proportion to their shareholding. Such an issue is always offered at a certain discount from the going market price of the already trading shares of the company. The discount is in the nature of a bonus to the shareholders. Obviously, a rights issue is open only to an existing public limited corporation, not to a new one. Old corporations also increase their capitalization (paid-up capital) by deClaring bonus to their shareholders, which means issue of new shares to them in a fixed ratio to their shareholding without charging any price from thE:m. This is a way of converting a part of accumulated reserves into company's paid-up capital. Secondary Market in Old Issues: This market deals in existing securities. Its main function is to provide liquidity to such securities. Liquidity of an asset means its easy convertibility into cash at short notice and with minimal loss of capital value. This liquidity is provided by providing a continuous market for securities, that is, a market where a security can be bought or sold at any time during business hours at small transaction cost and at comparatively small variations from the last quoted price. This of course, is true of only' active' securities for which there are always buyers and sellers in the market. 'Activeness' is a property of individual securities not of the market.

154

Treasury Bill Market

The function of providing liquidity to old stocks is important both for attracting new finance and in other ways. It encourages prospective investors to invest in securities, old or new, because they know that any time they want to get out of them into cash, they can go to the market and sell them off. In the absence of any organized 'securities market, this will not be easily feasible. So the investing public will keep away from securities. Then, the secondary market provides an opportunity to all concerned to invest in securities and when they li-ke. This opens a way for continuous inflow of funds into the market. This is specially important for such investors who do not want to risk their funds by investing in new ventures, but are perfectly willing to invest in the securities of ongoing concerns. On the other end, there are venturesome Investors who invest in new issues in the hope of making capital gains later when the new concerns have established themselves well. In a sense, they season new issues and sell them off when the market acceptability of these issues has improved. With their funds released from sale of their old holdings, they can move into other new issues coming into the market. Thus, investment into new issues is facilitated greatly by the operations of the secondary market. The new investment is influenced in another way too by what is happening in the secondary market. The latter acts as an important indicator of the investment climate in the economy. When stock prices of existing securities are rising and the volume of trading activity in the secondary market goes up to new issues also tend to increase as the new issues market (underwriters, stockbrokers, and investors) is (are) better prepared and more willing to accept new issues. This is also a good time for companies to come forward with new issues. When the secondary market is in doldrums, the new issues market also languishes. The underwriters are reluctant to underwrite and stockbrokers reluctant to assume the responsibility of selling new issues to the public. Then, firms are also advised to postpone their new issues for better times. There are two segments of the secondary market: (a) organized stock exchange, (b) over-the-counter market. The latter deals in such securities as are not 'listed' on an organized stock exchange. These

Treasury Bill Market

155

are securities of small companies and have only a limited market. Their prices are determined through direct negotiation between stock brokers and not Through open bidding as is the case with listed, securities on a stock exchange. The main action of the stock market is concentrated on these exchanges. We explain briefly their organization and functioning. Stock Exchanges: A stock .exchange is an organization for orderly buying and selling of 'listed' (approved) existing securities. The organization includes an association of persons or firms to regulate and supervise all transactions, rules, regulations and standard practices to govern all market transactions, authorized stock brokers, and an exchange floor or hall where stock brokers or their authorized agents meet during fixed business hours to buy and sell securities. At present in India there are 11 recognized stock exchanges in various parts of the country. The one at Bombay is the leading stock exchange. It leads other exchanges in terms of the number of securities listed there, the importance of companies whose stocks are traded there, the average volume of daily business, and its capacity to absorb big buy and sell orders. Listed securities are securities that appear on the approved list of a stock exchange. Approval depends on several considerations, such as the size of the issue, whether it is widely held by the public or closely held in a few hands, timely production of annual accounts, etc. Only listed securities are traded on the floor of the exchange. Therefore, listing improves marketability of a stock. An organized stock exchange is an 'auction' type market where prices of traded stocks are settled by open b bids and offers on the floor of the exchange. Therefore, it is said that these prices are formed competitively. To the extent that is so and to the extent buyers and sellers are well in formed and while bidding prices they take into consideration all the relevant factors, present and prospective, concerning not only the particular enterprise and the industry, but also the general economic and political conditions, the stock prices will be good measures of the true real worth of enterprises. In the process, better-run profit-making enterprises will appreciate in real value as compared to others. In a private-ownership economy (0T" sector this helps and guides greatly the allocation of new resources

156

Treasury Bill Market

In actual practice nearly all the statements of the previous paragraph need to be qualified. Competition is not perfect in the stock market. This market is no leveller of the high and low. Big investors carry more weight and can influence the market their way. Already, the weight or big financial institutions such as the LIC, the UTI, the GIC and subsidiaries has corne to be felt. This meet not always be to the disadvantage of the small investor. Problems arise only when there is artificial manipulation of the market or when the firrnholding of good stocks by j~lStitutions (and promoters) reduces too much the floating supply of stich stocks in the market. Then, a slight increase in the demand for such stocks shoots their prices up. Also small investors are not that well-informed. Nor do they have the requisite ability to analyse and interpret the myriad of forces that impinge on stock prices. Therefore, without the leadership of financial institutions, the prices formed by their transactions need not be good indicators of the true values of stocks. They are easily swayed by 'animal spirits'. The result is frequent ups and downs of stock prices. There is also an excess dose of speculation present in the market, especially during periods of market booms. Then, in a planned mixed economy, allocation of resources cannot be left to the operations of free market forces. A more purposive and socially informed allocation is needed. This is one of the justifications of the public sector and the Capital Issues (Control) Act, operating in the country. Gilt-edged Market: The gilt-edged market is the market in government securities or the securities guaranteed (as to both principal and interest) by the government. The former include securities of the Government of India and of the state governments: the latter are securities issued by local authorities (like city corporations, municipalities, and port trusts) and autonomous government undertakings like development banks, state electricity boards, etc. The term gilt-edged means of the best quality. It has corne to be reserved for government securities as they do not suffer from the risk of default. Besides, government securities are highly liquid, as they can be easily sold in the market at their going market price. The open market operations of the RBI are also conducted in government securities.

Treasury Bill Market

157

Government securities have become a very important component of capital market in several countries. In India they have gained steadily in importance since 1954-55 as the pressure for raising funds to finance public sector projects under five year plans built up. The total amount outstanding of the internal government debt in the form of market loans, special bonds and treasury bills was about Rs. 76,000 crores at the end of March, 1986. During 1985-86 alone this debt had increased by about Rs. 13,000 crores, while gross savings of the house-hold sector in the form of financial assets for the year where estimated at Rs. 25,600 crores. This shows that the government was able to appropriate for Itself the equivalent of about 50% such financial savings through the device of treasury bills and market loans sold to banks and other financial institutions (over and above direct mobilisation of household financial savings through post office deposits, 'small savings schemes' and public provident funds run by the post offices, government provident funds and' compulsory deposits' from the public). The gilt-edged market may be divided in two parts: the treasury bill market and the government bond market. We have already studied the former, the organization of the latter is explained below. On the borrower side, the RBI manages entirely the public debt operations of the central as well as state governments. As such, it is responsible for all the new Issues of loans. This will be explained further in later chapter. There is also a large secondary market in old issues of government loans. It is heavily concentrated in Bombay with supporting markets in Calcutta, Madras, and Delhi. This market largely works through a few large stockbrokers who keep in constant touch with the RBI and other prospective buyers and sellers. Sometimes financial institutions negotiate directly with ~e RBI. But this is not very common. The RBI keeps the market informed through recognized brokers abOl!t its buying and selling prices for various loans outstanding. It keeps on ready sale securities of . various maturities to meet the market demand for them. In all this, the RBI's position is that of a monopolist. There are only brokers or investors in the market and no dealers or .jobbers (other than the RBI) who would make a market in government loans by standing

158

Treasury Bill Market

ready to buy and sell any amount of government securities on their own account. This special feature of India's gilt-edged market should be carefully understood. It distinguishes this market from the gilt-edged markets of the USA, the UK and Canada, where the central bank of the country is not the sole dealer in government securities as the RBI is in India. On the demand side, the gilt-edged market is dominated by financial institutions. Apart from the RBI, the major holders are commercial banks, insurance companies, provident funds, and trust funds. These financial intermediaries mobilize savings of the public and through their investment in government securities transfer these savings to the government. They constitute what is called the 'captive market' for government securities, as they are required statutorily to hold certain minimum proportions of their total liabilities (assets) in government securities. Therefore, as the total liabilities of these institutions grow, the demand for government securities also grows. Besides these financial institutions, local authorities, semigovernment bodies, and non-residents also invest some amounts in government securities. The demand for these securities from nonfinancial companies and individuals is negligible. Due to the special features of India's gilt-edged market spelled out above, namely, the monopoly-dealer position of the RBI and the 'captive' nature of the demand for government securities, the prices of such securities are not formed freely in the market. Instead, they are very much under the direct control of the RBI. One main reason for the virtual absence of non-captive buyers from this market Is that the rate of interest on government bonds has been kept artificially low - much lower than the rates of interest available on other financial assets such as fixed deposits with banks and post offices, with a much shorter maturity of five years and fiscal (incometax) concessions, which have bossed up the effective rates of interest on them for income-tax payers. The low interest rate policy for government debt was adopted deliberately to keep the interest cost of market debt to the government as low as possible. To snake it effective, the RBI, over the years, has been called upon to take up a sizeable proportion of the new issues

159

Treasury Bill Market

of government loans as high as 64% of the net market borrowing of the Central Government in 1981-82. This, too, as in the case of treasury bills, leads to magnetization of debt. (The RBI, then, through Its open market operations, sells some of these securities to other financial institutions throughout the year). In recent years, as a matter of welcome conscious policy, the coupon rates on central government loans have been progressively revised upward. For example, the coupon rate on new issues of long dated securities with 30 year maturity has been raised in measured annual steps from 8% per annum in 1981-82 to 11.5% per annum in 2008-09.

***

Chapter

11 tItI OFFICE MACHINES Office machines have come a long way since Queen Anne granted a patent for a writing machine in 1714 and since Christopher Sholes presented the world with the first practical typewriter in 1873. Today entrepreneurs are faced with a bewildering array of machines that have been devised for all types of operations. Mechanization, coming first to factory processes to and physical operations in production, has now moved into office and administrative processes at a pace surpassing its progress in the factory. The reasons for accelerated mechanization in management processes are apparent. The relatively slow beginning left a long way to go, and at least part of the movement must be regarded as a catching-up process. Basic changes in the nature of companies and the operations involved are having profound effects; one indication is that the white-collar work-force became larger than the blue-collar workforce for the first time in 1956 and is now rapidly increasing its lead. By 2009 there will be approximately two white-collar workers for each blue-collar worker. Growth in size and complexity of businesses and ever keener competition are influencing management to look for sharper tools in physical production and in mental work, such as problem recognition, analysis, memory, and communication, to achieve

Office Machines

161

understanding. Technological advances in office machines and related equipment to meet administrative needs are now progressing with amazing speed. For the past thirty years the office equipment industry has been one of the leading growth industries. Developments are now so rapid that managers find it difficult to keep. abreast of new equipment available. This difficulty is perhaps best explained by the appearance of a new growth industry -special service organizations that help users select equipment from the many different types on the market. General criteria for design or choice of methods for performing operations can be summarized under the headings of effectiveness, economy, and impact on employees. These criteria apply directly to problems of mechanization in the office. Guides for applying them to specific problems, such as matching needs and equipment, will be presented in this chapter. Mechanization in the sense used here includes all type's of general and special purpose office machines except those directly related to electronic data processing. This industry and equipment have become so important and are growing at such a rate that it will be separately discussed. Establishing the Need:

A logical beginning to any situation in which purchase of an office machine is being considered is to question need and selection. For most office operations need seems almost a foregone conclusion. But even when a machine is readily available commercially, its need should never be taken for granted; alternatives should be considered first. One alternative is that the work itself could be eliminated, simplified, rescheduled, or altered to eliminate the necessity for mechanization. The management of one company was considering expanding its data processing installation to take care of a heavy weekly peak load until it discovered that the problem could be solved without additional equipment by better scheduling and fuller utilization of present equipment. Subcontracting is another alternative. What are the possibilities for subcontracting the work to outside service agencies? A

162

Office Machines

remarkable development of service agencies is now occurring, and no alert management will overlook the possibility that a service agency might perform many types of work effectively and economically. If the work operations are necessary, is a machine really required, or could the work be done by simple, non-mechanical means? A prepared table of values, such as of rates, prices, and products of numbers commonly multiplied, is an often overlooked alternative to mechanical devices.

The one situation generally responsible for office mechanization is fluctuating volume that peaks in cycles. Considerable attention should be devoted to the question. "ls it possible to even out the peak loads?" Mechanization geared to peak loads (a necessity for service and production requirements) results in considerable Idle or unused machine time and, ultimately, in inefficient and uneconomical operatiOns. Making the Selection: When purchase of a machine is justified, the problem becomes one of choice Of, in some cases, one of special design. A wide range of types of machines is available, and technology is continuously developing new and different types. There are a great many competitive models in most types; each is likely to provide optional or special features that should be considered by the buyer. Moreover, investing in the typical office machine requires considerable money, and the possibility of obsolescence causes a machine to be an unstable asset. These considerations suggest the need for objective study of the proposed purchase of any office machine. An analysis in three stages usually will be justified, following the sequence below. What are the requirements of the operation that may be met through mechanization? What goals are sought in mechanization - improved customer service, reduced administrative costs, facilitation of other internal operations, fewer errors, less monotonous work for employees, or a solution to the labour shortage? Then, what specific processes are involved, what are their volume

Office Machines

163

and speed requirements, how highly standardized are they, and what are future prospects for this operation (it permanent or temporary, growing or declining)? Both the precise nature of goals sought and of the specific processes involved are necessary in establishing the need. If competitive success in the industry depends heavily upon prompt service, this consideration may outweigh all others. If the enterprise is caught in a cost squeeze, getting the work done more economically may be the dominant consideration. Or the optimum combination of these and other goals may be sought, with some of major and some of minor concern. The nature of the process involved, the capacity and speed requirements, the degree of standardization. Which will be more appropriate - special purpose equipment to do only this operation but do it well, or general purpose equipment that will perform this and other operations under widely varying conditions? A check writing machine is a special purpose machine; a desk calculator or typewriter would come nearer to being general purpose, although the difference is one of degree - for example, one calculator may be more versatile than another. Which machines, among competitive types and makes available, appear to have the capacity, speed, and special features needed in the operation? The rapid growth of the office equipment industry has attracted many competitors, and few, if any, machine needs do not have a large number of prospective suppliers. Office machines, like automobiles, are now available in wide varieties of "horsepower", size, speed, and special features. It is important, therefore, to ascertain which suppliers have equipment that fits the needs of an operation; leads are available through advertisements in trade publications, machines exhibitions, reputable suppliers, and recommendations by consultants. Evaluating the available features of a supplier's equipment will justify close study and comparison; although a supplier may offer a considerable variety of features, it IS Ii ke\y that his equipment will excel in certain aspects and be somewhat less satisfactory in Others. One make of copying machine may produce clearer copies but at

Office Machines

164

higher costs; the buyer must decide which is more important for his need. There is also wide variation in speed and capacity. It is usually possible to find nearly the optimum characteristics if one searches carefully - so, why pay for a labeling machine capable of affixing labels to various materials at 12,000 an hour if the need is for labeling only one type of material and the volume is 12,000 a week? Or why get the automatic division feature on a desk calculator unless the operation requires enough of this work to make it worthwhile? On the other hand, if ther7 is a recurring need to rush blueprints to distant units of a firm, facsimile reproduction and transmission may be a wiser approach than a slower and less costly method of providing the blue prints. As obvious as such precautions may appear, it is likely that most machine selections are somewhat less than the best quality currently available for uses intended. And there is of course the continuing problem of remaining informed on new developments that might place a choice in an entirely different light. Which of the machines that appear to quality for the operation would offer the best overall ~olution to the specific needs of the company? In general one might be justified in saying" the simplest, least expensive machine to do the job," but a set of more specific questions should usually be considered. With the preceding discussion as background, a checklist of pertinent questions follows: 1.

Is the output of a machine suitable to needs in terms of accuracy, neatness, and other quality factors?

2.

Is speed of service adequate for meeting customer needs or for facilitating other internal operations that may depend upon this one?

3.

Is cost justified by benefits gained, either in direct dollar savings or in indirect benefits such as competitive advantage through prompter service or better infon;nation for long-range plans? Though it is not an easy undertaking efforts ordinarily should be made to assess the value of such intangible benefits as the last mentioned. The

Office Machines

165

alternatives may be a penny-wise, pound-foolish approach or a tendency to commit the firm to luxuries that may be impressive but impractical. The large investment involved in many modem data processing installations makes a combination of open mindedness and prudence particularly appropriate in this area. (a) Does the obsolescence factor warrant special consideration for the equipment under study? Many firms have policies requiring that machines of certain types pay for themselves in a specified number of years or, perhaps, in one fourth of their useful life. Such policies have merit considering the current rapid rate of obsolescence of many machines, but if used, they should reflect varying rates of obsolescence, and allowance should be made for intangible benefits such as those discussed above. (b) Does the outlook for the operation under study justify special considerations? Is the need likely to continue, or may it be uncertain because of the changing nature or volume of work, the prospect of major overhauling of systems, or other reasons?

4.

Does the equipment offer the necessary flexibility and adaptability? Consider not only variations in the given opeJ;ation but other operations that might employ the equipment as well.

5.

Is leasing possible? If so, would leasing be preferable to purchase? This important alternative will be considered in a brief, separate section.

6.

Could maintenance needs be met effectively and economically? Key factors in maintenance decisions will be treated in a separate section.

7.

Could the very important problems of employee adjustment be solved - acceptance of change, adequate ~ply of potentially able employees, training needs, and reduction of such problems as drudgery and excessive errors where present?

166

Office Machines

Before the final choice is made, actual tryout of one or more of the most likely machines can be vitally beneficial. Arrangements can usually be made to bring smaller machines to the finn for a short trial on the work to be processed. Larger equipment often can be tried out, with a reasonable degree of satisfaction, on the premises of the supplier. Purchase versus Lease: Leasing as a means of financing office equipment is now in extensive and growing use. Important reasons include the following: 1. Reduced capital outlay for equipment: Funds may be limited. Even if this is not the case, more profitable uses of funds may exist, such as in programs for more aggressive research or sales promotion involving addition of skilled personnel, or inventory that can be moved quickly, or general expansion. 2. Up-to-date equipment without permanent commitment of funds: The obsolescence danger can be minimized for many types of equipment by leasing recent models, with the opportunity to retain the equipment or change to newer models when the lease period expires. 3. Temporary or fill-in needs: Short-tenn needs, for special or temporary programs and for filling in during peak loads of work volume, may be met more wisely by leasing than by outright purchase. 4. Trial use : Suppliers may offer free trial of certain types of equipment for short periods. For equipment not available for trial, or for equipment justifying longer and more intensive' trial before purchase, leasing arrangements are often available. 5. Servicing provided: Leasing arrangements usually provide for servicing the equipment leased. Each benefit of leasing has its price, of course. Firms having heavy, continuing needs for equipment, or having no better alternatives for use of funds, or lacking the opportunity to lease, will continue to purchase office equipment. It appears however that alternative uses of funds are being scrutinized much more

Office Machines

167

closely than in earlier years. Also, accelerated obsolescence is causing many management's to take a harder look at purchasing equipment. When a machine breaks down or fuTh::ti<ms improperly. much valuable time can be lost, other operations are interrupted, costly errors occur, and other damages result. Hence, management's may give almost as much thought to equipment maintenance in some cases as they do to equipment selection. Alternative arrangements for the maintenance of office equipment include the following: 1.

Combining rental and maintenance services in lease agreements (discussed above);

2.

Service contracts - either with supplier or with independent agencies;

3. On call service by supplier or independent agency on special request; and 4.

Providing own maintenance personnel and facilities.

In most companies outside service is ordinarily used. Larger firms may have the resources to service certain types of office equipment but are likely to be forced to rely on outside specialists for most maintenance requirements. The choice between service contracts or on-call service is controversial even among firms that make use of both. Service contracts specify a fixed fee (which may be considered an advantage by some firms) for providing pre-tentative maintenance through regular checkups and servicing. They also offer prompt service when breakdowns occur. However the fees may be considered expensive, particularly equipment is not heavily utilized. On-call service may be considered advantageous where: Equipment utilization is not extremely heavy; Maintenance service is available on short notice; Trade-ins of certain equipment (such as typewriters) are made frequently enough to minimize maintenance requirements; and

168

Office Machines Cost comparisons show savings without serious interruption of normal operations.

Responsibility for Equipment Selection and Maintenance: Factors considered ir. the above discussion indicate that several persons or groups normally should participate in office equipment selection decisions. Equipment selection is an important part of the overall problem of systems design. Hence, a systems analyst or, in smaller firms, an office manager who does systems and methods analysis along with other duties, would have the necessary special qualifications. They can aid in establishing the need, evaluating past experiences as revealed by equipment records, insuring conformance to overall standardization programs, and determining and evaluating alternative types of equipment available. Employees who operate the equipment and their supervisors should of course contribute their ideas regarding equipment. Their recommendations should be considered and systems requirements may sometimes require a much broader view. Ideally most decisions will be made by a team-users, systems analysts, and sometimes cost analysts. Valuable outside help can be secured from sales representatives of equipment suppliers, who have acquired knowledge and experience in working with other enterprises. One of the most, notable trends in office equipment and supplies competition is the provision of more and better systems help, even to the point of doing much of the basic systems design, training the user's personnel, and following up at intervals to ensure proper usage. Particularly striking are the current efforts of computer manufacturers to design programs (or software) to fit the systems requirements of certain industries and even individual enterprises that use their equipment. The need to maintain an objective attitude toward the offerings and advantages of different suppliers is important; reputable suppliers attempt (not always with complete success) to train and supervise their representatives to ensure - customer satisfaction to a degree where they will recommend other prospective buyers, and encourage repair business. Trying out the offerings of two or more suppliers is of obvious value.

Office Machines

169

The services of independent consultants will seldom be required in office equipment selection, although when advising on complex systems problems, consultants often strongly influence specific choices of equipment. Direct assistance with comparative cost analysis and other dimensions of the problem is available if desired. And, as mentioned earlier, consultants can conduct an impartial analysis of needs and equipment available and make specific recommendations to users. There is no easy way to classify office equipment. One can list many types - some having specialized uses and others serving a variety of operations. For the sake of continuity we shall relate classes of equipment to the basic categories of methods by which office operations are carried out: Assembling; Processing; Recording; Communicating. The sequence suggested is followed in only a general way. Virtually all office processes fall into one or more of these categories. Equipment for Assembling Data: "Data collecting" may be a more descriptive term for this category of operations. There are few data collecting machines as such. Most ~riginal data come into the enterprise either as oral or written messages in activities such as purchasing] and sales. Other data arise from subsequent activities such as production, provision of manpower, materials and equipment, and accounting. Feedback data for control purposes are developed continuously from work in process. All such data may be entered manually or mechanically on forms, reports, and other documents. Certain highly promising developments are occurring in sourcedata automation. Among these are optical scanning devices, magnetic ink readers, and voice-to-written message translation. These devices will be treated in the section on data processing that

170

Office Machines

deals with data acquisition, since they enter directly into processing sequences. Equipment for Processing Data: Data processing involves actually changing data into a more refined and useful form, either as a part of current operations or from specific planning or control usage. Machine methods are in heavy use for processing data. Among principal processing machines are: Adding machines; Calculating machines; Punched card machines; Computers. Equipment for Recording Data: A broad definition of recording equipment also takes in many types of machines, including those for initial recording, reproduction, and retention. Prominent among the recording machines are: Typewriters; Copying machines (for a few copies) Duplicating machines (for many copies) Microfilming equipment. Files and other records storage equipment serve the primary functions of retention and retrieval; an increasing portion of records storage is being done in computer storage equipment and mechanized files. Forms, reports, and other documents are also important recording methods. Of course the most basic method for original entry of data is still handwriting. Equipment for Communicating Data: Rapid and significant advances in communications equipment of many types have been made. Major groupings include: Mailroom equipment (mailing, addressing, labelling, etc.)

Office Machines

171

Dictating and transaibing equipment; Intercommunications equipment; External transmission equipment; Pneumatic tubes. Having particular promise is equipment for transmitting data from machine to machine. This has become so important that data transmission is treated as a major section in a later chapter, Most types of equipment mentioned thus far are best understood and appreciated when considered in relation to the basic processes with which they are associated. External message transmission equipment - the teletypewriter, for example - can be appraised most effectively by considering the general function, processes, and requirements of communication. For this reason these types of equipment will be considered in later chapters that deal with basic categories of office methods and services, the only exceptions to this approach are certain machines that are general purpose and do not fall neatly into process categories. These include typewriters; adding, calculating, and accounting machines; and punched card machines. These will now be given brief treatment in the following section. Of special consideration is the fact that basic equipment of the first three types, while performing primary functions, now frequently produce by products such as paper tape, magnetic tape, or punched cards, which serve as input to computers and other electronic data processing machines. Detailed descriptions of the many types of equipment available are neither possible nor appropriate in this book. Moreover, new and improved models of many types of equipment are appearing at such a rapid pace that nearly any model pictured or described might soon be obsolete. Individuals or companies needing specific description of available equipment can easily obtain them by : Communicating directly with suppliers representatives; Referring to advertisements in trade and professional Publications; Attending equipment exhibitions;

172

Office Machines Following and

~p

on leads furnished by business associates;

Completing equipment advertisement reply cards inserted in issues of administrative and office management journals. Typewriters: Still the most widely used office machine, the modem typewriter is definitely not what it used to be. The electric typewriter is the workhorse in most offices. It has undergone continued development in an effort to improve the quality and efficiency of type-writing. The popularity of today's electric typewriters arises from their ability to produce uniform print, cleaner type, more carbon copies, and greater output with less operator batigue than their ancestors. Important features of the modem typewriter include: Self-correcting - typewriter has built-in correcting tape enabling the typist to correct errors as a normal part of typing; Interchangeable typing elements - allows the typist to select the typing element best suited to the job (for example, with the IBM Selectric over thirty interchangeable typing elements are available); Proportional spacing - enables the typist to at vary the amount of space between each letter or word in a document; Ribbon cartridges - provides ease and convenience when changing ribbons; and Dual pitch -enables machine to type either ten or twelve characters per inch. IBM pioneered the development and marketing of sophisticated electric typewriters. For example, the IBM Selectric series of electric typewriters, which has many of the features listed above, also offers considerable typing versatility, no key jars, ease of cleaning, and requires less desk space than carriage-return models because only the rotating head moves back and forth across the typewriter body. Other important typewriter developments include the memory typewriter (which permits the storage of typed material within the

Office Machines

173

typewriter); magnetic media typewriters (for example, the IBM magnetic card and magnetic tape typewriters); and electronic editing and composing typewriters (which feature memory capabilities and allow typist to align both margins and set format). Adding, Calculating, and Accounting Machines:

Standard office equipment for arithmetic operations include adding, calculating, and accounting machines. Even with widespread use of high-powered electronic devices, these machines seem likely to remain as solid standbys in the arsenal of office machinery. One reason for this is that, although efficient programming is prevalent today, tasks of an exceptional nature still arise. Also, many offices are not yet utilizing integrated data processing (lOP) equipment. This being true, manufacturers of such standard equipment and machinery continue to improve it. The speed of these machines will probably not be increased greatly, but more and more operations can be performed automatically. Adding Machines:

Adding machines are limited to addition and subtraction in most cases. They may be used for multiplication and division, but their speed and capacity in this work is not as great as other types of machines. Most adding machines in use today are electric and employ automatic printing devices that print both the factors and the results They are available with a choice of a full keyboard or a ten key arrangement. Calculating Machines:

Calculating machines have traditionally been used for multiplication and division, accomplishing these functions by repetitive, high-speed addition and subtraction. Calculators tend to be most useful in statistical work in which a large number of percentages and ratios are determined, and in invoice and payroll work that requires extensive calculations. The older type calculators are key-driven machines which operate when a key is depressed and rotary calculators, which require depression of an activating bar.

174

Office Machines

In recent years there has been a revolution in the development of desktop and hand-held electronic calculators. The "new generation" of electronic calculators that operate on integrated circuits have gained widespread utilization in most organizations. The small, hand-held calculator has become a popular consumer item to millions of Americans. The electronic calculator varies in capability from performing simple arithmetic functions to very complex scientific calculations. Although there is considerable variation in df>sign and capabilities, electronic calculators may offer such features as: Programming capability with multiple memory cells; Printing capability - the units produce "hard" or printed copy of results; Pressure sensitive keyboards; and Visual (digital) displays of results. The electronic calculator has, in effect, become a small computer. The machines have the capability to perform complex functions that only a few years ago required the use of a computer. Since their introduction several years ago prices for electronic calculators have decreased substantially while machine capabilities have increased dramatically. Accounting Machines: Accounting machine is a broad classification used to include bookkeeping, billing, and posting machines. Accounting machines have several accumulators, or registers, whereby totals from several classifications of data may be obtained. Accounting machines perform accounting work ill the literal sense of the word, their basic purpose being to prepare accounting documents and to total accumulated sums. The primary factor distinguishing bookkeeping and accounting machines from other office machines is their ability to enter descriptive information such as simple numerical codes or complete alphabetical descriptions. Some of the larger accounting machines will, for example, type the customer's name together with a brief description of the sale and the unit cost and then compute the discount, compute the total amount, pick up the previous balance, and print the new balance.

Office Machines

175

Typical applications of accounting machines involve accounts payable, customer billing, and preparing the depositor's ledger and statement for bank operations. The previous section dealt with office equipment of both a general and specific nature for handling routine administrative work. Reference was made to data processing equipment in several instances because even routine equipment, such as typewriters, communication equipment, and accounting machines, is frequently connected directly to punched Card data processing systems. This section will deal with unit record systems or what has been called punched card data processing systems. Electronic data processing is the subject of the following chapter. Punched Card:

The common machine language for the unit record system is the punched card. Joseph Jacquard first conceived the punched card to control the operations of machines. In 1801 he developed a system of cards with patterns of punched holes that controlled weaving looms in producing various patterns of cloth automatically. The punched card has been used in business record keeping and simple accounting-oriented problems for over seventyfive years. Punched card data processing for commercial use was conceived by Dr. Herman Hollerith, when he developed a system for processing the 1890 Bureau of Census data. Computation of 1890 census data required only two to three years; it had required five to seven years to analyze the 1880 census data by manual methods, and in 1880 the population was 20 per cent smaller. Once the practical application of the punched card system proved successful in government census and vital statistics systems, commercial firms were eager to adopt the equipment and processes for industrial needs. Some of the early uses were actuarial analysis by insurance firms and routine paperwork in department stores and in transportation industries. The punched card is the key to the unit record system An IBM stc:ndard punched card. The card measures 7 3/ 8" by 31.4" and is .007" thick. There are eighty columns on the card from left to right. Each column is divided into twelve punching rows; ten rows are

176

Office Machines

marked by the digits 0 through 9 the other two rows are in the blank space immediately above the row of zeros. These zone punches are called a 12 and an 11 punch or an "x" and "y" punch, respectively. The punch code devised by Dr. Hollerith in the 1980s is still used today. Numeric data are represented simply by a digit in the proper column of the card. Alphabet characters require a two-punch combination of a zone and a digital punch. For example, an "a" is represented as a 12 zone and a digit 1 punch - both in the same column. The zone punch used to represent the letters s through z is the 0 digit punch. Each of the eighty columns of the card will accommodate a digit, an alphabet letter, or a special character. The comer costs on the card help to group ce;tain types of cards used for specific purposes and to assure that cards will be facing the proper direction for machine processing. The design of the punched card provides for basic operations field definition and data coding. Field definition is nothing more than selecting certain columns of the card to be used for fixed data, such as account number and date, that will appear on each of the cards. For permanent use, field data can be printed on the face of the card itself to facilitate manual handling. Coding involves selecting an alpha or numeric punch or some combination of both to represent grouped data. For examp1e zip codes now are used to represent cities, and industrial classification codes are used to represent business firms with different numbers of employees. The use of a code permits faster machine handling and reduces the number of card columns required to record data. Unit Record Machines: Unit record machines are recognised as the most economical means of entry to automatic data processing. However much of the punched card equipment in the nation is found in installations that not only do not have a computer system but have no plans for acquiring one because of the limited size of the company or because of the prohibitive cost involved. The significance of punched card machines lies in the common language provided by the punched card. The punched card is an important element in the concept of integrated data processing

Office Machines

177

discussed in the following chapters. Once the data is punched in the cards, the cards can be summarized, sorted, and processed in an almost unlimited variety of operations as required by management or by the nature of the operations. Equipment designed primarily to process punched card data are the card punch, card verifier, interpreter, sorter, collator, reproducing punch and accounting or tabulating machines. These will be discussed briefly in tum, followed by a simple illustration of a unit record system. Card punch: This machine is commonly referred to as the key punch and punches holes in the cards from a keyboard that resembles a standard typewriter keyboard. The operator reads the source document and by depressing the proper key, converts the information into punches on the card. The card punch will, under semiautomatic programming control, skip or space over predetermined card columns (fields), duplicate into a succeeding card the information contained in the preceding card, control the alpha or numeric shift, and feed, position, and eject cards. An experienced operator can produce some 8,000 to 10,000 key strokes an hour. Card verifier: The card verifier is similar in most respects to the card punch, but the verifier only senses the punched data. The operator reads the same source data used with the card punch and depresses the keys on the keyboard. A difference in what has been punched in the card and what the verifying operator enters causes the machine to stop. After a closer inspection, if the punched data are incorrect, a notch will be cut in the top of the card for visual reference later in the correction process.

Reproducing punch: This machine is a fast automatic data punching machine controlled by a wired control panel. The reproducing punch is capable of gang punching, that is, punching identical information from a header card into all succeeding cards and punching a new card from data punched in an original card. The reproducing punch also receives punch signals from other data processing rna chines in a "summary punch" operation. Totals of various classifications can be quickly acquired by processing

178

Office Machines

summary card, punched on the reproducing punch machine as a by product of other related operations, Mark sense punching is also performed on the reproducer. Mark sense punching is the automatic punching of data by means of electrically conducive marks made on the card with a special pencil. The original data, for example, a utility meter reading or inventory counts, can be recorded at the location and then transferred into punched card form by machine processing.

Interpreter: The interpreter is controlled by a wired panel and simply translates the punched data into the proper alpha, numeric, or special character and prints this in a certain position on the card. Interpreting the punched data is a necessity when the cards are to be used for permanent file documents and manual reference is required. Sorter: The sorter, along with the collator discussed later, is essential in processing the mass of punched cards. Efficiency and economy in punched card data processing require reusing the cards (data) as many times as possible once the data has been recorded (punched). Current models of sorters will process punched cards at the rate of 4000 per minute. The machine sorts by reading or sensing the punch in a selected column and depositing the card in the proper pocket. There are thirteen pockets on the sorter, one for each digit from 0 through 9, one for each zone row, and also a reject pocket. Only one column can be sorted at a time. Sorting machines are also equipped with selectors, which enable cards to be rejected except for those that contain a specific punch; these are sorted into the proper pocket. Actually in this selection process, the sorter simply suppresses (ignores) all punches except those that will select the desired cards. Collator: The collator assumes the prodigious task of filing the punched cards. The sorter can function as a collator, but the process is much slower. Collators operate under direction of a wired control panel and have two card feed pockets and four selection pockets. Collators can (1) merge two groups of punched cards into one sequential file according to field or coded data punched in the card, (2) verify sequence of the cards, and (3) match (verify) the sequence

Office Machines

179

of two groups of punched cards. A typical use of a collator is to merge new cards into a master file of punched cards. Tabulating or accounting machine: All the previous machines and Operations are necessary to record the data and to prepare the cards for processing on tabulating or accounting machines. These machines operate from wired control panels and can, at the discretion of the operator who wires the control panel, perform routine accounting functions such as listing cards for reports, selecting cards for listing, and adding and subtracting in several classes or groups of totals, subtotals, and grand totals. Some accounting machine models have small storage locators in which repetitive, information, such as column heading and date of bills, can be entered only once but will be printed out on command. Accounting machines are the core of any unit record system, for here "hard copy" is obtained that will be used internally in the organization for data such as that on bills mailed to customers. A Unit Record Data Processing System: The following example briefly describes how punched cards are used to prepare bills for a typical telephone company. Several cards are necessary in this process three permanent cards that are reused each cycle and several one-time cards, used to enter current charges or credits. Specifically, there are the following punched cards: 1.

Permanent file card containing customer's telephone number, name, address, credit rating, and other identifying information (green);

2.

Permanent file card for local service charges, depending upon type of service, number of telephones, etc. (manila colour);

3.

Permanent file card for yellow page .directory advertising (orange); and

4.

One-time-only cards to enter monthly charges (manila colour with different coloured stripes); and one card for each of the following: (a) long distance calls -summary, (b) fractional month charges or credits, (c) balance from

180

Office Machines previous bill - debit or credit, (d) inter-zone charges intrametropolitan area long distance charges.

The basic complement of machines for this operation is five card or key punches, two card verifiers, one interpreter, one reproducing punch, one sorter, one collator, and one accountingtabulating machine. The basic document for changes in the permanent data cards is the service order. This single document authorizes new account cards and changes to the name and address card, the local service card, and the directory advertising punched cards. Each customer account is considered part of a particular control unit for billing purposes. All billing charges must be balanced according to these control units; for example, the total local service charge for a control unit for the previous month's billing is updated to account for any additions (new customers, upgrading of service) and for reductions (discounts, moves, downgrading of service) to obtain a current control unit total of local service charges. A similar operation occurs for the directory advertising charges. The three permanent cards - each of a different colour are then merged together according to telephone number sequence to await final merging with the one-time charge cards. Up to this point, the card punches, interpreter, sorter, collator, reproducing punch, and accounting machine have all been used. Specially striped coloured cards for one-time only charges are punched with the telephone number and the amount from previously prepared statements, which will accompany the customer's bill. The charges in these cards are then balanced against previously determined control totals for billing charges; the cards are then merged with the permanent file cards. All cards are then in telephone number sequence ready for processing on the accounting machine. This process results in the customers' bills being printed, along with control totals for each classification of charges for each control unit. Once the control unit bills have been prepared and the total charges balanced, the customers, bills are processed for mailing and the billing cards prepared for storage until the next cycle. This requires a selection process with the sorter. The three permanent

181

Office Machines

cards are selected according to their card number (and separated at the same time), while the one-time-only cards are separated and destroyed. In a normal month's operation about 300,000 customers bills will be prepared requiring a total processing of more than 1,500,000 cards, of which about 100,000-200,000 will be one-time-only cards used simply to enter a charge on the customer's bill. The customer billing operation is not simple, but it does save considerable time, and it results in a reduction of the work force needed for customer billing. As with most mechanized data processing operations, however, the total number of employees soon increases because of the additional work assigned to the unit record equipment. Of special importance to the development of a common language for sequential processing of the data on an integrated basis are the tape punch attachments, which produce punched tape as a by product of the regular operations. Punched paper tape attachments or features are quite common on such standard office machines as typewriters, adding, calculating, and accounting machines. These features allow a tape to be punched of the essential data generated from operating the office machine - totals, summaries, or even the complete data, the punched tape output is compatible with standard tabulating or electronic data-processing equipment and is a direct input source for computer systems or for other machines that have tape-read devices attached and are capable of automatic operation. These paper punch features allow isolated, small firms to prepare their basic records in their usual way but also to simultaneously prepare a punched tape that is processed by service bureaus in preparing consolidated reports, billing, and similar routine office reports or summaries.

***

Chapter

12 tItI PRODUCTION CONTROL

The coordinative mechanisms are general in character and are applicable, therefore, to a wide range of industry. The particular combination of these mechanisms which may best serve the purpose will necessarily vary widely with the characteristics of the company considered, but usually there is little difficulty in selecting such a combination as will ensure management control of the several functions and departments. In certain productive companies, however, there is, in addition, a much more difficult problem, namely, that of controlling production so that the required goods shall be produced in the best and cheapest method, that it shall be of the required quality, and that it shall be produced at the required time. Since the work of practically all of the departments of a manufacturing plant, the arrangement of equipment, and the personnel of the plant are influenced to a greater or less degree by this problem, it is desirable to discuss it at some length before proceeding with detailed discussions of these other departments and functions. Some typical methods of production control will first be described, and the possibilities and limitations of their application to various kinds of companies will then be briefly discussed. In a continuous-process industry, where the raw material enters one end of the factory artdflows through it in a steady stream, the problem of production control is obviously very simple, since the

Production Control

183

path or route that the material is to follow is fixed by the natural sequence of processes, and the times of operations are fixed largely by the capacity of the machines and processes. In an intermittentprocess industry of the special-order type, where products are made only to customer's orders and where repetition of such orders is unusual, the case is very different. Here each succeeding part produced may follow a new path through the shop; the time required for each operation may not be known; and unlike the continuousprocess industry, the parts do not move automatically from machine to machine but must be so moved as occasion requires. It will be clear that unless some supervision is given to the sequence of parts, congested conditions will arise in the factory, some machines having more work than they can do and some being under loaded, and as a consequence the goods will not be produced at the time set for delivery. There are, many modifications of these extreme types of companies. One of the most common and most important of these is what may be termed the lot-intermittent type. In this type of manufacturing, standard goods are carried through the factory in lots in anticipation of sales. The delivery of goods to sales is made from a store of finished products in the stock room, and the number of machines or other products in each lot and the frequency with which manuJacturing orders are placed with the factory are governed by the quantity of goods on hand and the probable market demand. If a variety of products is manufactured and if lotmanufacturing orders for each kind of goods are infrequent, the conditions approach those of a special-order industry. If, on the other hand, only a few kinds of goods are manufactured, and if manufacturing orders for each kind of goods come at regular, frequent intervals, the conditions approach those of a continuous industry. In the majority of cases some kind of production control is required in this form of production as in the case of special-order work, and this control is usually attempted through a so-called planning department. Development of Planning Departments: The growth of the planning department is of interest. A few years ago a typical organization of a production department

184

Production Control

consisted of the superintendent, the several foremen, and a few special officers, such as a storekeeper and timekeeper. The superintendent received the formal order and instructions for the work; gave it a number, :etter, or some other distinguishing mark; and sent each foreman an order instructing him how to proceed with his part of the work, trusting to natural cooperation among the foremen to keep the correct sequence of operations so that the finished goods would be shipped in time. A record was kept of all time and material expended on the job, and the total cost of the work recorded, though, in general, detail costs were not obtained. As the necessity of more detailed costs became greater and the science of cost keeping grew, the instructions or work orders issued to the workmen were made more and more in detail for each job. As works increased in size, it became increasingly difficult for the foreman and others charged with the production to keep the proper sequence of operations on a mental and verbal basis; and when one considers the complexity of the modem shop and the immense number of small parts passing through even a fair-sized establishment, the performance of some of these superintendents and foremen seems marvellous indeed. The next step in this development was the establishment of "production departments," so-called, usually directly under the superintendent, which were intended to relieve the foremen and others of the burden of keeping the required sequence of operations. A schedule of performance, more or less complete, was laid out for each production order by the production manager and an effort was made to meet this schedule by means of "tracers" or "stock chasers" as they are sometimes called. These are clerical assistants to the production manager, usually well informed concerning the shop and the goods, who follow the work through the shop, correcting and adjusting conditions and removing difficulties. Under certain conditions satisfactory results can be obtained in this manner, and not a few of such departments are now in operation. Obviously much of the work of such simple production departments has to do with relieving difficulties after they have. occurred. True planning, however, aims to prevent difficulties fr.om

Production Control

185

occurring, and there has been a constant movement, therefore, especially in large companies, toward the development of plaRl1ing departments that can plan productive operations in advance just as the engineering department plans the structural side of the goods. Plan!ung of work may be done in one of two ways, namely, empirically or statistically. Any man highly experienced in a given line of work can easily plan a desirable sequence of operations for a given piece of work, basing his predictions on his experience and judgment, but there will be definite limitations to the accuracy of his predictions. For instance, if there are several desirable ways of performing the work, he will not, in general, be able to say which is the best way unless he or some other equally competent man has tried them all and recorded his results. Again, he may be able to assign the approximate time necessary to perform the work or the tools that are most efficient for the purpose; but, in general, unless he possesses recorded data bearing on these matters, his empirical estimates are approximate only, and his predictions useful only within the range of his experience. Where recorded data are to be had, however, the basis of prediction is much more sound; and if such data form a record of high-grade performances, they are inestimably superior to empirical estimates. The engineering and drafting department is the finest example of the separation of mental and manual processes and the prediction of results on the basis of recorded data. True, a considerable amount of the work of this department is still empirical and will remain so for many years; yet the progress that has been made is remarkable and foreshadows what may be expected to occur in the planning of manufacturing operations when a sufficient volume of data bearing on capacities of machines, forms of cutting tools, the times required for operations, etc., has been collected. Functional Foremanship: The first important attempt to solve the problem of production control was that of the late F. W. Taylor in connection with his plan of shop management commonly known as functional foremanship. Since this plan has been the basis of practically all such efforts, its most important features will be described. Mr. Taylor's typical

Production Control

186

organization, as here outlined, is particularly adapted to metalworking establishments that machine large pieces, but the principles involved are of almost universal application. Under Mr. Taylor's system the work now ordinarily performed by the foreman under the old methods is divided into several parts, or functions," each performed by a separate functional foreman or functional boss as Mr. Taylor styles him. Care is taken to separate planning functions from executive junctions, and all planning is removed, as far as possible, from the shop to the planning department. The latter then performs for the constructive side of the industry what the engineering department has long performed for the designing side of the work. In fact, the movement to do the planning of all productive processes in advance and in a separate department is analogous to the movement that formed the engineering department. It is in strict accord with the general principles of division of labour and the separation of mental and manual processes. H

In his work at the Bethlehem Steel Company, Mr. Taylor found the following subdivision and rearrangement of functions profitable:

In the planning department: 1.

The order-of-work or route clerk.

2.

The instruction-card clerk.

3.

The time and cost clerk.

In the shop: 4.

The gang boss.

5.

The speed boss.

6.

The inspector.

7.

The repair boss.

And for the entire works: 8.

The shop disciplinarian.

The follOWing is a very brief statement of the duties of these several bosses as stated by Mr. Taylor: The order-of-work or route clerk lays out the route that the piece is to follow through the several shops and the sequence of machines

Production Control

187

and men that are to operate upon it in each shop. He prepares the route sheet and from it he or his assistant makes out the work or operation orders for each man or machine operating upon it. The work order must give the order number of the job, the number of the instruction card 0, or other references that may be needed to identify it. The order-of-work or route clerk is responsible ror the sequence of work in the shop, though in some modified applications of Mr. Taylor's system both a route clerk and an order-of-work clerk are used, the first laying out the route and schedule and the second seeing to its operation and enforcement. This division would naturally come about in a large plant, but even then these two men must work in close harmony. The instruction-card clerk fills out the instruction card, which bears the same relation to the planning department that a drawing does to the drafting room. It gives all the information regarding the necessary drawings, jigs, fixtures, etc., and gives the exact sequence of detail operations that must be followed by each workman. It may give the number of cuts, the depth of each cut, the speeds and feeds, and the time that each cut and operation should take. It may also give full information regarding the piece rate, day rate, or premium on which the work is to be performed. In certain cases it is clear that it might include the information listed on the operation card just described, but usually it is more convenient to use the two cards. The time and cost cleark prepares for the instruction card the necessary instructions to the workman for the recording of time and cost of all work and for securing from the workman the proper returns for making cost and time records. The gang boss makes all preparations for getting the work to the workman, collecting the necessary jigs, drawings, etc., and sees that the work is properly set in the machine. He relieves the workman of all preliminary planning as far as placi~g the piece in working position is concerned. The work of the speed boss begins after the piece is set in the machine. He sees that the right tools are used and that the feeds and speeds are according to instructions. He also instructs the workman in the best method of doing the work.

188

Production Control

The inspector is charged with the duty of seeing that all work is up to standard in workmanship and finish. The repair boss has charge of all machines, belts, etc., and sees that they are kept in good order and repair. The shop disciplinarian is responsible for discipline and good order. He is also the peacemaker and assists in adjusting wages. He represents the disciplinary functions formerly executed by the foreman. This rearrangement of duties virtually amounts to replacing all line organization below the superintendent of production with functional organization The value of functionalization had, of course, long been recognized and applied as illustrated in the typical organization diagrams where such duties as shipping, purchasing, inspecting, and stores keeping are shown as functional duties. And these diagrams show that the movement toward functionalization of duties had long been operative in the upper part of the organization diagram. Taylor's work, therefore, completed a movement already well under way and carried functionalization to the very bottom of the diagram. It should be noted in passing that functionalized duties, such as engineering, accounting, cost finding, tool-making, purchasing, etc., make progress in that direction in proportion to the growth of their scientific background and in accordance with the general law of division of labour. Taylor's plan, therefore, is a perfectly logical extension of a movement that had been gathering force for some time but required vision and ability to demonstrate by an actual practical example. A careful consideration of the foregoing will make clear that there are no new economic principles involved in so-called scientific management but rather an extension and application of well known principles. The rearrangement of duties is essentially an application of division of labour. The combined duties of the foreman and the workman are separated into component parts, and similar parts are then reassembled under fu.nctionalized supervisors. The workman is relieved of all planning in connection with his work and can, therefore, devote all of his time and energy to actual production. The actual worker is charged only with the

Production Control

189

responsibility of the major factor of prod uction, and all minor factors are placed in the hands of specialists who guide and assist him exactly in the same way that engineering design was taken from the factory floor and centralized in the engineering department many years ago. And, as in the case of the engineering department, the functionalizing of these minor factors in an effective manner depends v~ry greatly upon the accuracy of the fundamental data available upon which to base these activities. With accurate data on the cutting of metals and with accurate recorded observations of the time required to do the operations, Taylor was able to predict where, when, and how the work was to be performed. Again, it will be obvious that with such a rearrangement of duties and such an extension of division of labour an increase in production might be expected. Such was the case in Taylor's original experiment. It is self-evident that an operator, whether doing handwork or operating a machine, will be able to do much more actual productive work when relieved of all responsibility of transporting material, finding tools and -fixtures, planning the sequence of operations, etc. This has been proved too frequently to admit of argument. It does not follow, however, that an increase of production through such means will necessarily be accompanied by lowered costs; in fact, they may be even higher than when the work is performed by simpler methods. There are several reasons why this may be so. First, as noted in Art. 51, any extension of division of labour must be accompanied by some form of coordinative influence to be successful, and Taylor's functional foremanship is no exception to this rule. The particular coordinative measureS that have been devised for this purpose are discussed fully in succeeding sections. Functional foremanship with its accompanying coordinative mechanisms is costly and unless the fillnncial gnin due to increased production exceeds the cost of these refined methods a loss in profit instead of a gain is incurred. In other words, the principle of diminishing returns holds true here as well as elsewhere. A lack of understanding of this important principle was responsible for not a few financial failures among those who first tried to apply Taylor's methods to small or mediumsized plants.

190

Production Control

Furthermore, it should be remembered that the major factor in production usually could be operated at high efficiency only if some of the minor factors operate at comparatively low efficiency. The tendency for service departments to be inefficient and the necessity of stimulating them constantly are too well known to merit discussion. Necessarily, this tendency is increased in organizations as refined as that discussed in the foregoing, which again tends.to accelerate the principle of diminishing returns. Experience has also shown that efforts to stimulate production by these means, to be successful, must be accompanied by some form of financial incentive for the worker. The worker instinctively expects greater pay for greater output, and all modem plans of administration recognize this principle. Incentive-wage systems are now very widely used; and although they vary considerably in their detail methods, basically they all rest upon the foregoing principle. Naturally, this principle, while tending to increase production and decrease unit costs, tends also to increase total labour costs. Essentials of Planning: Mr. Taylor's plan of production control has not.been widely adopted in the exact form that he used at Bethlehem. Many modified forms of this system are, however, in use, and there is a constant tendency to adopt many of his control mechanisms in various combinations to suit the circumstances. The influence of his work on the problem of planning shop operations in advance of their actual performance has been very great, and all modem planning departments are modelled more or less upon his methods. The planning of industrial operations involves four considerations, namely, what work shall be done, how the work shall be done, where the work shall be done, and, lastly, when the work shall be done. The problem of what work shall be done is one for the management and the engineering department to solve. It is assumed, therefore, that the planning department will receive full information from these sources as to the quantity to be produced; the shipping directions, if goods are to be shipped directly from production; the date, if any, on which delivery has been promised; and the necessary engineering specifications and drawings. The planning department

Production Control

191

will then be required to perform one or all of the following functions depending upon the degree of control required: 1.

Issuing all orders that are necessary for production.

2.

Routing or laying out the sequence of machines, processes, and operations that are the most desirable and efficient.

3.

Scheduling or assigning to each process and operation the time that should be required for its completion.

4.

Dispatching or starting all operations and processes at the time set and in the manner in which they have been planned and ensuring that the materials and tools required are at hand when needed.

5.

Collecting all returns and records of performance that are necessary for the work of the several
In many instances, the work of the planning department is confined to the first function, but in progressive shops the last four are rapidly becoming important and necessary parts of productive processes. Some remarkable planning departments are now in operation in which the complete schedule of operations is predicted not only as to the manner and place of each operation but also as to the time that is to be consumed. These highly developed planning departments are connected, of course, most frequently with industries involving mass production. The planning department may, and often does, include other functions. A published description of a factory where so-called scientific management has been installed lists the following men as under the planning department: shop engineer, storekeeper, cost clerk, shipping clerk, receiving clerk, and inspector, as well as several others directly engaged in planning. In a small companies it not only is feasible but may be good management to include all these activities under one department. It is, however, contrary to the elementary principles of division of labourer, which assigns as few duties as possible to either a man or a department, these duties being of a similar character as far as possible. The function of the planning department is the planning and scheduling of the work; and as factory increase in

192

Production Control

size, such dissimilar functions as inspection, cost finding, and others listed above nalurally tend to become independent departments functionalized under the factory manager, or as he is more correctly named productifJn manager. They are in reality more highly specialized functions that he formerly was expected to perform himself, and the manner of their formation will depend, to a large extent, on the size of the works and the character of the men obtainable for the several positions. On the other hand, there seems to be no good reason for making the planning department independent of the factory manager (if there be one), thus making the head of the planning department a thorn in the side of the superintendent who is charged with the responsibility for production. The planning department should be incharge of the factory manager, and the head of the planning department should be of the character of an assistant superintendent. When organized independently, as is sometimes the case, it usually results in much duplicate work and opens up an opportunity for interdepartmental bickering. Issuing Orders :

The degree of detail in which orders are issued to the factory depends largely upon the degree of refinement needed in compiling the costs of production. Production is usually initiated by the general manager's sending the factory manager a production order which is the authority for the latter to proceed with the work described in the order. If the work authorized by this order is simple in character, it may be passed by the factory manager directly to the planning department as a manufacturing order. If, however, several machines of different character are authorized by the production order, the factory manager may, after consultation with the cost accountant, divide the production order into several manufacturing orders. The planning department again may subdivide each manufacturing order into a large number of work orders or operation orders. Quite frequently a work order is issued for each operation to be performed, and all production orders, manufacturing orders, and work orders are identified by number or symbol, as-described hi Art: so that all instructions issued concerning each part can be clearly understood and all labour and material used in its

Production Control

193

production can be accurately cha-rged against it in the cost system, a cost sheet being usually opened for each machine or part so ordered and identified. When a work order is issued to a workman, instructing him to proceed with a particular operation, it is accompanied by such instruction cards, time cards, engineering data, and other information as are necessary for the work. The planning department will also issue orders on which material is to be drawn, directing the moving and transportation of material in process (if such a system is used), and orders for such tools and equipment as may be necessary.

Routing: The demand for a more systematic method of carrying the work through the shop gave rise to the practice of routing. Routing may be defined as the selection of paths or routes over which each piece is to travel in being transformed from raw material into finished goods. The object of routing is to determine the best and cheapest sequence of operations and to ensure that this sequence is followed. It will be noted that routing is automatic in continuous industries, since the plant itself is laid out with a view to passing the goods through a fixed, predetermined series of processes. In intermittent industries, however, there is sometimes a very large number of sequences that can be followed, though there is usually one series of operations that is best for any given article. The process is analogous to selecting the best railroad route from one place to another. The economic advantage of routing is based upon division of labourer. Someone must do this planning, and it demands deliberation and concentration of mind wqich the busy foreman cannot always bestow upon the problem. Routing constitutes a function that can well be separated from others wherever there is sufficient volume of business to warrant this procedure. Once a good route has been worked out and recorded, furthermore, it can be used again for other similar jobs, thus securing the advantages of recorded data. For this reason routing can often be done to advantage in the drafting room, the route being recorded on the drawings

194

Production Control

themselves. If routing is done in the drafting room, care should be taken that it is directed by someone who has accurate knowledge of factory conditions and equipment. The degree of refinement to which routing may be carried will vary with the factory and the goods. In some cases it is sufficient to designate the successive departments through which the piece in question is to pass, while, again, it may be advantageous to go further and designate the particular machine and process that is to be used. It will be obvious that successful routing requires that the route clerk must have great knowledge of the goods and of the manufacturing equipment, and he must also have readily available full knowledge of the capacity and characteristics of every macr.ine and process. It will be clear also that the engineering department, if there is one, can be of great aid in intelligent routing.

Assembly Routing: In complex products such as computer and automobiles the sequence of operations in assembling is often very important and is, therefore, carefully planned. The importance of an orderly procedure in the assembly of such goods will be clear on brief consideration, for example, of a computer or an automobile. Many of these complex constructions consist wholly or in part of an assemblage of unit assemblies or subassemblies, as they are sometimes called, each one of which is composed of a number of individual parts. Thus the engine of an automobile is assembled in the machine as a unit and not built up in place from individual parts. Obviously there is one best way of assembling these units and also of assembling them into the completed goods, and this can be accomplished only by careful routing and standardization of assembling procedure. Perhaps the best illustration of such procedure is the progressive assembiy used in assembling certain automobiles. In such an assembly the frame of the automobile is attached to one end of a travelling chain or carrier about 600 feet long and moving about 5 or 6 feet per minute. Along this chain at fixed intervals workmen or groups of workmen are stationed, each charged with the duty of attaching an individual part or unit assembly in its proper place in the machine during the time it moves

Production Control

195

past the station. Thus by the time the frame reaches the other end of the carrier a complete automobile has been assembled upon it. The sequence of assembly operations is presumably the best that can be devised, and the several component part;s are routed either directly from production or from stores, so that they arrive at the proper place in the chain of events. The assembly of component parts such as the engine is conducted in a similar manner. The problem of routing the material through the factory may have a great influence upon the design of the buildings and the arrangement of the machines. Even in extreme intermittent-process industries, such as a shipbuilding plant, great savings can be made by a logical arrangement of buildings and processes. In such companies as automobile, computer, rolling-mill, and similar massproduction plants, economical routing in the design of the factory is of greatest importance, and in purely continuous-process factories the arrangement of buildings and processes is almost entirely a problem in routing. Scheduling in General: Routing has been defined as the determination of the proper sequence of a number of operations. Scheduling is defined as the determination of the time that should be required to perform each operation and also the time necessary to perform the entire series, as routed, making allowance for all factors concerned. The analogy of the railway may again be helpful. The route shows the passenger the path that he is to pursue in passing from one point to another. The schedule gives him the time elements of his progress in passing from place to place. The problem of routing is, in general, not a difficult one, but the problem of assigning time elements to productive processes with accuracy is often very difficult and sometimes necessitates many refined data.

Scheduling, like routing, may be of three degrees of refinement, namely, 1.

Master scheduling, or the assigning of the dates on which important features of a production are to be completed.

2.

Operation scheduling, or the assigning of the total time required to do a given piece of work with a given machine or process.

"

Production Control

196

3.

Detail-operation scheduling, or the assigning of the time required to do each detail operation of a given job with a given machine or process.

These degrees of refinement may be visualized more clearly by considering the construction of a ship, the contract for which calls for delivery upon a specified date. Beginning at that date and measuring backward a series of dates may be set fixing the latest time on which important features of the work must be completed if the delivery date is to be met. The dates, therefore, for beginning the trial trip, for the completion of the installation of all machinery, for the completion of the construction of the boilers and engines, for the launching of the hull, for the arrival of steel for the boilers and hull, etc., may be set off as a master schedule for the general guidance of all concerned in the schedule of events. It will be clear also that a similar master schedule can be made for each and every large element entering into the construction of the ship. Thus a series of time elements may be laid out for all important parts of the engines so that the base plate or bed, the columns, cylinders, cranks, etc., shall all arrive at the assembly floor at the proper time and so that the date of completion of the engine will conform to that set by the controlling master schedule. It is an adaptation of the Gantt chart in which horizontal distances are used to measure times of performance. The important steps into which the work was analyzed are numbered on the lefthand side from 1 to 30. The time by weeks is indicated along the top of the diagram. As in the case of the ship, a controlling date, May 7, was fixed, on which the building was to be turned over to the owner. The schedule was then marked back from this date, the time for each element being so set that if completed on scheduled time the date of delivery would be met. The heavy horizontal lines indicate the scheduled time; the heavy broken lines show whether the work is up to schedule, behind schedule, or ahead of schedule. In column 3 a cross indicates any item that is not up to schedule, and in column 4 t~e heavy horizontal lines indicate the percetitage of each item that is completed. When this heavy line extends entirely across the column, it signifies that this particular item is completed and needs no further attention. The schedule is brought up to date each

Production Control

197

week by a field engineer, and a copy is sent to the main office, thus permitting the manager of construction to make suggestions or modify the schedule. Not the least value of such a schedule is the fact that it records clearly the progress and delays attendant upon the venture, and this is of great value in estimating future undertakings. Consider next a machine part such as one of the eJ1gine cylinders, which is finished by a series of operations such as boring, planing, milling, drilling, etc., similar to the list of operations. Obviously time elements can be assigned to each of these operations which, if they are fulfilled, will ensure that the cylinder will be produced at the proper time. This would be operation scheduling. Sometimes routing and operation scheduling are both listed upon the same sheet. Such sheets are sometimes called planned-operation sheets, but such planning is simple operation scheduling and should be clearly distinguished from detail-operation scheduling, which is to be described. Detail-operation scheduling is the assigning of time elements to each detail operation, which is usually known as an instruction sheet or instruction card. This is the extreme of refinement in scheduling; and as will be seen, a considerable amount of data on the characteristics of the machinery of production and of the time required to do basic operatiOns must be available in classified form before such refined prediction of time elements is attempted. These required data and the methods of securing them are fully discussed in a succeeding section. Master Schedules-Control Boards:

The master schedule is based naturally upon the sales orders or the prospective sales requirements. Such schedules can be made up intelligently, therefore, only on a clear understanding of such requirements and the volume of work already in process. General policies and the necessity of keeping all divisions of the plant employed as far as possible will, therefore, enter into its compilation. Usually the making of a master schedule for a single piece of goods, however complex it may be in itself, is not a difficult matter; but where many production orders are to be scheduled more or It'S5

198

Production Control

simultaneously, the problem may be very difficult. It should be noted that in purely continuous-process industries routing and scheduling are automatically performed by the machinery of production, and the nearer an industry approaches to this type the simpler are the problems of routing and scheduling. In a factory manufacturing largely on specific sales orders there will be jobs like that of the ship described in the preceding article where there is ample time to meet the delivery date by following the regular procedure laid down. But it may be that one or more of these orders may be coincident as to time in their main features; and unless the master schedule is carefully compiled, congested conditions, on the one hand, and idle machines, on the other, are likely to result. Then again, repair jobs or jobs that for other reasons must be rushed through as quickly as possible may make it necessary to modify the master schedule so as to prevent congestion and obtain the desired results. It may be also that the plant produces lines of goods for stock in antic~pation of sales orders. Orders for such goods can be issued at such times as will help to keep the schedule balanced. The problem of the master schedule in plants that manufacture entirely for stock is not markedly different. More consideration must be given, of course, to market conditions and prospective sales, and questions of general policy are more dominant in compiling the master schedule. This is particularly true where production in anticipation of sales ties up a large amount of capital in materials and labour. The size, sequence, and character of the lots of parts or complete machines that are scheduled for production must be given very careful consideration, especially as the schedules for this type of production must usually be determined months in advance of completion of the goods. A master schedule, therefore, should not be considered as a fixed procedure that admits of no change. Constant minor changes are usually necessary to accommodate new conditions as they arise, and sometimes major changes are imperative because of unforeseen troubles. In many cases the master schedule consists simply of a limited number of important dates, the problem of directing the

Production Control

199

production so that the several parts will be completed at the proper time being left to the superintendent and foreman to work out as best they can. The author has witnessed some very extensive and important contracts carried through to successful completion in this simple manner. In most advanced modem practice, however, it is not uncommon to chart all important events for all work on the master schedule, thus making some form of control board. The Gantt chart is one of the most effective forms of such graphical schedules. On this chart, as has been noted, horizontal lines represent time, and hence a large number of desired events can be scheduled on a comparatively small space and in a form that makes them easy to visualize. On GenU chart the date for starting the several operations, the amount scheduled per week, and the total amount scheduled to date are indicated by the key at the right hand of the chart. The heavy black lines indicate the proportion of work actually completed. A similar diagram showing the work ahead for various machines and processes and known as a machineload chart is often very useful in routing and scheduling. It will be obvious that the idea on which the Gantt chart is based is capable of wide application. The most interesting and most complete application of the principle to control-board methods is that devised by Major George Babcock for the Franklin Motor Company. On this board a great degree of flexibility was attained by movable markers placed upon the horizontal elements that indicate time. It was, in fact, a mechanical Gantt chart.

At the left-hand side are listed vertically, first the machines in Department first and below these the machines in next Department. At the top of the picture, part way down, between the two lists of machines, and at the bottom of the picture, are identical time scales showing consecutive time by days divided into 8 hours each. A traveller, the frame of which is back of the board, carries two white strings set 8 hours, or one working day, apart. They mark the events that are scheduled for one day in both departments. Opposite each machine number there is a metal holder shown clearly on the righthand side, into which can be placed paper strips that indicate the rate at which it is expected the several operations will be performed.

200

Production Control

These paper strips are laid off into hourly divisions of the same length as those in the calendar strips at the top and bottom of the board. The half hours are indicated by short lines, and every fifth hour is marked by a longer division line to facilitate calculations. Each paper slip also carries a record of the identifying symbol, the number of operations, the manufacturing order number, and the operation number. Thus, opposite the first 10 x 24 Norton grinder. The production slip indicates that at the beginning of the fifth hour on the last working day in January production was started on part No. x-So The number of parts ordered is 1250; the production order number is 2626; and the number of the required operation is 20. It is expected that this work will be completed by the end of the sixth hour on specific day. The strings indicate the work that is to be performed on specific day, provided the schedule has been adhered to and all operations are up to schedule. All deviations from schedule are reported by the dispatchers on the machine floors, and the board is corrected by sliding the slips forward or backward as may be necessary. Small riders of various colours are clipped over the control slips to indicate variations in schedule caused by such troubles as breakdown of machines, lack of material, etc. Some of these clips may be seen on the picture. The actual control board from which this model was made is long enough to control three months' work, at the end of which time the board is reset from the left end. The hourly division lines are machine printed, and the material for the control slips is furnished in rolls, the schedule operator simply cutting off the desired length. It will be noted that when all of the machines are running, the

board opposite the lists of machines will be completely filled with control slips. On the model board a considerable amOlmt of machine idleness is shown, and this is a valuable characteristic of such control boards, since they show at a glance the degree of activity in the plant. Again, the total hours of work scheduled for any day is an index of the number of workmen needed at any time, and this assists planning in advance for the working force. Thus for specific day only 62 man-hours of work are scheduled for the first group of machines, assuming one man to each machine, whereas the total

Production Control

201

capacity of the group is 128 man-hours on the same assumption. The department is therefore working at less than half capacity. It will be obvious that the general principles are capable of wide variation. A most interesting variation that has been attempted is to schedule only the jobs that fall behind or are delayed from one cause or another. In a plant having, normally, a steady flow of work, there would be a great saving in scheduling only the exceptional jobs that are thus out of line, so to speak. This would be an application of management by exception, to which further reference is made elsewhere. Dispatching:

The most important functions in dispatching are 1.

The procurement for the workman of all tools and fixtures necessary for each operation in advance of the time when they will be needed.

2.

Initiating the work by giving the workman all work orders, instructions, drawings, etc., at the time when work should begin.

3.

Recording the time of starting and completing each operation.

4.

Moving the work after completion to the next operation or process listed upon the route sheet.

5.

Tracing the progress of all production and making adjustments in the schedule to accommodate necessary changes.

The work of dispatching may be made clearer by considering one of the methods in common use for this work. All of these methods are patterned more or less after Taylor's original plan. An order box containing not fewer than three compartments is placed near each workman. The first compartment holds the work order, instruction card, drawings, etc., for the work in process; the second compartment contains similar instructions, etc., for the next job for which the necessary tools, jigs, and fixtures will be collected by the time that work is to begin upon it. The third compartment may be used to hold instructions for future work, the sequence of which has not as

202

Production Control

yet been determined. In the offices of the planning department is placed a planning or control board as it is usually named, made up of sets of compartments that are duplicates of those in the shop, each compartment containing instructions and orders that are, in general, duplicates of those in the corresponding compartments at the machine. When any change is made on the planning board by moving instruction material from one compartment to another, a corresponding change is made in the compartments at the machine so that the planning board always shows the exact amount of work before each man or machine. The order-of-work clerk keeps fully informed of the desired dates of delivery, as outlined by the schedule, and of any changes that may be made in these dates. By means of the planning board he can control fully the sequence of operations and make close estimates of the time required to complete work in process or new work on which such an estimate is desired. The moving of all material to and from machines and processes is usually in charge of a centralized transportation service, and the term move man working under a move order designates the individual who performs this function. Sometimes this service also includes the procurement of tools, fixtures, etc., as in the case of Mr. Taylor's "gang boss," but again there may be a special messenger service for this purpose operated by the dispatch clerk at the departmental board. There must also be a special messenger service for synchronizing the central board and the departmental board, adjusting difficulties, and tracing job orders that may need special attention.

***

Chapter

13

--

TYPICAL PRODUCTION CONTROL PROCEDURE The complex relations may be made clear by considering a typical production-control procedure which was devised by Professor John R. Bangs, of Cornell University, for this special purpose. In this system all office functions are shown above the heavy horizontal line and all shop functions are placed below it. Full lines indicate the paths of orders and instructions moving downward; dotted lines indicate the paths of records and returns moving upward. Let it be assumed that a sales order has been received from the sales department. This order will first be approved by the credit department under the controller or corresponding official. If so approved it will pass to the factory manager who will issue such production orders as may be necessary. In routine work this is frequently accomplished as indicated in the system, the approved sales order serving as a production order, copies being sent to the superintendent of the planning department and to the engineering department. The superintendent of planning will now divide the work called for by the production order into such items as may seem desirable and will issue a manufacturing order for each item. He will also lay out the master schedule for the whole work and fix the important dates of delivery, etc., for each item. All of this information will then

204

Typical Production Control Procedure

be forwarded to the route clerk. The engineering department will prepare or furnish all drawings, dawning lists specification and bills of material. The drawings and drawing lists will also identify each part by number, All of these documents will also be forwarded to the route clerk. The route clerk will now layout the route sheet for each machine part or lot of parts to be produced. Or if a combined route and schedule sheet is in use, he will prepare those sheets, calling upon the time-study department for any information that he may need regarding the total time required for the several operations and with due regard to the work already scheduled upon the planning board. He will then forward the route sheets, drawings, specifications, etc., to the route-file clerk. . The route-file clerk will then proceed as follows for each operation called for upon the planned-operation sheets: First, if material is to be drawn from stores for the operation, he will inquire of the balanceof-stores clerk if the required material is on hand. If it is on hand, the balance-of-stores clerk reserves the necessary amount and deducts the material so apportioned from available stores. If the material required is not on hand, the balance-of-stores clerk will make a requisition upon the purchasing department which will purchase the material and have it on hand when needed, the entire transaction being reported back to the route-file clerk. The route-file clerk will now write all orders for issuing materials from stores of the necessary move order if the work is to be brought from some other machine. He will make out the necessary orders for procuring tools and equipment and for the identification tags that are to be attached to the work and move with it; and lastly he will make out the operation orders and the instructions to the inspector concerning the times for inspection. For convenience, the operation order, the identification tag, the move order, etc., that pertam to each operation may be placed together in an envelope sometimes called a job or operation envelope, and these with the route sheets, or plannedoperation sheets, the draWings, and other general directions pertaining to the work scheduled may all be placed in a larger

Typical Production Control Procedure

205

envelope or container known as a route file and forwarded to the time-study department. Here the instruction-card clerk will furnish an instruction card for each operation if such a card is to be used, and the rate-setting clerk will furnish the proper time card, piecework or bonus card as may be needed, each of these being placed in the operation envelope to which they belong. The relation of these several documents to each other may be more clearly understood which shows these relations completely for a single manufacturing order and which was devised by Professor John R. Bangs for this purpose. The order-of-work clerk has charge of the planning board and correlates it with the several departmental dispatch boards. When he receives the route file for a given machine or goods, he retains the route sheets or planned-operation lists, and he assigns each operation to be performed to the machine of production center for which it has been routed, by removing the duplicate work order and other duplicate documents necessary for complete identification and control of the operation from the operation envelope and placing them on the planning board, upon the hooks, or in the pockets controlling the particular machine to which the work is assigned. The operation envelope, with its remaining duplicate contents, is placed in corresponding position upon the departmental dispatch board controlling the production center or process to which the work is assigned. He will do this for each operation for which the route file contains operation envelopes, placing them so that the work orders are in the sequence called for by the scheduled time of performance. Let it be assumed that the first of these machines or processes to which work has been so assigned and let it be assumed, furthermore, that there is plenty of work ahead of it so that this particular work order and its related instructions in the operation envelope are placed in proper sequence in the upper 01; jobs-ahead pocket of the planning board. In due process of time the er\.velope will be advanced to the second or next-job pocket, corresponding changes, of course, being made upon the departmental dispatch bO<;lrd. When the work order has been advanced to this position, the dispatch clerk takes the material-issue order from the operation

206

Typical Production Control Procedure

envelope, if material is to be drawn from stores, and also the identification tags that are to be fastened to the work bearing the identification numbers, etc., and gives them to the move man. The move man, with this authority, draws the material, tags it, and moves it to the machine. When this is completed, he signs the material-issues order and returns it to the stores clerk. The stores clerk, upon the delivery of the material, corrects his bin-tag records and forwards the material-issues order to the balance-of-stores clerk, who corrects his balance-of-stores records, prices the material-issue order, and forwards it to the cost department where it is charged up against the cost of the production order. If no material is to be drawn from stores but is to be moved from some other machine, the same procedure applies except that in this case the stores are not involved. The dispatch clerk also issues the equipment orders to the move man, who, with this as authority, procures all special tools and appliances and brings them to the machine in advance of the beginning of operations. Let it now be assumed that the operator on machine No. 50 has finished the job in process. He takes his operation order, instruction card, time card, etc., to the dispatch station and returns them to the dispatch clerk who stamps the time upon the time card. The dispatch clerk now takes the duplicate documents pertaining to the work just completed from the work-in-process pocket and advances the corresponding documents of the job next in order to that position. He stamps the time upon the time card in this new set and gives it to the workman with the work order, instruction card, etc., for the new operation. The workman then returns to his machine and starts the new operation for which complete preparation has been made. The dispatch clerk also issues the new inspection orders to the inspector. The move man takes the work just completed on machine No. 50 to the next machine listed upon the route, and returns all tools and fixtures to the tool storage. The dispatch clerk returns all work orders, drawings, drawing lists, etc., to the order-of-work clerk, who checks the completed operation on the planned-operation list and returns the drawings, instruction cards, etc., to the engineering department. The time cards are sent to the controller's department, where they are first checked against the attendance-board record or

Typical Production Control Procedure

207

time-clock record, depending upon which is in use, and then used as a basis for the pay roll. They are then forwarded to the cost department where, with the material issues, they form the basis of production costs. In recent years a number of control boards, card index systems,

etc., have appeared, many of which are helpful in production control and similar problems. It is fitted to carry three sets of control data for each machine .. It is built in vertical sections so that it can be extended as desired. It is a mechanical Gantt chart. At the left is the "visible index" which lists and identifies the items that are to be controlled. Each indexed item aligns with a double row of small holes spaced five to the inch. At the top is placed an adjustable calendar. Vertical lines from top to bottom indicate the dates of the several items being controlled. At the right of each index pocket a white string carrying a peg can be stretched horizontally across the board, the peg holding the string to the desired length. This string is wound up automatically by a spring inside the board. When extended it makes a white band across the board. Coloured pegs of various shape1?and colours may be placed in the adjoining row of holes to indicate various factors of the control. This board can be used for many purposes such as inventory control, sales progress,

etc. Modification and Adaptation:

The foregoing discussion describes a complete plan of production control based on Taylor's methods and typical of a number of such plans now in actual use. In this discussion an effort has been made to define and describe the principal functions in such a plan and to illustrate the primary documents connected with each function. Thus the moving of material is defined as a separate function under the move man, so-called, and the move order is the fundamental order connected with that function. It will be obvious, however, that there is an endless number of pOSSible modifications, abbreviations, and adaptations of these general principles, and many such are in actual use, the particular combination of basic functions used and the method of their combination varying widely with the character of the enterprise

208

Typical Production Control Procedure

and the degree of control desired. In these modifications and <\daptations several functions may be performed by one man and his assistants, and in a similar manner the basic documents may be combined. An example of such combination is purposely where both routing and scheduling are listed upon the same sheet. A combination operation order and bonus time card is not unusual. A not unusual modification is one where routing and scheduling are fairly complete but dispatching is left largely to the foremen with the aid of follow-up men or tracers, as they are often called, whose sole duty it is to keep track of the several orders and to assist the foreman in removing any obstacles that may stand in the way of fulfilling the schedule. There are two methods of organizing such a force of tracers. In the first method every manufacturing order is assigned to some one man and his assistants, who follow the order through production whether there are delays or not. If delays do occur, the tracers endeavor to remove the difficulties that delay the schedule, through conference with foremen and other officials. In large plants a tracer or group of tracers is visually given charge of a particular class of production, thus specializing their efforts. The second method is to tum over to the tracers only those jobs which are behind their schedule. The source of information on this point is usually the foreman or the progress report if such a report is compiled. This method, of course, requires fewer tracers than the first and is, therefore, cheaper, but it is not so thorough. The choice of methods will depend somewhat upon circumstances and upon the degree of refinement in routing and scheduling. If the routing and scheduling are poorly done, the tracing must be correspondingly searching if schedules are to be kept. Tracing is greatly facilitated by conferences among the tracing staff and also conferences with the foreman and others charged with the problems of production. Requirements for Production Control: It should be noted that the degree of refinement possible in production control depends upon the degree of refinement with

Typical Production Control Procedure

209

which route sheets, operation sheets, and instruction cards can be compiled and upon the degree to which the several departments are organized to fulfil the predicted performances. In general, good production control for metalworking establishments requires that the following information be available in convenient form and that following specified conditions exist in the plant: 1.

Complete detailed drawings and other engineering information.

2.

Complete information regarding special tools, such as jigs and fixtures, whether existent or to be provided.

3.

Complete information on times and costs of previous performances.

4.

Accurate up-to-date information regarding the stores and finished stock that are to be used,

5. 6.

Exact knowledge of the progress of the work in process. Complete tabulated data on power, speeds, and feeds of all machines.

7.

Complete data, as far as can be obtained, on the most effective forms of cutting tools and the best combinations of speeds, feeds, and depth of cuts for the metal to be machined.

8.

Records of the best performances on similar work with best combination of tools, feeds, and speeds. And to ensure the attainment of the performance predicted on the instruction card, there must be

9.

Careful instruction of the workmen by the speed boss or some similar person.

10. Careful following up and correction of the shop schedule. 11. Careful inspection of all tools and appliances to make sure that they are up to standard conditions. 12. A financial incentive that will enlist the interest of the workman. Brief reflection will show that similar conditions and requirements apply to other forms of industry, the principles being capable of wide extension.

210

Typical Production Control Procedure

Of these requirements several are now fairly well met in many modern metalworking shops. Thus (1) presupposes a first-class engineering and designing department; (2) a well-developed toolroom; (3) a first-class cost system; (4) an accurate continuousinventory system, all of which have reached a high state of development in many plants. The remaining requirements however, are in a rudimentary stage in many shops, and it may be of advantage to discuss them briefly. Thus (5) presupposes an accurate knowledge of the progress of work such as is obtained only by the dispatching methods. Data on Machines: It is evident that before the instruction-card man can intelligently instruct the workman regarding the size of cuts and feeds and speeds to be used, very complete data must be compiled bearing on the cutting power and the speeds and feeds or similar data obtainable with each machine. This information is not available in many shops and must be collected. It is also evident that this would be much simplified if all machines of the same kind were made along standard lines. At present a machine of given nominal size made by any given manufacturer is usually very different in its characteristics from those of rival makers. These new methods of control will undoubtedly have an effect tending to standardize tools of all kinds.

Industrial Data-The Art of Cutting Metal: It would most naturally be supposed that an experienced,

skilled workman would know more than anyone else regarding the best shapes of cutting tools and most efficient combinations of feeds and speeds for the work of his particular calling. In simple trades these or corresponding data may be easily obtained, but, in general, the information possessed by the mechanic is empirical and based on inherited practice that is never questioned by him. All trades and calling abound in practices that are transmitted downward with almost superstitious exactness and with little or no thought as to whether a better way can be found. This is very well instanced in the case of cutting of metals. Here (according to F. W. Taylor) there are 12 principal variables involved, and it is evident that no man

211

Typical Production Control Procedure

can carry in his head the best combination for any given case. Actual experience has shown this to be so and has demonstrated that the best combination of these variables can be found much more accurately by mathematical analysis than by the best empirical knowledge. This problem illustrates the complexity of what may appear to be simple processes. A considerable amount of general information on this subject has been collected from time to time, but the first comprehensive attempt to solve this problem was that made by F. W. Taylor and recorded in full in the Transactions of the American Society of Mechanical Engineers, Vol. 28,1907. Mr. Taylor's experimental work and the laws that he deduced therefrom were reduced to mathematical expressions by him and his assistants. The complexity of the problem will be appreciated when it is considered that no less than 12 variables are involved. By means of very ingenious slide rules, however, Carl G. Barth succeeded in making these expressions usable, and with these slide rules the most efficient combinations of speeds and feeds are quickly obtainable. These slide rules are made in several forms and for different machines, and any extended discussion of them is beyond the limits of this book; their general characteristics. In this slide rule, the parts A and B are movable and slide endwise relative to the main body of the rule and to each other. The upper scale shows the cutting speeds, and next to it is a scale that indicates the hardness of the material, in this case steel, by a hardness class number. The lower edge of the upper slide carries a scale that indicates the feed in inches. The upper edge of the lower slide carries a scale that indicates the depth of cut in inches, while the lower edge carries a small scale that indicates various sizes of tools. Adjoining this scale upon the fixed part of the rule is another short scale indicating the cutting life" of the tool. As the rule is set it shows that a 3/ 4-inch tool of standard form will cut well f()r 20 minutes when the depth of cut is 3/16 inch and the feed 1/16 inch on steel of a hardness number of 13 and a speed of 60 feet per minute. If the steel is of No. 10 hardness, the cutting speed may be 80 feet per minute, etc. U

Tabulated data on cutting feeds and speeds for various machines drawn from Taylor's work and elsewhere are to be found

212

Typical Production Control Procedure

in Kent's "Mechanical Engineers' Hand book" and also in Mark's "Mechanical Engineers' Handbook." Taylor's work did not cover all kinds of metals, and it has been very greatly supplemented by more recent experimental work. There is a vast amount of work to be done in other industries before similar data will be common In these other lines of work. Records of Performance: What has been said of the average worker's lack of know ledge of industrial processes is even more true of his lack of exactness as to the time required to do a given piece of work and of the best procedure in doing it. Since this item is of importance and requires a somewhat lengthy discussion it is made the subject of the succeeding chapter. Methods of Ensuring Performance: It is clear that if the standard performances are based on records somewhat lower even than the best record, they will be beyond the attainment of many of the less skilled workers. It is clear, also, that 'if the output of the factory is raised to these standard, in general, one of two courses must be pursued. Either the less skilled men must be eliminated and their places filled with better men, or they must be educated and taught how to raise their performance to the standard. The latter method is, of course, the more humane and in the long run will be the more effective. H. L. Gantt was the first, the author believes, to appreciate fully the opportunities of this field, and his work and writings on this phase of shop management form a very valuable addition to the literature of general industrial education. It is also self-evident that if the planning department is to predict performances that can be successfully executed, all machines and tools must be in the first-class condition that the planner must presume them to be. For this reason the inspection, care, and repair of all productive apparatus should, if possible, be under one man whose business it is to see to these matters and nothing else. Such a man can earn his salary even in a comparatively small shop. Under such a system many costly delays can be obviated by pre-inspection and repair, and the same principle applies to apparatus in general.

Typical Production Control Procedure

213

And last, and by no means least, if the worker is to raise his output to a standard higher than he has been accustomed to, he must receive extra compensation for his extra effort. Otherwise he will not make the effort. It has been noted previously that the worker is usually skeptical regarding the effect of increased output. It is useless to point out to him that increased output will tend to help him because of the ultimate good flowing from abundant production. The reasoning is usually beyond him, and the only incentive that will move him is an immediate gain. All efforts to increase production by the methods described in the foregoing paragraphs usually are, and in fact must be, operated in connection with some method of rewarding labour that gives increased compensation for increased effort. Collecting and Recording of Data: The last function of the planning department is the collection of returns and records of performance. The planning department does not, of course, collect all the returns. It does, however, record all times of beginning and completing work and all details of time expended upon direct production, which form one of the factors in production costs. All progress reports and all reports as to idle equipment and spoiled work are compiled in this department. If special studies of productive operations, such as time study and motion study, are attempted, they are usually conducted by the standards department and made available for its use. Limitations: The foregoing is a very brief account of the more important tendencies in the planning of factory operations as they apply particularly to metalworking plants. It will be obvious that the principles involved can be and have been applied to other forms of production where information comparable to that listed in Art. 128 can be obtained. It should be noted that functional foremanship and similar methods are in no way connected with any particular form of wage system, nor do the methods discussed in this chapter, taken singly or collectively, constitute a complete philosophy or scheme of management that will be best for all cases. The combination and arrangement that will be best to use will

214

Typical Production Control Procedure

necessarily, vary with the conditions, and what may be good for one place would not apply at all in another. These methods, however, are excellent illustrations of the separation of mental and manual processes and the use of division of labour and transfer of skill. The strong coordinative influences necessary for such forms of organization are found in the instruction card and route card and the incentive of extra compensation for extra effort. Some very complete applications of these methods have been made in this country, though, as yet, few complete accounts of such applications have appeared. It should be noted, also, that these methods are, for the most part, refined extensions of old principles. Some of them are efforts to apply the scientific method to the measurement of human effort and aim to do for the field of management what engineering research has already done for the designing department. How far they can be considered to be scientific is a debated question. Mr. Taylor and many of his followers maintain that these methods can be considered very scientific. Others as strongly insist that the personal equation enters into these methods so greatly as to "make accurate and scientific results impossible. Clearly these methods do touch the human side of industry very closely. Mr. Gilbreth said that they are closely connected with experience, skill, contentment, training, habit, fatigue, and other personal matters. A resume of these debated points of view can be made more intelligently after a consideration of other industrial problems, and will, therefore, be deferred to a later chapter.

Objection is often made, particularly by managers of the older type, to the introduction of any such system as described in this and the preceding chapter on the ground that it adds to the cost of production. This may often seem to be true, as most of the men employed in planning and carrying the work through the shop do not work directly upon the goods. There is no doubt, furthermore, that a useless and costly system is sometimes installed where the conditions do not warrant, and in such cases the cost of the goods is necessarily raised. There is no virtue in system of any kind unless it is installed intelligently and with a clear idea of the results that it is desired to obtain. Usually there is no difficulty in deciding how far it is economical to go in providing system to collect valuable information, as in cost

Typical Production Control Procedure

215

systems or in a system for facilitating the transmission and use of information that will hasten operations and thereby increase the efficiency of productive processes already existing, but it is not always easy to decide such questions when they involve the separation of productive processes into mental and manual constituents. Functional foremanship, for instance, is based on a somewhat different reasoning from that underlying a cost system. A cost system is valuable no matter how large or small the shop may be, although its characteristics might vary with the size of the shop. But all extensions of the principle of division of labour that involve separation of mental and manual processes and transfer of skill necessarily involve a reduction in the amount of time and labour actually spent upon the work and an increase in the amount of planning or indirect labour expended upon it. Whether or not such a rearrangement of duties will result in netting a greater output and reduced cost will depend on the quantity to be made and the character of the work, and it is very easy to over systematize unless these conditions are fully understood. This statement is fully borne out by the number of industrial plants that have introduced quite complete systems of production control and afterward either have abandoned these systems or have greatly modified them, retaining only those features which were of real economic value. It cannot be disputed, however, that these principles do result in increased output and decreased cost when properly applied, and the manager who does not use them as far as the limitations of his case will allow, simply because he does not believe in system of any kind, is~linding himself to his opportunities.

Management by Exceptions: In general the aim to visualize and control all details of the work in hand, and therein lies the danger of over systematization and possible loss therefrom. The thoughtful manager will therefore seek togicallimits for his procedure. One of the most effective methods of limiting managerial system is by the so-called principle of exceptions, by which the manager concentrates his attention "solely upon those executive matters which vary from routine plan or standard." This idea runs like a thread throughout the entire field of organization, particularly wherever standards of any kind

216

Typical Production Control Procedure

have been set, deviations from which can be noted and reported. Thus it is not necessary to report to the general manager all of the details of the operation of the power plant so long as its performance is up to standard, whel~as it is highly important to report the occasional deviation of performance from the standard. If the costs of all products are not greater than the standard costs that have been set, it is clearly a waste of the manager's time to go over all of the cost details. But when costs exceed the expectations, the principle of exception would naturally be applied through a special cost report. And so in scheduling work through the plant it may not be necessary to layout the progress of every shop order but it may be sufficient to post only those orders which are behind their schedule or are irregular. Thus in manufacturing that approaches continuous production or where the production orders are comparatively few in number and where the execution of each requires a considerable period of time, it may be necessary to schedule only those which fall behind thrdugh one cause or another. Mr. C. D. Hart of the Western Electric Company has thus successfully used the exception principle in manufacturing telephone cables, employing a modified Gantt chart. The principle is of broad application, and the thoughtful administrator will give it careful consideration in organizing his procedure. As Mr. F. W. Taylor so truthfully remarked when discussing this principle: Under the exception principle, the manager should receive only condensed, summarized, and invariably comparative reports, covering, however, all of the elements entering into the ~anagement, and even these summaries should all be carefully gone over by an assistant before they reach the manager and have all of the exceptions to past averages or to the standards pointed out, both the especially good and especially bad exceptions, thus giving him in a few minutes a full view of progress that is being made or the reverse and living him free to consider the broad lines of policy and to study the character and fitness of important men under him .

•••

Chapter

14

**

DECISION·MAKING

FRAMEWORK FOR EXPORT OPERATION In the long run, the basic motivation revolves around the profit that a company can obtain by getting involved in export business. Conceptually, profit is the result of simultaneous interaction of a number of key variables. These are: cost, volume and price. These variables in tum are influenced by other economic forces. For example, price is the result of the extent of competition, costs are a function of the level of the efficiency of the production unit and the volume depends on the behaviour of the market, viz., whether it is expanding, stagnant or declining. The interaction process determining the ultimate profitability is shown in the chart below: It, therefore, becomes evident that whenever these variables change, the rate of profitability will also change. For example, a change in the production and distribution costs in the absence of any corresponding change in the price will result in a decline in profitability. Or, costs remaining the same, if prices have to be t:,equced becauSe of increased competition, the amount of profit will again record a decline. The same is true of a change in volume in the absence of an offsetting change in prices.

Decision-Making Framework for Export Operation

218

Interaction Chart Profit

I Price

Competition

Minus

Cost

Efficieny

Times

Volume

Size of Market

The basic decision which a company will have to take when it decides to embark on export business relates to whether it will essentially be operating as a domestic company or international business will form an integral part of the total operations of the company. For a new-comer most probably the decision will be in favour of domestic operations and embarking on export business only when it suits his convenience. In such situations, corporate decisions will be made primarily on the basis of domestic considerations. The company may decide to enter into export contracts only when there is an underutilized capacity. The company may decide for export business if the relative profitability from export operations is higher than the corresponding rate from domestic business. In such a case, there will have to be a trade off between the total quantity to be sold in the domestic market and the quantity to be sold in the export markets. Production capacity will be increased only, when a change in the domestic demand necessitates an increase in installed capacity. For a company which looks at the world as its market, it will, however, take decisions on new investments based on the total appreciation of the demand for its (company's) products originating from all the markets. In this situation, international business becomes as important a decision parameter as domestic considerations.

219

Decision-Making Framework for Export Operation

The factors which a company will have to take into account while accepting foreign orders and for the evaluation of their profitability will vary from one situation to another. Relative profitability of a series of orders might be different even when prices quoted are the same. This might happen because of the incidence on costs as a result of a change in the volume of production in the short run. The mechanism of evaluation of export orders on corporate profitability is illustrated below by taking an example. Example 1 :

Let us consider an Indian export company M/ s ABC Co. Ltd., which is manufacturing mango jelly. The production capacity of the company is 10,000 dozens of bottles per annum. The company is at the moment manufacturing 9,000 dozens of bottles and its product is being sold at Rs. 72 per dozen in the· domestic market. The profit and loss statement of the company is given in Table 1. TABLE 1 : Present Profit and Less Statement of ABC Co. I.

Gross Sales 9,000 doz. @ Rs. 72 per doz.

II a.

Direct production costs Materials Labour Consumables

Rs. 6,48,900 Rs. 2,16,000 Rs. 1,62,000 Rs.27,OOO Rs. 4,05,000

If b.

II c.

Indirect production costs Indirect labour Other Indirect expenses Selling and distribution costs Selling & distribution costs Salaries of sales staff

Rs. 15,000 Rs. 10,000

RS.25,009

Rs.45,ooO Rs.55,OOO Rs. 1,00,000

II d.

Administrative overhead Staff salaries Office expenses

Rs.36,OOO Rs. 14,000 Rs.50,OOO

II.

Total costs

III.

Profit as % of Gross Sales

Rs. 5,80,000 Rs.68,OOO 10.46

220

Decision-Making Framework for Export Operation

Let us assume that the company has got an export order for 2,000 dozens of bottles. The price to be received is Rs. 66 per dozen f.o.c>. Mumbai. The company can execute the order by utilizing the underutilized capacity to the extent of 1,000 dozens of bottles and also produce the additional 1,000 dozens without increasing its capacity. The profitability of the export order is calculated in Table 2. TABLE 2 : Evaluation of the Export Order Export Order - 2,000 doz. @ Rs. 66 per doz. f.o.b. (Mumbai)

I.

Gross Sales Income 2,000 doz. @Rs. 66

Rs. 1,32,000

Less Agency commission @ 5% on f.o.b. value

Rs.6,600

Net Sales Income

11 a.

Cost of Manufacture Material Labour Consumables

Rs. 1,25,400

Marginal cost per unit

Total variable costs

2.00 1.50 0.25

Rs.48,000 Rs.36,000 Rs. 6,000 Rs.90,000

II b.

Add!. Selling Expenses

Rs.2,000

Add!. distribution costs (from factory to Bombay port)

Rs.3,000 Rs.

5,000

II c.

Total Additional costs

Rs.95,000

III.

Additional profit

Rs.30,400

as % of gross sales

23.03

It is evident from Table 2 that the profit that can be made by accepting the export order is of a very high magnitude. This is essentially due to the fact that, first, the capacity will be fully utilized and secondly, 10 per cent additional production in excess of the installed capacity does not result in any cost escalation. It will, therefore, be advisable for the company to accept this particular order.

Let us further assume that the overseas party which first gave the order to the ABC Limited is very much satisfied with the quality of the product and is willing to increase the volume of the order to

Decision-Making Framework for Export Operation

221

4,000 dozens. The ABC Limited will, therefore, have to recalculate the profitability of the additional 2,000 dozen order. It is to be remembered that its capacity utilisation is already over extended and therefore unless new investment is made, any increase in production will result in increase in costs in the short run. Let us assume that this additional 2,000 dozens can be manufactured by paying overtime to the existing labour force. Materials will not pose any problem as they are available in the domestic market at the going market price. Apart from the over times payment which will be at higher than the normal wage rate, the company will also need to appoint a man who will exclusively devote his attention to the execution of the export order. This will be necessary because the total export business will now constitute a substantial proportion of the company's sales. There will, therefore, be an increase in the fixed cost element to the extent of annual salary to be paid to the new appointee. The 'company will also need more working capital to finance the production and sale of this additional amount. Let us assume that company will need additional working capital to the extent of eight weeks' sales turnover and it wiII have to pay interest at the rate of 15 per cent on that amount which it wiII have to procure from the banker. The effects of all these changes are tabulated in Table 3. It immediately becomes apparent that even though the price to be obtained from the first and subsequent orders is the same, the profitability of the additional order is about 41 per cent of the profit made in the first order. The management will therefore have to take a decision as to the advisabili.ty of accepting this additional order, as the rate of profitability goes down drastically. The management might also like to consider not only the fact of the additional order on a short-term basis but on a long-term perspective if it feels that a stream of such orders wiII be forthcoming in the coming years. In such an eventuality it wiII have to take a decision as to whether it would be advisable for the company to increase its production capacity. This decision can be taken on the basis of the return on investment caiculated on discounted cash flow basis and also the • return on investment on the same basis as is used for alternative

222

Decision-Making Framework for Export Operation

purposes, if the relative rate of return for increasing the capacity is better than the alternative opportunities that might be open to the company, the management may decide to commit further resources for increasing the installed capacity. The management can approach the profitability problem in a scientific way. TABLE 3-Profitability Evaluation of Additi01ral Production I.

Gross Sales Income 2,000 doz. @ Rs. 66 Less;

Rs. 1,32,000

Agency com mission @ 5% on f.o.b. value

Rs.6,600

Net Sales Income II. a.

Rs. 1,25,400 Marginal

Total

Costs per

variable

Rs.2.00

Rs.48,000

Labour @ 125% of basic wage rats

Rs. 1.875

Rs.45,000

Consumables

Rs.

Rs.

Costs of manufacture Materials

0.25

6,000 Rs.99,OOO

II. b.

Addl. selling and distribution expenses

III.

Additional fixed expenses (One staff member newly appointed to look after export sales) annual salarj

IV.

Total costs

V.

Profit

VI.

Interest on bank overdraft @ 15%

VII.

Profit after interest charges as % of gross sales

Rs.

5,000

Rs.

6,000

Rs. 1,10,000 . Rs. 15,400 Rs.3,045 Rs. 12,355 9.36

Logic Chart I

Follow Chart II

I

•

No

I

What are the total costs of accepting the order?

Add - Direct manufacturing costs - Indirect manufacturing costs - Distribution costs -Overhead

-.

/ihat are the additional costs 0~1 products adaptation apart from normal costs? Add: - Cost of product adaptation - Direct manufacturing costs - Indirect manufacturing costs - Distribution costs -OVerhead

.

What is the profit margin? (Net ex-works realisation-total costs)

.

Is the margin acceptable?

•

II s \he co ntnbutlonII

Yes

t

No

~yes acceptable?

Export_ 1...--_

I

Export

I Deduct overhead from to-

I tal costs

224

Decision-Making Framework for Export Operation Logic Chart II

I

What are the cost implications of increasing capacity?

I

- Additional Investment costs - Additional fixed costs - Additional working capital costs What is the Contribution martin of the present order?

What is the Break-even volume?

Compare. Break-even volume vs Present and expected orders.

Yes

-

Does the comparison suggest the acceptance of addl financial commitments?

-

No

Continue present production volume and don't increase production

Increase capacity and expoert

•••

Chapter

15

ee PRIVATISATION

Since around 1980, there has been a marked change across the world towards privatisation. This trend is expected to become so pronounced in future that it is described as the "wave of the future". Privatisation means transfer of ownership and/ or management of an organisation from the public sector to the private sector, it also means the withdrawal of the State from an economic sector partially or fully. Privatisation marks a change from dogmatism to pragmatism and amounts to a reversal of policy. The trend towards privatisation has been observed in develo'ped and developing economies; in market-oriented and socialist, including communist countries; and it cuts across sociocultural systems. In the 1960s, there was a trend towards rationalisation in Britain. But, since the late 1970s, the trend has been towards privatisation by selling State owned enterprises (SOEs). Besides the U .K., countries which have sold or announced the policy of sale of SOEs in the recent years include Argentina, Bangladesh, Brazil, Britain, Federal Republic of Germany, France, Italy, Japan, Mexico, Nigeria, Spain, Thailand and Turkey. A number of other countries, including India, have deregulated or liberalized the industrial sector in varying degrees. Countries like China and the U.5.5.R. now permit private-owned enterprises (POEs) in a number of areas.

226

Privatisation

As Professor Berg rightly remarks, the privatisation response is in a real sense a reaction to the worldwide growth of government. The rapidity with which the public sector in many countries expanded over thelast four decades, roughly in the period from 1960 to 2000, is frequently overlooked. In effect a revolution, a quiet one, occurred in the shifting of resources into the public sector in the decade of the 1970s. In the less developed countries and in many of the poorest countries, the growth of the public sector was characterised by the growth of the parast,atal sector-State-owned enterprises. State-owned enterprises now account for 10 to 20 per cent of GDP in much of the less developed world, and they are dominant in manufacturing in a great number of countries. What is true for GDP is also true for capital investment. Parastatal enterprises are estimated to be responsible for between 20 and 60 per cent of total investment spending in the less developed world. Regardless of whether socialist or market-oriented, virtually all countries in the 1960s and 1970s saw an expansion of the public sector, and in particular an expansion of state-owned enterprises, across a broad front. The performance of SOEs in many countries have, by and large, been far from satisfactory. They have often put large burdens on public budgets and external debt. For example, the net deficit of a sample of SOEs accounted for about 4 per cent of Niger's GDP in 1982. For the seven largest Latin American economies, the combined deficit of SOEs rose from about 1 per cent of GNP in the mid-1970s, to about 4 per cent in 1980-82. One study has found that countries in which SOEs accounted for higher shares of gross domestic investment generally had lower rates of economic growth. The heavy financial burden imposed by the SOEs and the growing public discontent against them due to their inefficiency; indifferent, irresponsible and sometimes even arrogant attitude and lack of concern for the customer needs; and corruption, nepotism and squander associated with their organisation and management have led to the growing interest in privatisation. As Professor Samuel Paul points out in country after country, unbridled state expansion has led to:

Privatisation

227

(i) economic inefficiency in the production activities of the public sector, with high costs of production, inability to innovate, and costly delays in delivery of t!le goods produced; (ii) ineffectiveness in the provision of goods and services, such

as failure to meet intended objectives, diversion of benefits to elite groups, and political interference in the management of enterprises; and (iii) rapid expansion of the bureaucracy, severely straining the public budget, causing problems in labour relations within the public sector, inefficiency in government, and adverse effects on the whole economy. These problems have led many governments to undertake programmes of public sector reform and, pushed by a need to curb public expenditure, to re-evaluate the possibilities for shifting publicly managed activities into the private sector. There are many methods of achieving privatisation. One important method is Divestiture, or privatisation of ownership, through the sale of equity. In countries where there are well functioning capital markets, this entails selling stock to the public. In industrial countries privatisation has corne mainly through divestiture of government economic activities. Among the developing countries, Bangladesh, Chile, Jamaica, Brazil, Peru, Zaire, Pakistan, the Philippines and Sudan offer examples of divestiture. Japan has a century-old history of divestiture. After an initial attempt to promote industrialization through state ownership, the Japanese government in the 1880s sold many state firms, including 52 factories, 10 mines and 3 shipyards. Privatisation has assumed importance in Japan in 1980s too. On the recommendations made by an administrative reforms committee consisting of experts and businessmen, Japan has recently made legislation which enables the privatisation of two of the most lucrative state enterprises, namely, Nippon Telegraph & Telephone and Japan Tobacco & Salt Corporation. The objective is to reduce government expenditure and raise administrative efficiency by withdrawing government

228

Priva tisa tion

presence from areas which can be managed better by private people. Divestiture became so common in the Western Europe that hardly a week or month went by without some new evidence of sale of state enterprise by such Western European countries as France, Italy, Sweden, the Federal Republic of Germany, and, of course, the champion industrial company privatizer, Britain. In the Republic of Korea, the government pioneered the establishment of basic industries such as oil refining, steel, and machine tools and then sold them to the private sector once their profitability was established, using the funds raised to pioneer other industries. Brazil created a commission for divestitute in 1981 and Jamica set up a divestiture committee. There are a large number of cases where privatisation has taken the form of denationalization or reprivatisation. A considerably large number of organisation were denationalized in countries like Chile, Bangladesh and Pakistan. Another method of privatisation in contracting. Governments may contract out services they have planned and specified to other enterprises that produce and deliver them. Franchising authorizing the delivery of certain services in designated geographical areas - is common in utilities and urban transport. Contracting is common in public works, defense and many specialized services. Where suppliers compete for contracts and where there is no loss of economies of scale, contracting is efficient. But there is scope for corruption in contracting, and long-term contracts tend to encourage monopolistic behaviour by the private supplier. Contracts for road construction and maintenance are common in countries such as Brazi( Colombia, India and Kenya. In agriculture and urban development in the Philippines and in water supply in the Ivory Coast, private contracts have played an important role. Another option for the government is to withdraw from the provision of certain goods and services leaving them wholly or partly to the private sector. Privatisation may also take the form of privatisation of management, using leases and management contracts.

Privatisation

229

Government can shed the burden also by liquidation which can be either formal or informal. Formal liquidation involves the closure of an enterprise and the sale of its assets. Under informal liquidation, a firm retains its legal status even though some or all of its operations may be suspended. When compared to the industrial countries, the progress of privatisationhas been slow in the LDCs. As the World Bank points out, governments confront several obstacles, like those mentioned below, when they decide to divest SOEs. (i) Governments usually want to sell the least profitable enterprises, those that the private sector is not willing to buy at a price acceptable to the Government. (ii) Divestiture tends to arouse political opposition from

employees who may lose their jobs; from politicians who fear short-term unemployment consequences of liquidation or of cost reduction by private owners; from bureaucrats who stand to lose patronage; and from those sections of the public that fear that national assets are being cornered by foreigners, the rich or a particular ethnic group. (iii) Relatively undeveloped capital markets sometimes make it difficult for governments to float shares and for individual buyers to finance large purchases. Professor Samuel Paul points out that if privatization is to succeed, in the sense of raising efficiency or effectiveness in the production or delivery of goods and services, the following seven conditions must be met: First, privatization cannot be sustained unless the political leadership is committed to it, and unless it reflects a shift in the preferences of the public arising out of dissatisfaction with the performance of other alternatives. Privatization has in the past worked best when a government was' strongly committed to a change, or w~en a new government vowed to reverse the actions of its predecessors, a$"has happened in Chile and the United Kingdom. More recently, some governments that have faced severe economic crises, with massive budgetary deficits, have turned to privatization and divestiture as a part of their adjustment strategy.

230

Privatisation

Second, any alternative institutional arrangements chosen should not stifle competition among suppliers. Replacement of a government monopoly by a private monopoly may not increase public welfare - there must be a multipliCity of private suppliers. This can be a difficult problem where there are few competent suppliers. Though government may wish to contract out a service, if there are only one or two qualified contractors, the benefits of competition are unlikely to follow.

In this context, most developing countries' systems of regulation need major review and reform. Over regulation of iI).dustry discourages private initiative; Over regulation of urban land use and building construction retards urban development; and unduly low ceilings on the prices of industrial products and utilities, such as bus transport and electricity, inflate demaRd and depress the incentives for production. The third, related, condition is freedom of entry to provide goods and services. Long-term contracts ;,md franchises limit competition and consumers' choice. In some services that are capital intensive, freedom of entry is difficult to achieve. But in others, such as refuse collection. or health services, the public will be better served by seve,ral private suppliers competing than by one agency monopolizing the market through a long-term contract. Fourth, public services to be provided by the private sector must be specific or have a measurable outcome. Physical construction or utility services, for example, can be measured, but most educational services and police protection are not easy to quantify, even though their inputs can be measured. Lack of specificity makes it more difficult to control services provided by the private sector, especially if the public served is illiterate, unorganized, and unassertive. Service delivery by non-governmental organizations or local governments may be more appropriate under these conditions. Fifth, consumers should be able to link the benefits they receive from a service to the costs they pay for it, since they will then shop more wisely for different services. User charges are one way of establishing this link. The importance of educating consumers and disseminating information to the public cannot be overemphasized here.

Privatisation

231.

Sixth, privately provided services should be less susceptible to fraud than government services if they are to be effective. Services provided through collective or co-operative action at the community level are probably the least susceptible to fraud. Seventh, equity is an important consideration in the delivery of public services. Broadly speaking, the benefits of privatization can accrue to the capital owner who supplies the service; to the consumer, who receives a more efficient service; and to the public at large, through a reduction in the public sector deficit, and hence in taxes or the rate of inflation, or both. Privatization will be counterproductive if the ability of the public to pay, determined by the prevailing income distribution, becomes the sole guide for the delivery of services. And, if the benefits of privatization are likely to be reaped solely by local elite's, expatriate groups, or multinational corporations, political resistance to reform is likely to increase. In India, though there were some isolated cases of privatisation, no clear policy decision on this has been taken so far except some deregulation's and liberalization's. Soon after Mr. Rajiv Gandhi assumed Prime Ministership, there was a feeling in some circles that dogmatism would be replaced by pragmatism. However, in the context of the search for new political alignments, the situation appears to be confused and devoid of clear direction. There was a proposal for involving the private sector in the construction of highways and bridges but it appears to have been shelved. Although most political parties and trade unions are against privatization's, there appears to be a growing public opinion in favour of privatisation. The expert planning group in its report on 'civil aviation at the tum of the century' has recommended partial privatisation of AirIndia and Indian Airlines. It has been felt that conversion of Air India into a joint stock company with part of its equity capital being released for public investment would help give it greater commercial orientation and user sensitivity. There are indeed a number of areas where partial or full privatisation is advisable. It was reported that the Kerala Government was toying with the idea of privatizing some of the prestigious hotels run by the

232

Privatisation

Kerala State Tourism Development Corporation as these hotels had been making huge losses. Opposition from political parties and trade unions seems to have shelved this idea. However, the Government of Karnataka took a bold decision to dispose of loss-making SOEs. This was made clear by the State's Minister for Industries, Mr. J.H. Patel, in the Legislative Council on 8th September, 1987, and declared that there was no justification to run industries manufacturing soaps, detergents, cosmetics, leather products and such like by incurring heavy losses. Earlier, on March 6,1987, the Chief Minister, Mr. Ramakrishna Hegde, stoutly defended the move of the government to disin vest its shares in the public sector and maintained that the state could no longer afford " to be dogmatic in its approach in this respect. Stating that his faith in the public sector was thoroughly shaken because of its dismal performance, he asked: "What is the point in the country investing over Rs. 55,000 crores in the public sector if there is no matching return?" The Mahadeshwara Co-operative Sugar Factory in Kollegal was sold to the Khodays and the state government had resolved to sell another one, the Vanivilas Sugar Factory, which was also in very unhealthy condition. In India, the public sector, both the Central as well as State, has expanded indiscriminately and it has been extended to non-priority sectors and sectors where the private sector would perform better. Populist political appeal and vested interests of politicians and bureaucrats have contributed to this. State governments have set up public corporations after corporations to expand the empire of the political parties and to give berths to political leaders. The accumulated losses of many SOEs, including some state transport corporations, are larger than the capital invested in them. These public sector deficits compel governments to increase taxation and curtail development expendirnres. There is no justification for imposing such burden on the public by the state carrying out activities which the private sector can do more efficiently. Privatisation of certain sectors and enterprises are, therefore, necessary to red uce the budgetary burden on the public, t~ make available more resources for the development activities, to enable

Privatisation

233

the government to concentrate more on the essential government functions and priority areas and to relieve the consumers from the indifferent and arrogant attitude of the public sector. Road transport is an area where privatisation can be easily carried out in a phased manner. When numerous private parties can more efficiently operate the road transport, what is the justification for harassing the passengers and burdening the public with the losses they incur? There will, of course, be opposition from political parties and trade unions. A major reason for political opposition is the 'harvest' that will be lost. It is often said that there are large kick-backs in the large-scale purchases of the corporations and huge amounts are collected for appointments to various positions. Governments should dispose of SOEs in the non-priority sectors, particularly the loss mal,
Privatisation

234

Don't we have a right to a better alternative to the inefficient state transport services which harass the customers? Should not the state concentra te more on the effective discharge of its essential functions and on dealing with the priority issues than laying its hands on everything, creating an unwieldy gamut of activities, wasting the scarce resources and putting more burden on the weary shoulders of the common man? Besides other benefits, privatisation will help trim the size of the administrative machinery leading to considerable savings to the exchequer. Village, Small and Ancillary Industries

The importance of and the need to promote the development of the small industries sector have been emphasised by all the industrial policy resolutions and statements and a number of protective and promotional measures have been taken accordingly to ensure their survival and to encourage their growth. The VSI Sector:

The village and small industries (VSI) sector in India consists broadly of: (i) traditional cottage and household industries (viz., hand loom, khadi and village industries, sericulture, handicrafts and coir) and (ii) modern small-scale industries including tiny units and powerlooms. While traditional industries arc generally artisan based, located mostly in rural and semi-,urban areas, involve lower levels of investment in machinery and provide largely part-time employment, modem small"scale units and powerlooms use mostly power operated appliances and machinery, have some technological sophistication and are generally located close to or in the urban areas including large industrial centers. However, as a part of the industrial dispersal policy and rural industrialization, governments have been encouring modem small-scale units in rural areas. There has also been an increase in the variety of products manufactured by the small-scale sector. They have ventured into the manufacture of many new and sophisticated items. The smallscale industries today produce more than 5000 items. Their contribution has been very notable in important segments of the

Priva tisation

235

electronics industry. Their share in the total production is about 45 per cent in consumer electronics, 75 per cent in instruments and instrumentation and 45 per cent in computer and allied items. Importance:

The khadi, village and small-scale industries have a very important role in the Indian economy characterised by its vast spatial spread, unemployment and underemployment, rapidly rising labour force, capital scarcity, numerous market segments and diverse demand pattern, broad and diverse resource base and supply, predominance of widely scattered numerous village settlements, growing modem large industrial sector giving scope for ancillarisation and so on. The distinguishing features and major advantages of these industries, particularly khadi and village industries, are the following: (1) In an economy, like India, characterised by abundant labour supply and the concomitant unemployment and underemployment and rapidly rising labour force, khadi, village and small industries assume special significance because of its high employment potential. (2) Another important advantage is their ability to provide employment in the off-season. To a large number of people, agriculture provides only seasonal employment. Khadi, cottage and some other village industries provide employment opportunities during the off-season and help many households to mitigate their problems during the off-season. (3) Khadi, cottage and certain other village industries provide vast scope for employment of special categories of people like women, children, old aged, physically handicapped, etc. It is also an avenue for part-time employment for those who are employed elsewhere, either full-time or part-time. (4) Some of these industries provide employment opportunities within the household premises and some others near the

236

Privatisation place of residence. The locational advantage of these industries are, thus, very great. (5) A major advantage of these industries is that the capitaloutput and capital-labour ratios are comparatively very low. That is, the amount of capital investment required per unit of employment and the capital investment required per unit of output are comparatively very low. In other words, the khadi and village industries in particular and the small-scale units in general maximize employment and output for a given amount of capital. This is of particular importance to a labour-abundant and capital-scarce economy like India. (6) Because of the low capital-output ratio and low gestation period they promote non-inflationary growth. (7) Khadi and village industries have been found to be of particular help to the weaker sections of the society. The participation of scheduled castes, scheduled tribes, women and other weaker sections of the society in this sector is significant. (8) These industries promote economizing of resource utilisation and conservation of resources. They are expected to ensure maximum utilisation of locally available raw materials by adopting easily adaptable techniques. In some cases, non-conventional raw materials are used thereby converting waste into wealth. (9) These industries can develop in almost all areas including backward, tribal, hilly and inaccessible areas. They are, thus, helpful in achieving wider spatial dispersal of industrial activities and thereby reducing the regional economic imbalances. (10) They help increase the pace of rural development through the generation of additional employment opportunities and income and through its input and output linkages with the other sectors of the rural economy. (11) The small indu,stries have acquired more attention in recent years due to the very less ecological problems they create, compared to the large industries.

Privatisation

237

(12) As khadi and village industries do not use or use only very little electric power or oil, they do not cause energy crisis and foreign exchange crisis. (13) The fact that the village and small industries account for abOut" one-third of our total export earnings shows how important they are to the Indian economy constrained by shortage of foreign exchange. Development of VISs under the Five Year Plans:

All our Five Year Plans and Industrial Policy statements have stressed the need to accelerate the development of village and small industries to create large-scale employment opportunities, promote decentralization and dispersal of industries, achieve diffusion of ownership and prevention of concentration of economic power, promote entrepreneurship, develop agrobased and ancillary industries, improve the skills of artisans and quality of their products, reduce the role of subsidies and to step up the productions of essential articles and those having potential for exports. The Government, Central and States, have taken a number of measures to solve the age-old problems of these industries, such as lack of credit facilities, outmoded methods and techniques, absence of organized marketing, unsatisfactory arrangements for the supply of raw materials and competition from large-scale units. The Union Government has set up a number of agencies to foster the development of the VSI. These include the National Small Industries Corporation, the Small-Scale Industries Board, the Khadi and Village Industries Commission, the All-India Handicrafts Board, the All-India Handloom Board, the Coir Borad and the Silk Borad. Apart from these, credit facilities are made available to these industries through a number of institutions. Industrial estates and rural industrial projects have been set up, and industrial cooperatives have been organised. State Directorates of Industries and other agencies are responsible for their development in the States. Objectives:

The objectives of the development of village and small industries, as laid down in our five year plans are:

238

Privatisation (i) to assist in the growth and widespread dispersal of industries; (ii) to increase the levels of earnings of artisans; (iii) to sustain jlnd create avenues of self-employment; (iv) to ensure regular supply of goods and services through use of local skills and resources; (v) to develop entrepreneurship in combination with improved.. methods of production through appropriate training and package of incentives; and (vi) to preserve craftsmanship and art heritage of the country. Promotional Measures

A number of measures have been taken by the governments, central and state, to protect this sector from the onslaught of the large sector and to promote its growth. They include the following: (i) Reservation of Products: Market protection is provided to the small-scale units by the reservation of items for exclusive production in the small-scale sector. Over the years there has been an increase in the number of items so reserved and it stood at 835 at the end of January 1989.

(ii) Preference in Government Procurement: Preference is given to the small-scale sector in government procurement. Under this programme, more than 400 items are reserved for exclusive purchase from the small-scale sector while a limited number of items (13 in January 1989) are reserved for purchase upto 75 per cent and a number ofitems (28 in January 1989) for purchase upto 50 per cent. (iii) Infrastructurel and Institutional Support: Infrastructurel and institutional supports are provided though industrial estates, district industries centres (DICs), Small Industries Service Institute, Khadi and Village Industries Commission (KVIC) and other specialised institutions which provide technical assistance, testing facilities, etc. (iv) Machinery on Hire Purchase: The National Small Industries Corporation (NSIC) arranges supply of machines on hire purchase to small-scale units.

Privatisation

239

(v) Marketing Assistance: Marketing assistance's including export promotion assistance are provided by instihltions such as the NSIC, the Small Industries Development Organisation (SIDO), Handicrafts and Handlooms Export Promotion Corporation, KVIC

etc. (vi) Financial Assistance: Financial assistance is provided at concessional terms by commercial banks, state level financial institutions, etc. In order to step up the flow of assistance to the small sector and to provide a focal point to coordinate at the apex level the availability of both financial and non-financial inputs required for the orderly growth of this sector, the Small Industries Development Fund (SIDF) was established within the IDBI in 1986. (vii) Training: Training for existing and potential entrepreneurs and others associated with the working of the small units are offered by Entrepreneurship Development Institute of India (EDI!), Technical Consultancy Organizations (TCOs), financial institutions and commercial banks, management institutes, NSIC etc. (viii) Supply of Raw Materials: Arrangements have also been made for the supply of raw materials, particularly of scarce items, to the small-scale units. (ix) Promotion of Ancillarisation: The Industrial policy also gives importance to ancillarisation. This has been recognised as one of the objectives of the public sector industry. One of the factors considered by the government while evaluating application from the private sector for industrial license is the scope for ancillarisation by the proposed project

There has been a significant growth of the Small-Scale Sector. According to the estimates of the Development Commissioner, Small-Scale Industries (DCSSI), in 2009-2010, there were 15.921akh small-scale units. Their estimated number was 16,000 in 1950; 36,000 in 1961; 2,38,000 in 1971 and 8 lakhs in 1980. They had provided employment to over a million people in 2008-2009. (These figures do not include the khadi and village industries.) In 2009-2010, the small-scale sector contributed more than 29 per cent of India's export earnings.

240

Priva tisa tion

Khadi and Village Industries:

Khadi means any cloth '.voven on hand looms in India from cotton, silk or woollen yarn handspun in India or from mixture of any two or all such yarns. Industries coming under the purview of Village Industries are: (1) Bookkeeping; (2) Cottage Match, manufacture of fireworks and Agarbath-ies; (3) Cottage Pottery; (4) Cottage Soap; (5) Flaying, curing and tanning of hides and skins and ancillary industries connected with the same and cottage leather industry; (6) Ghani Oil; (7) Handmade paper; (8) Manufacture of cane-gur and khandasari; (9) Palmgur making and other palm products; (10) Processing, packaging and marketing of cereals, pulses, spices, condiments, massalas, etc. (11) Manufacture and use of manure and methane gas from cowdung and other waste products (such as flesh of dead animals, night soil, etc.) (12) Lime stone, lime shell and other lime products; (13) Manufacture of shellac; (14) Collection of forest plants and fruite; for medicinal purposes; (15) Fruit and vegetable processing, preservation and canning, including pickles; (16) Bamboo and cane work; (17) Blacksmithy; (18) Carpentry; (19) Fibber other than coir; (20) Manufacture of household utensils in aluminum; (21) Manufacture of Katha; (22) Manufacture of gums and resins; (23) Manufacture of Lokvastra; (24) Manufacture of Poly vastra; (25) Processing of maize and ragi. KVle:

The Khadi and Village Industries Commission (KVIC) is a statutory organization engaged in the task of promoting and developing khadi and village industries with a view to creating employment opportunities in the rural areas and thereby strengthening the rural economy. It was established in 1957 by an Act of Parliament. It is an autonomous body which took over from its predecessor, the All-India Khadi and Village Industries Board, set up in 1953. The broad objectives that the KVIC has set before it are: (i) the social objective of providing employment; (ii) the economic objective of producing saleable articles; and

Privatisation

241

(iii) the wider objective of creating self-reliance amongst the people and building up a strong rural community spirit. The functions of the KVle are generally to plan, organize and implement programmes for the promotion and development of khadi and village industries. In particular they include: (a) training of persons engaged in production of khadi and village industries; (b) building up reserve of raw materials and implements and supplying them to persons engaged in the production of KVls at economical rates;

(c) to provide for sale and marketing of khadi and products of village industries and handicrafts; (d) to encourage and promote research in the technique of production of khadi and in the development of village industries, and to provide facilities for study of problems relating to KVls; (e) to maintain or assist in the maintenance of institutions for the devE'lopment of KVls; (f)

to undertake, assist or encourage production of khadi or development of village industries;

(g) to promote and encourage co-operative efforts among manufacturers of khadi and persons engaged in village industries; and (h) for ensuring the genuineness of and for granting certificates

to producers of or dealers in, khadi or the products of any village industry. The KVle have created an organisational base for further development with 26 State KVI Boards, more than a thousand registered institutions and about 30,000 industrial co-operatives. KVle has over 11,000 sales outlets in the country. This is an unique national organisation in the country which has its roots in the villages and has wide organisational linkages. Its activities cover over 1.3 lakh villages in the country. A substantial number of beneficiaries belong to the scheduled caste and scheduled tribes

242

Privatisation

and inhabitants in hill and border areas. The participation of women in the activities is also very high, i.e. 45 per cent. In 2008-2009, the khadi and village industrial units assisted by the KVle were estimated to have provided employment to nearly 40 lakhs people (26 lakhs in the village industries and 13.7Iakhs in the khadi industries), compared to less than 16 lakhs in 1956-57 (8.80 lakhs in khadi and 6.781akhs in village industries). The output of the KVI sector is estimated to have increased from less than Rs. 21 crores (Rs. 8.23 crores of khadi and Rs. 12.72 crores in the village industries) in 1956-57 to Rs. 1236 crores (Rs. 202 crores in the khadi sector and Rs. 1,034 crores in the village industries) in 2008-2009. Employment in the khadi sector appears to have saturated. Ancillary Industries:

Integration of small and large industries through ancillarisation is an important feature of industrial development of countries like U.S.A and Japan. In India, the government policy has been one of encouraging ancillarisation. An ancillary unit is one having an investment in plant and machinery, whether held on ownership basis or by lease or by hire purchase, not exceeding Rs. 45 lakhs and engaged in the manufacture of parts, components, sub-assemblies, toolings and intermediates or the rendering of services of proposing to render, provided 50 per cent or more of their total production or service as the case may be is for other units for production of other articles. Though all industries are not amenable to ancillarisation, there are a number of industries with scope for considerable ancillarisation. Large industries may benefit from ancillarisation in different ways. One benefit of ancillarisation is the realisation of economies of scale. If the requirement of any item is less than the economic size of production, it stands to gain by purchasing the item from an outside unit of economic size. Further, a large company can relieve itself from the problem of tying up of capital, managerial time, etc., on minor items which can be efficiently produced by ancillaries. The society also benefits from the economies of scale and other efficiencies associated with ancillarisation. As the impact

Privatisation

243

of energy crisis and credit squeeze is comparatively less on smallscale units, ancillarisation offers further advantages to large units in an era of power shortage and financial problems. Ancillarisation and sub-contracting, however, have some problems also. The parts or components supplied by these units may not some tim.?s be of satisfactory quality. The small units usually do not have the resources for carrying out research and development. Hence, parent units will have to help them to update technology and enforce strict quality control. Industrial machinery, agricultural and earth moving machinery; machine tools; industrial; scientific and mathematical instruments; locomotives and rolling stock; ships; aircraft's; bicycles; boilers; steam generating plants; steam engine; automotive parts; turbine; internal combustion engine; commercial, office and household equipment; telecommunication equipment; electronics; electrical equipment; packaging items for use in chemicals; some iron and steel industry items arc but some fields where there is good scope for ancillarisation. The extent of ancillarisation possible in different fields in India is as high as 60 to 90 per cent in transportation industry; 50 to 75 per cent in communications industry and 30 to 50 per cent in prime movers and power-based industry. It is 20 to 40 per cent in industrial machinery and machine tools; 15 to 30 per cent in chemicals and pharmaceuticals industry; 10 to 30 per cent in consumption and consumer durable goods industry; and 5 to 10 per cent in basic industry, such as metals, minerals, cement and petroleum. The lowest range is 2 to 10 per cent in wood, paper fibers, glass, ceramics, leather, rubber, etc.' Drawbacks:

The number of small units have increased remarkably. The role of this sector in the Indian economy cannot be underestimated. However, as the Planning Commission observes, some of the important objectives set for the village and small industries sector are yet to be fully achieved. The dispersal of small-scale units far away from the metropolitan areas and large cities has not taken place to an

244

Privatisation

appreciable extent. Available data indicate that the industrially developed ,States account for a very large share of the registered small scale units. Within the developed States, there has been concentration of units in a areas which are either metropolitan or large cities or industrial complexes. Though accurate estimates are not available, industrial sickness appears to be widespread in the small-scale sector. A number of promotional measures designed to develop the VSI sector have not produced the expected results. For example, the Entrepreneurial Development Programme has not made significant progress except in a few States like Gujarat in widening the entrepreneurial base. Low levels of technology resulting in poor productivity and inadequate returns continue to characterise the traditional industrial sector. It has been pointed out that a number of the registered smallscale units are bogus; they have been registered to avail the credit and other facilities offered to this sector. There is deliberate diversion of resources from the genuine use. Units are delibe~ately made sick after swindling the credit amount.

Though a number of arguments are put forward in favour of the VSI sector, in a number of cases the VSI units are promoted and sustained at a heavy social cost. The enormous subsidies they are granted, like concessional finance, fiscal incentives, price preferences, etc., have to be borne by the society. The earning levels of a large number of people employed in the VSI sector, especially in the traditional sector, are very low. Unless productivity in this sector increases, there might not be significant improvement in the earning levels. Problems: Though accurate estimates are not available, industrial sickness appears to be widespread in the small-scale sector. It has been estimated that the capacity utilisation in different village and small industries has been ranging from about 45 to 60 per cent. The major problems of the small-scale units are the following:

,Privatisation

245

(i) Problem ofInputs: Inadequacy or non-availability of inputs - of proper quality at reasonable price is important problem facing a number of units. It is pointed out that the allotments of raw materials by Slate supply corporations have always been inadequate and are hardly enough to work thirty to forty per cent of the installed capacity. (ii) Financial problems: Many small units face financial crisis. Though there has been an increase in the flow of institutional credit to this sector, large part of this has gone to the relatively large units in this sector. The increased flow of institutional funds in favour of the decentralized industrial sector has not covered the artisan sector adequately which continues to depend, for a major part of its capital requirements, on non-institutional sources, often, at exorbitant rates of interest. (iii) Marketingproblems : Marketing is a major problem area for the small units in general. Small entrepreneurs, generally, do not have resources and expertise to market their products effectively. Financial constraints do not permit them to offer attractive credit terms and the like to the marketing intermediaries. The VSI sector is in a weak bargaining position so much so that the intermediaries take advantage of the situation. Though the governments have taken some steps, marketing arrangements for selling of the products of the small units are still quite inadequate. (iv) Competition from the large units: One serious problem faced by many small units is the severe competition from the large units. The large units by virtue of their resources, expertise and image, coupled with quality aspects, are able to dominate the market vis-avis the small units. The small units are thus relegated to a disadvantageous position. (v) Competition between small units: Problems arising out of competition between the small units themselves are not uncommon. . Many units supplying the same product creates a situation wherein the large companies purchasing items from the small-scale sector and the dealers find themselves in a strong bargaining position so that the small units stand to lose in the bargain.

246

Privatisation

(vi) Obsolete technology and low productivity: Productivity in the VSI sector is, by and large, not satisfactory. No much progress could be made in the upgradation of technology particularly in the traditional sector. (vii) Institutional constraints: Though a number of measures have been taken by the Central and State Governments to assist the VSI sector, they have not come up to the expectations. The small entrepreneurs have to cross many hurdles to obtain assistance from them. The District Industries Centers (DICs) have not come up to the expectations. There are many criticisms about the functioning of the organizations meant to assist the VSI sector. In short, as the Planning Commission observes, low levels of technology resulting in poor productivity and inadequate returns continue to characterise the village and small industries. Coupled with this, the problem of obtaining raw materials of desirable quality at reasonable prices and lack of marketing arrangements for selling their produce at fair prices have deprived the artisans of a good part of the earnings which should have accrued to them .

•••

Chapter

16 tIti INDUSTRIAL SICKNESS

Date available since the late 1970s clearly show that sickness has been steadily growing in the large, medium and small industries in India, both in terms of the number of sick companies and the amount of bank credit blocked up in such companies. Industrial sickness is a matter of serious national concern because besides affecting the owners, employees, creditors and suppliers, it causes wastage of national resources and social unrest. Definition of Sick Company:

There are different perceptions of the symptoms and characteristics of industrial sickness. Sickness is a relative concept. Further, "a given sickness manifests itself in several forms, and at a point of time these forms may not throw unambiguous or clear-cut signals. No wonder, then, that sickness is found being understood, interpreted and measured differently by individuals and even by institutions" . "To a layman, a sick company is one which is not healthy. To an investor, it is one which skips dividends. To an industrialist, it is a company which is marking losses and tottering on the brink of closure. To a banker, it is a company which has incurred cash losses in the previous year and is likely to repeat the performance in the current and following years". In terms of the definition evolved by

248

Industrial Sickness

the Reserve Bank of India, an industrial company is regarded as sick if it has incurred cash loss for one year and in the judgement of ' the bank, it is likely 10 continue to incur cash loss in the two following years and it has imbalance in its financial structure such as current ratio being less than 1:1 and worsening debt equity ratio. The Sick Industrial Companies (Special Provisions) Act, 1985, defines a sick industrial company as an industrial company (being a company registered for not less than seven years) which has at the end of any financial year accumulated losses equal to or exceeding its entire net worth and has also suffered cash losses in such financial year and the financial year immediately preceding such financial year. The definition is for the purpose of application of the Act and it covers only registered companies which have been in existence for at least seven years. Common symptoms of industrial sickness include failure to pay statutory liabilities like Provident Fund and E.S.I, contributions, failure to pay timely installment of capital and interest on loans taken from financial institutions and through public deposits, increas~ in inventories with a large number of slow or non-moving items, high rate of rejection of goods manufactured, low capacity utilisation and frequent industrial disputes. Weak Companies:

According to the Sick Industrial Companies (Special Provisions) Act, an industrial company is regarded as sick only if it has, at the end of any financial year, accumulated losses equal to or exceeding its entire net worth. It is, however, important to detect sickness at the incipient stage and take necessary remedial measures. The Reserve Bank has, therefore, ad vised the commercial banks to take remedial measures in respects companies at the stage of 50 per cent erosion of their net worth. Such companies are termed as weak companies to distinguish them from sick industrial companies as defined in the Sick Industrial Companies Act. An Industrial company is termed as weak if at the end of any accounting year it has: (i) accumulated losses equal to or exceeding 50 per cent of its peak net worth in the immediately preceding five accounting years,

Industrial Sickness

249

(ii) a current debt-equity ratio of less than 1:1, and

(iii) suffers a cash loss in the immediately preceding accounting year. Magnitude The number of sick companies enjoying bank credit has grown from 22,366 at the end of December 1979 to 159,938 at the end of June 2009 and the total bank credit outstanding in respect of them increased from Rs. 1809 erases to 5737.88 crores representing increases of 615 percent and 217 per cent respectively. Of the 159938 sick companies at the end of June 2009,1057 were non-55I companies (as defined in SICA) involving a bank credit of over Rs. 2680 crores and the remaining were SSI companies. It may be noted that the statistics of industrial sickness pertain

to companies enjoying bank credit and statistics regarding others are not available. Of the 1057 non-SSI sick companies referred to above, viability studies were completed in respect of 862 companies and about 60 per cent of them were found to be non-viable. Of the 151408 sick small-scale companies, of which viability studies were done, about 92 per cent were found to be non-viable. Of the 655 non-SSI weak companies, banks had taken decision about viability or otherwise of 481 companies and 219 of them were regarded by banks as non-viable. One is tempted to question the rationale of classifying those companies which are non-viable as weak companies rather than sick companies. The extent of industrial sickness varies by sectors and across regions. In the category of non-SSI companies, engineering and textile industries accounted for over 60 per cent of the total credit outstanding and 47 per cent of the total number of sick companies. Similarly, weak companies are preponderant in these industries. Maharashtra and West Bengal account for a substantial share of the non-SSI sick and weak companies. T~ a large extent, this regional concentration of sickness corresponds with the historical pattern of industrialization in India. Further, these regions are cHaracterised by the presence of industries in textiles, engineering goods and jute which happen to be the sectors afflicted with industrial sickness especially in the non-S5I category.

250

Industrial Sickness

Causes of Sickness:

There are many external and internal factors which can cause industrial sickness. In many cases, sickness is caused by a combination of factors. The Tiwari Committee has culled out, from several published research works, the following external and internal causes of sickness: (A) Internal Causes:

(1) Planning (a) Technical feasibility Inadequate technical know-how Locational disadvantage Outdated production process (b) Economic viability High cost of inputs

Break-even point too high Uneconomic size of project Under-estimation of financial requirements Unduly large investment in fixed assets Over-estimation of demand (2) Implementation

Cost overruns resultingfrom: Delays in gelling licenses/sanctions, etc. Inadequate mobilisation of finance. (3) Production

(a) Production management Inappropriate product-mix Poor quality control Poor capacity utilisation High cost of production Poor inventory management

Industrial Sickness

251

Inadequate maintenance Lack of timely and adequate modernisation, etc.

(b) Labour management Excessively high wage structure Inefficient handling of labour problems Excessive manpower Poor labour productivity (c)

Poor labour relations Marketing management Dependence on a single customer / single product Poor sales realisation Defective pricing policy Booking of large orders at fixed prices in an inflationary market Weak market organisation Lack of market feedback and market research

(d) Financial management Poor resources management Faulty costing Liberal dividend policy General financial in discipline Deficiency of funds Siphoning away of funds Over-trading Unfavourable gearing or keeping adverse debt-equity ratio (j) Administrative management

Over centralization Lack of professionalism Lack of feedback to management (Management Information System)

252

Industrial Sickness Lack of controls Lack of timely diversification Excessive expenditure onR&D Dividend loyalties (where the same management has interest in more than one company, cases are known where promoters of limited companies who also own private ownership firms tend to look after the interests of the latter, often at the cost of the former) Dissension within the management Incompetent management Dishonest management

(B) External Causes:

(a) Infrastructurel bottlenecks Non-availability of/irregular supply of critical raw materials or other inputs Chronic power shortage Transport bottlenecks (b) Financial bottlenecks

Non-availability of adequate finance (c) Government controls and policies, etc. Government price controls Fiscal duties Abrupt c~ange in Government policies Procedural delays on the part of the financial/licensing/ other controlling or regulating authorities (Banks, RBI, financial institutions, Government departments, licensing authorities, Monopolies and Restrictive Trade Practices Board, etc.) (d) Market constraints Market saturation Revolutionary technological advances renderihg one's pwducts obsolete

253

Industrial Sickn~ss (e) Extraneous factors Natural calamities Political situation (domestic as well as international) War Sympathetic strikes Multiplicity of labour unions

Those tnembers of the Tiwari Committee representing banks and financial institutions identified the causes of 341 sick companies in their portfolios as detailed below: Important causes of sickness

Percentage of companies affected by the cause

1. Management deficiencies/ mismanagement/dissension's

65.1

2. Marketing constraints/competitive market

29.0

3. Shortage of working capital/liquidity constraints

23.8

4. Power cuts

22.6

5. Labour trouble/poor labour relations

22.3

6. Raw materials shortage/non-availability

21.7

7. Plant imbalancelfrequent breakdowns/obsolete machinery

21.1

8. Del11and recessionlfluctuating demand

16.7

9. Higr cost of production

13.5

10. Under-utilisation of capacity

12.9

.According to the Chambers of Commerce, though it was difficult to generalise the causes of sickness, one of the reasons could be the fear on the part of the management to disclose the true state of affairs of the company lest their goodwill/business reputation be affected. Other causes attributed by the Chambers to make a company sick are: (i) lack of timely modernisation/machinery replacement; (ii) new industrial location policy; (iii) non-availability of adequate and timely working capital credit; (iv) price control and allied measures; (v) Infrastructurel bottlenecks; (vi) deficiencies in the functioning of canalising agencies;

Industrial Sickness

254

(vii) assessment of banks ignoring the realities of business fluctuations; (viii) delay in review of representations by the concerned agencies; (ix) recession;

(x) compulsion to pay minimum bonus under Bonus Act; (xi) deteriorating industrial relations; and

(xii) general managerial deficiency and misfeasance. Besides, it has also been pointed out that a study by the Tata Consultancy has shown that underutilisation of capacity in various segments of the industry is also a factor causing sickness. We feel that sometimes the attitude of labour, financial institutions and government which does not allow a company to take measures, before it becomes sick, to strengthen itself also may cause sickness. Rehabilitation packages suggested by the BIFR for several sick companies include such measures as closing down certain divisions or lines of business, modernisation, rationalisation and redeployment oflabour force, sale of assets to generate funds, etc. The pity, however, is that a company which proposes to take such measures before it becomes sick may have to face opposition from the trade unions and even from government/government agencies. And there will be suggestions to take such measures, offer of concessions and the like after the catastrophe has ushered in. Further, the swiftness with which the administrative r.lachinery responds to a grave problem is indicated by the fact that it took three years to establish the BIFR after the Tiwari Committee recommended such a measure! Preventive and Curative Measures: As the Tiwari Committee observes, "Industrial sickness tends to cause loss of production very often leading to unemployment/ loss of employment and resulting in blocking of scarce resources of the banks and financial institutions, besides entailing loss of substantial revenue to the exchequer. The magnitude and incidence of industrial sickness are matters of serious concern for the Central

industrial Sickness

255

and State governments, Reserve Bank of India, banks and financial institutions not merely due to the above factors, but also because such a trend undermines public confidence in the functioning of the organized sector with attendant repercussions on the overall investment climate in the economy of the country". Several measures have, therefore, been taken by the government and financial institutions to detect the symptoms of sickness, and to prevent or cure sickness to the extent possible. There are some laws which enable the Central Government to monitor and control the functioning of industrial undertakings and to deal with the problem of sickness. The Companies Act, 1956, empowers the government to collect information from the companies which would enable it to assess the state of affairs of the companies and to take certain measures to prevent mismanagement. The Industries (Development and Regulation) Act, 1951 (lORA), empowers the government to regulate the management of industrial undertakings, including the takeover of the management or the undertaking. The Sick Industrial Companies (Special Provisions) Act, 1985, is a very important law to deal with industrial sickness. Government endorsed the recommendation of the Chokshi Committee regarding amalgamation of sick companies and healthy companies and amended Section 72 A of the Income Tax Act relaxing the provision relating to carry forward and set off of accumulated business loss and unabsorbed depreciation allowances in case of amalgamation. In 1981, the government announced certain policy guidelines to deal with industrial sickness. These guidelines required the ministries administratively concerned with various industries to take responsibility for rehabilitation of sick companies. Banks and financial institutions were required to strengthen the monitoring arrangement for prevention of sickness. An important limitation on the ability to tackle sickness arise from the tact that commercial banks may legitimately consider sick companies as poor security risks.

256

Industrial Sickness

Government policy towards the prevention and treatment of industrial sickness is guided by the following considerations: On the preventive side, it is considered that closer and more vigilant involvement of the financial institutions in the companies with management of doubtful competence of integrity is essential. Financial institutions have jointly set up a group of professional directors who are full time employees of the institutions and who could be nominated on the Board of Directors of companies with doubtful management and in which the institutions have a substantial stake. These directors report to the institutions on the measures that should be taken to prevent sickness. If any such director comes across features of a company's operation which give cause to suspect malpractice or gross incompetence, he would report to the financial institutions for further investigation. The concerned institution will then report the matter to an inter-institutional group under the Chairmanship of Industrial Development Bank of India. If this group comes to the conclusion that the management has acted in a patently incompetent manner or has indulged in malpractice, all the institutions and the commercial banks should take a decision tha t this company or any other company under the same management will not be extended financial assistance until the management is changed. The rehabilitation scheme for a sick company will depend on the extent of sickness of the company, its future prospects and the management. Financial institutions have realised that the usual methods of rehabilitation are not quite adequate for acute cases of sickness. Such cases may require extraordinary efforts and measures including leasing out an undertaking, merger and amalgamation, restructure of capital and liabilities, selling a company on bloc!< basis, etc. In such cases, the cooperation of all concerned agencies is of utmost importance and invariably workers are called upon to extend greater cooperation. I t has been agreed that the lead financial institution and the lead bank will jointly ensure that a scheme is prepared within a time limit of 90 days as fixed under the Sick Industrial Companies (Special Provisions) Act. Some of the State Governments have also started taking preventive measures by

Industrial Sickness

257

announcing certain relief's and concessions in advance even for companies which do not attract the definition of industrial sickness. The Government has recently specified the economic size of companies in many industries. This measures is expected to help check sickness arising out of uneconomic size of industrial companies. The RBI has been closely monitoring certain specific industries where the incidence of sickness is high. Standing Committees have been set up in the RBI for the jute and sugar industries to consider the specific problems of these sectors. Another significant policy initiative has been the introduction of liberalized margin money scheme for supplementing the efforts of the State Governments in reducing sickness in the small-scale sector, in June 1987. Under this scheme, the State Governments are to make a matching contribution on a 50:50 basis in providing assistance to sick small-scale companies in their rehabilitation. In the revised scheme, the maximum quantum of assistance has been enhanced from Rs. 20,000 to Rs. 50,000 per company. In the past, the government took over the management of a number of sick companies under the lORA, with the objective of reviving them by providing management support and financial assistance through banks and financial institutions. For instance, between 1967 and 2009, the management of 80 companies were taken over. While some these companies were nursed back to health, a number of others continued to suffer huge losses. The government felt that it was a mistake to have gone on taking over sick companies and that the government should not be burdened with the mOlmting losses of the sick companies. Now the approach of the government towards rehabilitation of sick companies is very selective because the government is convinced that there is no point in throwing away further resources in support of the companies which are irretrievably sick. Only such companies which are found to be potentially viable be taken up for formulation of rehabilitation packages to restore them to health. The package consists of concessions from banks, financial institutions, government (Central/State), government agencies, shareholders,

258

Industrial Sickness

labour, suppliers of goods and services or other creditors, as may be necessary. A company maybe regarded as viable if it would be ill a position, after implementing a package of concessions, spread over a period not exceeding seven years from the commencement of the package to continue to service its repayment obligations, as agreed upon, including those forming part of the package, without the help of any further concessions after the aforesaid period. The repayment period for restructured debts sho~Ild not exceed 10 years from the date of implementation of the package. Sick Industrial Companies Act :

The enactment of the Sick Industrial Companies (Special Provisions) Act, 1985 (SICA), is an important step taken by the Central Government to deal with industrial sickness. It is declared that this Act is for giving effect to the policy of the State towards securing the principles specified in clauses (b) and (c) of article 39 of the Constitution. (These clauses say that the State shall direct its policy towards securing that the ownership and control of the material resources of the community are so distributed as best to sub-serve the common gO(ld and that the operation of the economic system does not result in the concentration of wealth and means of production to the common detriment).

The Act which extends to the whole of India, applies, in the first instance, to all the scheduled industries other than the scheduled industry relating to ship and other vessels drawn by power. However, the Central Government may, in consultation with the Reserve Bank of India, apply the provisions of the Act to this scheduled industry. The act provided for the establishment of a Board for Industrial and Financial Reconstruction (BIFR) to exercise jurisdiction and powers and discharge the functions and duties conferred or imposed on the Board by or under the Act. Further, the Central Government is empowered to constitute an Appellate Authority for Industrial and Financial Reconstruction, consisting of a chairman and not more than three other members, for hearing appeals against the orders of the BIFR under the Act.

Industrial Sickness

259

The BIFR was set up in January 1987 (and has become operative since May 15, 1987) for determining the preventive, ameliorative, remedial and other measures which are required to be taken in respect of sick industrial companies and for expeditious enforcement of the measures which are required to be taken in respect of sick industrial companies. The BIFR has been given wide-ranging powers in respect of approval of rehabilitation packages for sick industrial companies including their restructuring and revival. In cases where sickness is confirmed, BIFR will determine the course of action to be followed with regard to the company. This course of action may be: (i) allowing the company time on its own, i.e., as per the scheme already initiated by the banks / institutions, to make its net worth positive within a reasonable period; (ii) having a scheme prepared through the operating agency

in respect of the company; or (iii) deciding on the winding up of the company. The scheme under option (ii) above sanctioned by the BIFR has to be finalized in accordance with a time schedule stipulated in the Act. The scheme may contain provisions for financial assistance, merger, sale or lease of a part or whole of the company, suspension of existing agreements/ contracts etc. The decision of the BIFR is binding on all concerned. The Act has an overriding effect over all other laws except FERA and Urban Land (Ceiling and Regulation) Act. The jurisdiction of civil courts is barred in respect of matters coming under the purview of BIFR. It has been made mandatory on the Board of Directors of a sick industrial company to report sickness of the company to the BIFR. The BIFR is vested with power to institute the necessary inquiries to determine whether or not a company is sick.

The BIFR also has powers to appoint a Special Director on the sick company in case of mismanagement. It also has powers to debar the company management and all other companies of the management from any credit facilities from the organized sector for a period of 10 years.

260

Industrial Sickness

According to the Act, the management of a company will have to seek fresh mandate from the shareholders if 50 per cent of the net worth of the company is eroded. , It has been claimed by the Government that the BIFR is a major step for intervening at an early stage and detecting, preventing and taking remedial measures which need to be taken with respect to sick companies. It has, however, been pointed out that some of the provisions of the SICA need to be amended to make the role of BIFR more effective in dealing with the problems of the sick industries. Under SICA, rehabilitation measures are initiated at a very late stage, i.e, at 50 per cent and 100 per cent erosion of net worth. Companies should be asked to approach the BIFR much before their net worth is eroded. Further, despite the emphasis on timely detection of sickness and the adoption of expeditious schemes, the actual time involved between the reporting of sickness to the Board and the final implementation of the rehabilitation package is more than one year. In sickness, time is crucial. Therefore, it is necessary to reduce the delays in initiating suitable measures for the rehabilitation of potentially viable sick companies. The time allowed for the BIFR at various stages needs to be cut short.

The Act does not apply to government companies and those specifically exempted under the Act. Further, as the Act applies only to the registered companies, very few, it at all, small-scale and ancillary sick companies come under the Act. Financial Institutions and Industrial Sickness:

Financial institutions have to playa very important role in the prevention of sickness and rehabilitation of potentially viable sick companies. In view of the fact that large amount of bank credit was blocked up in the sick companies, the Reserve Bank had issued, in 1976, guidelines to the commercial banks so as to identify incipient sickness. The RBI had also set up a sick companies cell. The cell serve as a reference point and tries to bring about coordination in the efforts of banks, financial institutions and Government in solving the problems of sick companies and issues suitable instructions and guidelines to banks as and when necessary.

Industrial Sickness

261

The steps initiated by the commercial banks and other financial institutions and the government under the Sick Industrial Companies (Special Provisions) Act are helping in timely detection of sickness. From time to time, industrial studies have been conducted by the financial institutions where it has been found that sickness is afflicting the industrial growth and climate. Inter-institutional Rehabilitation Meetings (IIRMs) are periodically held under the auspices of Industrial Reconstruction Bank of India (IRBI) were sick cases are discussed in detail and detail rehabilitation packages drawn up, in addition to various policy issues relating to rehabilitation of sick industrial companies. As modernisation is one of the important measures to prevent sickness, financial institutions are extending soft loans for modernisation of industrial companies. In 1986 the IDBI established the Textile Modernisation Fund and the IFCI established the Jute Modernisation Fund. Further, in the same year, the lOBI created the Small Industries Development Fund (SIDF). In 1971, the Central Government established the Industrial Reconstruction Corporation of India (IRCI) with the specific objective of dealing with the problem of industrial sickness. The IRCI ceased to exist when the Industrial Reconstruction Bank of India (IRBI) was established in 1985. The assets and liabilities of the IRCI were taken over by the IRBI, which has been given statutory status so as to effectively discharge its function. It is reported that as a result of the efforts taken by the IRBI

towards prevention of industrial sickness, industrial companies are now approaching the IRBI for their cases at the incipient stage of sickness and that they have become aware of the need to correct the imbalances of long-term and short-term funds, replacement of balancing equipment and modernisation of obsolete and old plant and machinery at an early stage so that the cases of rehabilitation vis-a-vis their financial involvement to set right their industrial activities becomes less. In addition, the companies are also approaching IRBI for financial assistance for expansion, diversification, modernisation etc.

262

Industrial 5ickness

Sick Small-Scale Companies:

At the end ofJune, 2009, nearly 8 per cent of the total number of small-scale companies enjoying bank credit were found to be sick and they accounted for nearly 16 per cent of the bank credit to the small-scale companies. Reflecting the serious concern over the growing sickness in the small-scale sector, in February 2009 the Reserve Bank issued to all scheduled commercial banks guidelines for rehabilitation of smallscale companies. The separate guidelines regarding sick small-scale companies have been issued because, although sickness in the large, medium and small industrial companies exhibit many common features, any approach to sickness in 551 sector has to reckon with the relative weakness of such companies to withstand difficulties as also the distinction between the small-scale companies and tiny sector companies and companies in the decentralized sector comprising artisans, village and cottage industries companies. It has, therefore, been felt that the emphasis of the rehabilitation effort in the case of 551 companies should be on adequate and intensive relief measures and their speedy application rather than giving a long span of time to the companies for rehabilitation. According to the definition adopted by the guidelines, a 551 company should be considered sick if it has (a) incurred cash loss in the previous accounting year and is likely to continue to incur cash loss in the c1,lrrent accounting year and had an erosion on account of cumulative cash losses to the extent of 50 per cent or more of its net worth and/ or (b) continuously defaulted in meeting four consecutive quarterly installments of interest or two half-yearly installments of principal of term loans and there are persistent irregularities in the operations of its credit limits with the bank. While both the conditions (a) and (b) should be satisfied in the case of large 551 companies, it would suffice if either alternative (a) or (b) is satisfied in the case of the tiny and decentralized sector companies. The guidelines point out that it is of utmost importance to take measures to ensure that sickness is arrested at the incipient stage itself and the management of the companies financed should be advised about their primary responsibility to inform the banks if

Industrial Sickness

263

they face problems which could lead to sickness and to restore the companies to normal heal tho The bank branch officials, who are in constant contact with tb.em, should develop mutual confidence between the bank and the borrowers. The organisational arrangements at the branch level should also be fully geared for early detection of sickness and prompt remedial action. Bank/ Financial institutions will have to identify the companies showing symptoms of sickness by effective monitoring. The Guidelines give an illustrative list of warning signals of incipient sickness related to periodical financial data, stock statements, reports on inspection of factory premises and god owns etc. whi~ serve as a useful guide to the operating personnel. The branch officials who are familiar with the day-to-day operations in the borrowal accounts should be under obligation to identify the early warning signals and initiate corrective steps promptly. Such steps may include providing timely financial assistance depending on established need, if it is within the power of the branch manager, and an early reference to the controlling office where the relief's required are beyond his delegated powers. The branch manager should also help the company in sorting out difficulties which are non-financial in nature and require assistance from outside agencies like Government departments/ undertaking, Electricity Board etc. He should also keep the term lending institutions informed about the position of the companies wherever they are also involved. The Guidelines emphasis that only those companies which are considered as potentially viable be taken up for rehabilitation. According to the Guidelines, a company may be regarded as potentially viable if it would be in a position, after implementing a relief package spread over a period not exceeding 5 years from the commencement of the package from the banks, financial institutions, Government (Central/State) and other concerned agencies, as may be necessary to continue to service its repayment obligations as agreed upon including those foaming part of the package. In the case of tiny / decentralized sector companies, the period of relief's/ concessions and repayment period of restructured debts will be 2 years and 3 years respectively.

264

Industrial Sickness

LOC: The Industrial Reconstruction Bank of India (IRBI) introduced a Line of Credit~LOC) Scheme for the small-scale sector. Under this Scheme funds are given to State level institutions designated by the State Governments at a lower rate of interest. 5IDF: In May 1986, the IDBI created a Small Industries Development Fund to provide assistance for development, expansion, diversification, modernisation and rehabilitation of small-scale, cottage and village industries and tiny sector companies. National Equity Fund:

Another important step was the establishment of the National Equity Fund in 1986-87, with a contribution of Rs. 5 crores each by the Central Government and the lOBI. Under this scheme, administered by the lOBI and operated through nationalised banks, assistance will be provided by way of seed capital, in the form of soft loans to eligible small and tiny companies with the project cost not exceeding Rs. 5 lakhs and located in villages or towns with population not e.xceeding 5 lakhs. New companies, as also the potentially viable sick companies in the small-scale sector, eligible for assistance under the Refinance Scheme of lOBI, will get support out of the Fund. Assistance under the scheme is available upto a maximum of Rs. 75,000 per project at a nominal service charge of 1 per cent annum. The companies availing this assistance are required to mobiles cash contribution of 10 per cent of the project cost. Modified Definition of Sick 55I Companies:

The RBI has recently issued certain Guidelines. Accordingly: (i) The definition of sick SSI companies has been modified as under: . " A .small-scale industrial company should be considered as sicl$ if it has, at the end of any accounting year, accumulated losses equal to or exceeding 50% of its peak net worth in the immediately preceding five accounting years."

265

Industrial Sickness

In the case of tiny/decentralized sector also a company may be considered as sick if it satisfies the above definition. However, in the case of such companies, if it is difficult to get financial particulars, a company may be considered as sick if it defaults continuously for a period of one year, in the payment of interest or installments of principal and there are persistent irregularities in the operation of its credit limit with the bank.

(ii) In the SSI sector, particularly among the tiny and decentralized sector as well as those assisted under schemes like SEEUY, a number of companies, financed by the banks, are no longer in existence or are not traceable and/ or have no assets left, etc. It has been decided to treat . such companies as a category distinct from sick companies and collect data thereof separately. (iii) The above definition [vide item (1)) may be adopted for the purpose of reporting data from the half-year ending September, 2009, while for the purpose of identifying sick companies/ formulating nursing programme, banks should go by this definition with immediate effect. However, cases of SSI companies identified as sick and already put under nursing programmes on the basis of the previous definition, need not be reopened.

***

Chapter

17 It It SERVICE SECTOR AND MODERN

ENTREPRENEUR Service facilities like transport, insurance, warehousing, etc. are required to be arranged for production and marketing of goods. These could be taken up by producers and traders themselves. But in that case it would be highly expensive. Hence, separate business units have been set up to undertake the service activities. Small scale producers and traders with limited resources cannot arrange all the service facilities on their own. Large scale producers and traders also find it more economical to use the service facilities offered by other organisations. The need for transport arises to distribute the goods among the consumers. Warehousing is necessary to preserve the goods to meet the future demands of consumers. Insurance provides a cover against several risks of business. The businessman often faces the shortage of capital for buying materials and holding stocks. This necessitates the existence of banks and other financial institutions. Goods produced in bulk need to be put in convenient packages for easy handling and exchange in the process of distribution. Since goods and services are produced on a large scale, their availability, use, quality, etc. must be known to the ultimate consumers. Information relating to goods available is provided through advertisements sponsored by producers and traders.

267

Service Sector and Modem Entrepreneur Classification of Service Facilities:

The service facilities which are of vital importance to both industry and trade may be classified as follows: (i) Transport, (ii)

Banking,

(iii) Insurance,

(iv) Warehousing, Packaging, Advertising, Sales Promotion, etc. Transport Facilities: Transport refers to the means of physical movement of goods and passengers. The means of transportation may consist of roadways, railways, waterways, airways and even pipelines for oil. Transport helps in physical distribution of goods produced by different manufacturers. It removes the hindrance of place. In economics, it creates place utility for the goods. Means of Transport : The means of transport can be classified into following three main divisions: (1) Land Transport (Roads and Railways). (2) Water Transport. (3) Air Transport. Means of Transport

I

I

1

Land

Water

Air

I

1

1

1 Roadways

I

1

1

1

Railways

Canals

Rive

Sea

1

1

• 1"'1---";'-"""1 Vehicular (Bullock Carts, Tongas, Autorickshaws, Cars, Trucks, Buses)

Non· Passenger Vehicular Trains (Man,

1 Goods

Trains

r---1

Passen· Cargo gers

268

Service Sector and Modem Entrepreneur

Significance of Transport : Transport gives the physical means which facilitate the movement of persons, goods and services from on- place to another. It is an important part of commerce as it helps in removing the hindrance of distance. As a matter of fact, transportation has constituted one of the most important activities of man in every state of civilization. The importance of transient has increased so much that it is difficult to think of any busmen activity without the help of means of transport. Transport plays an important role in the economic, social and political development of a country. Rapid industrialisation and exchange of goods and services cannot take place unless sufficient facilities for transportation are available. It is with the help of means of transport that raw materials are transported from the place of their production to the industrial centers where they are converted into finished products. It is again transportation that facilitates the movement of goods from the producers to the users. By doing so, transportation removes the distance problem and creates place utility. It also creates time utility in the goods and services because speedy transport minimizes the time of their means of transit. Transport Leads to Regional Specialisation: A region may specialise in the production of those goods and services for which it is most suited. This leads to production of goods and services in different regions at the lowest possible cost. Transport also plays a crucial role in price mechanism. It tends to equalize and stabilise the prices of various commodities by moving the~ from the areas where they are surplus to those areas where they are in short supply. Functions of Transport : Efficient means of transport perform the following important functions : (i) Widening of MarKet: Transport helps in widening the market. With the emergence of improved means of transport, goods and services can be moved from one place to another at considerably low expense and with great ease and speed. This stimulates the producers to produce not only for the local market but also for the distant markets including the foreign markets. The expansion of

Service Sector and Modem Entrepreneur

269

national and international trade has taken place mainly due to efficient means of transport.

(ii) Mobilisation ofResources : Transport facilitates the mobility of men, materials and money which are necessary for large scale production and for having balanced development of various regions in the country. Now, it is not necessary to start production only near the source of production or near the market. A business enterprise can achieve a large number of economies by setting its business in those areas where there is less concentration of business units. (iii) Regional Specialisation: Transport leads to specialisation on geographical basis. A region need not be self sufficient in all the matters because of efficient means of transport. It can concentrate only on the production of those products for which it is most suited and can depend on transport to get its other requirements fulfilled from other regions and sell its surplus production to other regions. (iv) Price Stabilisation: Transport helps in stabilising prices by facilitating movement of goods from surplus areas to deficit areas This leads to equalisation of prices in different regions. (v) Economies of Scale: Transport facilitates the achiever of various economies of large scale production which lead to cost of production which is necessary to meet competition in the market. (vi) Growth of Industries: Transport helps the growth of industries using perishable goods like fruits, vegetables, and dairy products by carrying them quickly to various consumers located in different areas. (vii) Social Functions: Transport also performs certain functions for the benefit of the society. It provides employment to people. It helps in stabilising prices. It assists in removing regional disparities. It leads towards specialisation on geographical basis. Transportation is indispensable for the defense of a country. It also creates a bond of unity among people of various regions in the country. Form of Road Transport :

Of all forms of traru;port, road transport has shown the greatest growth in recent years in our country. Road transport is also used

270

Service Sector and Modem Entrepreneur

as a complementary means of transport to other means of transport. Roads are indispensable links for carrying goods and people to and from railway stations, ports or aerodromes. Transportation of goods by road may assume anyone or more of the following forms: Transport by human energy: Porters or coolies carry goods either on back or on head. This type of transport is generally used for short distance and in those areas, particularly hills, where animals, carts and vehicles cannot be used. (i)

(ii) Transport by animals: Pack animals like bullock, camel, donkey, elephant, horse, mule, shark and yak are frequently used for carrying goods and passengers. Camel is the only means of transport in desert areas. Elephant is frequently used fo~ transporting timber. This transport is flexible and can be taken anywhere to the point of loading and unloading

(iii) Transport by carts: Bullock-carts and horse-carts are used to carry loads from one place to another. (iv) Transport by automobiles: In includes motors, trucks and buses. It has assumed greater significance in modem industry and commerce because of its greater speed and low cost per kilometer. Advantages of Road Transport : The important advantages of road transport are as follows: 1.

Road transport is more flexible than any other means of transport. It provides door-to door service by loading goods at the cosigner's place of business and unloading them at the consignee's place of business.

2.

For short distances, say up to 300 kilometers, road transport is cheaper and quicker. The slow movement of road transport is more than made up by the adoption of direct and economic routes and by other benefits.

3.

Loading and unloading can be done at a less cost, in the least possible time and at the place of business of the consignor or the consignee.

4.

The requirements of packing are less and even in some cases, packing is not necessary.

Service Sector and Modem Entrepreneur 5.

271

Road transport serves those areas also where no other means of transportation is available.

6. The freight structure is simple to understand. Freight can be determiner easily. 7.

Roads are not to be constructed by the road transport owners. Usually, they are provided by the Government. Rich farmers and businessmen can have their own vehicles for the transportation of their products without any delay.

8.

Road transport is indispensable to other modes of transport because it acts as a feeder service to railways, airways and waterways.

9.

Road transport is very suitable for transporting perishable and delicate items. There is less risk of Joss, damage or pilferage because of proper handling and the element of personal service by the owners of transport enterprises.

Disadvantages of Road Transport :

Road transport has the following major drawbacks : 1.

Road transport is not suitable for long distance as it is costlier and consumes more time as compared to railways.

2.

It is less safe in certain respects. The probability of accident is higher. The goods are liable to damage because of faulty roads.

3.

Its freight charges are not stable in character. These are generally subject to bargaining. They vary from one operator to another.

4.

It is quite an irregular means of transport as trucks may not move regularly.

5.

It cannot be completely relied upon because of frequent breakdowns of vehicles and blockages of roads because of rain, flood, snow and other reasons.

Advantages and disadvantages of Rail Transport :

The provision of railways as a part of the infrastructure of an economy is vital for industrialisation. In most of the countries,

272

Service Sector and Modem Entrepreneur

railways constitute the principal means of transport for carrying goods and passengers. Rail transport is more reliable than any other of transport.

Advantages o/Rail Transport: Rail transport has the following major advantages as compared to other means of transport: 1.

It is the most suitable means of transport for carrying heavy and bulky goods over long distance.

2.

It provides regular service as it follows regular schedules . . So it is more dependable.

3.

The freight rates charged by railways are fixed and do not change frequently.

4.

It us bit affected by weather conditions unlike other modes of transport.

5.

It carries goods and passengers with greater speed than any other means of transport except the air transport.

6.

It is flexible in the sense that the number of wagons attached to a train may be a justed according to the volume of traffic.

7.

It is a safe means of transport as it protects the goods from exposure de to sun, rain or snow, if the goods are carried in closed wagons.

Disadvantages o/Rail Transport: Rail transport has the following major demerits: 1.

It requires huge capital expenditure for its establishment. It cannot operate economically in those areas where volume of traffic is inadequate.

2.

It is affected by the problem of terminals. A terminal is the point where goods have to be loaded or unloaded. It cannot rum to every customer's door because the track on which a train moves is fixed. In this sense, rail transport is inflexible. Since the customer has to take the help of road transport for carrying goods to and from his godown, it increases the cost of transport by rail.

3.

It is costlier for short distance as compared to road transport particularly because of terminal costs.

Service Sector and Modern Entrepreneur 4.

273

The task of loading, unloading, assembling and shunting is quite time consuming and it causes delays.

5. The maintenance of the tracks and wagons and efficient running of trains is very costly. 6.

Pilferage, delay and rough handings of goods during transshipment are not uncommon. Due to this, the railway administration has to pay every year heavy amounts by way of compensation.

Rail-Road Competition:

There has been a keen competition between the rail and road transports in recent years in our country. In some countries, railways have incurred heavy losses as a result of such competition. Road transport has an upp~r hand over rail transport because of the following reasons. 1.

Road transport is more flexible as compared to rail transport. It is capable of providing door-to-door services to its customers. Goods can be loaded and unloaded in trucks or other vehicles at the place of their production or manufacture. Businessmen choose road transport for short distance because it involves loading and unloading one time only. In case of rail transport, the businessman has to bear additional expenses of loading, and unloading because goods can only be transported at fixed terminals.

2..

It is easier to send goods through road transport companies than through railways. In case of railways, a large number

of formalities have to be observed both at the time of dispatch and delivery of goods. 3.

Freight rates are higher in case of railways than in case of roadways particularly for short distances. That is why short distance traffic is diverted to road transport.

4.

There is more risk to goods due to theft, loss or damage of goods in transit in case of railways because of impersonal service provided by it. Some businessmen like road transport due to personal service provided by their operators.

,..

274 5.

Service Sector and Modem Entrepreneur

Road transport is more suited for carrying perishable commodities like vegetables, fruits, milk, etc. Not much packing is required to transport them through road transport.

Need for Coordination: There is a need of a coordinated transport policy so that wasteful competition between rail and road transport is avoided. If free competition is allowed, roadways will take away all the short traffic. It will be more severe when the rail lines and roads run parallel to each other. Coordination of transport system is necessary to ensure:

" unnecessary (i) scarce resources are utilized efficiently and duplication is avoided; (ii) the transport system is developed according to the pattern of users' demand; and (iii) efficient services at lowest possible cost are provided to the society. Measure for Coordination: Coordination between railways and roadways may be achieved in any of the following ways: (i) by integration of the two systems of transport; (ii) by suitable legislative measures prohibiting the wasteful competition; and (iii) by nationalising the whole transport system with a view to achieve a coordinated system of transport. Committee on Transport Policy and Coordination: This committee was set up in July, 1959 under the chairmanship of K.c. Neogi and it submitted its report in 1966. It made the following recommendation for coordination: (i) The transport system should be viewed as an integrated and unified structure and the objective of coordination, therefore, should be to develop various means of transport as complementary services to one another.

Service Sector and Modem Entrepreneur

275

(ii) For effective coordination of transport programmes and policies, it is essential to develop adequate machinery, organisation and instrument. For this the establishment of National Council for Transport Coordination is necessary. (iii) A Committee of Ministers should be established at the center to facilitate coordination of important questions of policy and to provide guidance to various bodies connected with it. (iv) The responsibility for coordination and development of road transport within the state should devolve on the state Transport Authority. (v) A center for Transport Retouch and Training should be established to stimulate transport research and studies and to provide necessary training to persons drawn from Central and State Organizations. (vi) Road transport should be regulated uniformly throughout the country and it should stimulate the growth of underdeveloped regions. The road researches in the country should be fully exploited to reduce the cost of construction and maintenance of roads, and to utilize the indigenous and local materials. (vii) The need for collection and proper analysis of various information's and data relating to various modes of transport was also emphasised by the committee.

(viii) The chief objective of the national transport policy should be to fulfil the future transport requirements of the country.

Merits and demerits of Inland Water Transport and Ocean Transport: Water transport is one of the oldest form of transport. Though it is slow, it is the cheapest form of transport. It is very much suitable for bulky and cheaper goods. Water transport includes (i) inland water transport, and (ii) ocean transport.

Inland Water Transport : Inland waterways include rivers and canals. Rivers are the gift of nature which can be used for

276

Service Sector and Modem Entrepreneur

transporting goods and passengers. But canals are artificial waterways. They require huge amount of capital for their construction and maintenance. Water transport in India has been very popular because of the following advantages: (i) It is the most suitable means of transport for bulky and less costly goods like coal and timber. (ii) It is the cheapest means of transport, The cost of infrastructure is also low as compared to other means of transport.

Water transport also suffers from many drawbacks which are as follows: (i) Rivers and canals can serve only a limited area. (ii) The construction of canals requires huge capital expenditure. (iii) The speed of boats and steamers is very low as compared to other means of transport. So it cannot be used for quick delivery. Moreover., boats have very limited capacity. (iv) Rivers change their course abruptly which may cause dislocation of traffic. (v) Inland waterways are not always reliable. During rainy season, there may be too much disturbance in the water and during winter season the Water may get frozen. During summer season the level of water may not be adequate for navigation.

Ocean Transport: Ocean or sea transport is very important for the development of foreign trade. It is the only means of cheap transport between different countries of the world. Though air transport is also used for connecting different countries, but it is too expensive and cannot carry bulky goods in large quantities. Like inland waterways, the ocean transport also suffers from certain demerits which are as follows: (i) The speed of ocean transport is very low. So it cannot be used when the goods are to be sent quickly.

Service Sector and Modem Entrepreneur

277

(ii) There are a large number of risks inherent in carrying goods

through sea. (iii) The distance between places increases as the routes

followed b}' the ships are quite circuitous. (iv) The waterways may not be navigable due to seasonal changes. (v) Sea transport is not suitable for perishable goods as it is very slow. Despite these drawbacks, sea transport is widely used for foreign trade purposes. It is the cheapest mode of'transport. Its operating cost is the minimum. It does not involve huge capital expenditure for building the infrastructure as in railways and roadways. The ships are more spacious than and other means of transport. Sea transport may be of two types, namely, coastal shipping and overseas shipping. Coastal Shipping. It is prevalent in those countries whose borders touch the sea shore. It is the most suitable mode of transport for the movement of bulky cargoes like coal. It is the most economic form of transport for carrying goods from one po::-t on the coast to another, e.g., for transporting goods from the port of Madras to the port of Visakhapatnam. Overseas Shipping. When goods are carried across the high seas from one country to another, it is termed as overseas transport. For India, sea routes radiate mainly from the major ports, namely, Calcutta, Visakhapatnam, Madras, Cochin, Bombay and Kandla. Types of Cargo Ships:

(a) Liners: Liners are those ships which form part of a 'line' offering a fairly regular service between certain ports, with advertised schedules. A liner follows definite routes with fixed terminals and operates at regular intervals. Whether it receives full cargo or not, it does not hinder its movement. It is mostly used by those traders who have to meet the contracts of delivery of goods by fixed dates. The unit of liners is known as 'fleet'. (b) Tramps: In case of tramps, the unit is the single ship which does not follow any specific route and does not sail in accordance

278

Service Sector and Modem Entrepreneur

with a particular schedule. It moves whenever and wherever it finds cargo. Tramps can be chartered by major importers or exporters. Their freight charges are not fixed and uniform. They are owned and run by different companies each possessing one or more ships which have competition among them. But liners are mostly owned and run by one company. (c) Tankers: There are ships which are specially designed to carry crude oil and refined petroleum products. The load is discharged from the cargo by pipeline.

Air Transport : Air transport has also entered into freight traffic. Its greatest advantage is that it has reduced the time and distance barrier to a great extent. However, air transport is the costliest means of transport because of high cost of planes, their operation and maintenance. That is why, it has not gained much business in freight transport. Air transport can be classified into regular flights and chartered or special flights. Regular flights are run by the airlines on scheduled routes and at scheduled periods. But in case of a chartered flights, the entire plane is booked for a trip to a particular place. In India, air transport was nationalised in 1953. Two corporations, namely Indian Airlines Corporation and Air India International were set up for running internal and external air services respectively. Benefits of Air Transport : Air transport has the following advantages: 1.

Its speed is very high. So it is very suitable for perishable commodities or when time is the most important factor.

2.

It is most suitable for less bulky goods of high value, e.g.,

gold, Jewellry. 3.

Air transport helps in carrying goods to those areas which are inaccessible by any other means of transport.

4.

Air transport is most suitable when the other means of transportation are dislocated due to flood, earthquake or other natural calamities.

Service Sector and Modem Entrepreneur 5.

279

Air transport can follow the shortest possible route as no track or road is involved.

Demerits of Air Transport :

Air transport suffers from the following limitations. (i) The cost of operation of planes is the highest as compared to other means of transport. (ii) The freight charges are the highest in air transport. (iii)

It is highly uncertain and unreliable form of transport as it depends greatly upon the atmospheric conditions. A scheduled flight may have to be postponed or cancelled because of bad weather conditions.

(iv) The probability of accident is the highest in case of air transport. (v) Air transport is not suitable for carrying bulky goods and goods of small value. (vi) Air transport also suffers from the problem of terminals as in case of rail and water transport. Suitability of Different Modes of Transport : 1.

Road transport is most suitable for carrying goods of medium bulk and weight over short distances and for providing point to point service. It is widely used for transporting perishable commodities like vegetables, fruit, milk and milk products.

2.

Rail transport is the best means of transport for carrying bulky goods over long distance within the country as its speed is higher than road and water transport.

3.

Water transport is most suitable for bulky goods of low price which can bear handling and hazards of journey and when time is not the consideration.

4.

Air transport is most suitable for carrying Valuable, perishable and less bulky articles like gold, jewellery, medicines and spare parts where speed is the greatest consideration or where other means of transport cannot reach the particular place.

280

Service Sector and Modem Entrepreneur

Comparison of Different Means of Transport : In order to choose a particular means of transport out of Road, Rail, Water and Air, the following factors should be taken into consideration. 1. Cost: Water transport is the cheapest means of transport for carrying bulky goods over long distance, particularly when time is not the essential element. Railways rank second in terms of cost of service. It is cheaper than road transport for heavy goods and long distance movement. However, for small consignments which are to be carried over short distance, road transport is the cheapest. Air transport is the costliest means of transport because its operational cost is too high and its capacity is limited. 2. Carrying Capacity: Railways and waterways have larger carrying capacity than other means of transport. They are also cheaper when the whole wagon or vessel is booked for sending the cargo.

3. Speed: In respect of speed, air transport gets the first ranking while waterways is the slowest means of transport. Road transport has the merit of being faster than rail transport over short distance only because loading, unloading, assembling and shunting of wagons takes much time. However, for long distances rail transport is faster than road transport. 4. Flexibility o/Service: Water, rail and air transports are not flexible as they suffer from the problem of terminal. Goods have to be carried to and from the terminal in case the businessman decides to use a~ of these means of transport. But road transport is flexible. It covers the maximum areas of the country and is capable of providing door-to-door service. It carries goods from one businessman to another and this requires loading and unloading only for once. Road transport also acts as a complementary service to other modes of transport. 5. Regularity 0/ Service: Rail transport is the most regular service as it follows regular schedules and is generally uninfluenced by weather conditions. They may have to delay their trips or even cancel them sometimes. The impact of weather on roadways is comparatively less as compared to airways. 'f" .

Service Sector and Modem Entrepreneur

281

6. Safety: Roads are considered the safest means of transport. When the articles to be consigned require delicate handling, it is preferable to use road transport. Rails also provide sufficient safety to goods. They are less prone to accidents as compared to road vehicles. Airways and waterways are the most risky modes of transport. Merits and demerits of Road Transport and Water Transport:

Road Transport : 1.

It provides door to door service with the help of trucks, animals, carts and trams;

2.

Comparatively high speed.

3.

It is flexible.

4.

It is more dependable as compared to water transport.

5.

It is a costlier means of transport.

6.

It is available in all parts of a country.

7.

Comparatively more safe.

8.

Suitable for sending goods and passengers to the interior parts of the country.

9.

Capacity to carry goods is limited.

Water Transport: 1.

It does not provide door to door service as it uses river, canal and sea,

2.

Limited speed.

3.

It is not flexible

4.

It is less dependable.

5.

It is a cheaper means of transport.

6.

It is available where rivers, canals and sea routes are available.

7.

Comparatively less safe.

8.

Suitable only for regions near the rivers, canals and coast.

9.

Its capacity is much higher as compared to motor transport.

282

Service Sector and Modem Entrepreneur

Advantages and disadvanta~es of Rail Transport :

Rail Transport : 1.

Not possible.

2.

Comparatively speed.

3.

Not flexible because it runs on schedule.

4.

It is regular and more dependable.

5.

It is generally fit for all seasons.

6.

Its capacity to carry good is quite huge.

7.

It is more safe.

8.

It operates in the public sector.

9.

Transport charges are low.

10. Rail is the monopoly of the Government. 11. It is more suitable for long distances and for heavy or bulky goods.

Road Transport : 1.

Is possible.

2.

Limited speed over long distances.

3.

It is flexible as there is no rigid schedule.

4.

It is less dependable as chances of breakdown are higher.

5.

It is not fit during rainy season.

6.

Its capacity is very limited.

7.

It is less safe.

8.

It generally operates in the private sector.

9.

Transport charges are high.

10. There is competition in case of Road transport. 11. It is more suitable for short distances and light goods .

•••

Chapter

18

--

COMMERCIAL BANKS

A Commercial bank deals in money. It receive deposits from the public to lend money to those who are in need of it. The rate of interest charged by the bank on loans and advances is generally higher than the rate offered on its deposits. Modern banks perform a number of other services or functions like collection and payment of bills of exchange, issue of letter of credit, collecting credit information, safe custody of valuables, etc. The commercial bank is an institution which carries on the business of receiving money from customers subject to the obligation of honouring the cheques drawn by customers to the amount available on their accounts." Thus, the essential character-sties of a commercial bank are: (i) receiving deposits from the public; (ii)

paying against cheques drawn by account-holders;

(iii) collection of drafts and cheques on behalf of the customers. (iv) lending money to traders. etc. Function of a Commercial Bank: The functions of commercial banks may be divided into following two bread categories: 1 . Primary functions; and 2. Subsidiary functions.

284

Commercial Banks

Functions o/Banks : (i) Receipt of deposits, and (ii) Lending of money. (i) Receipt 0/ deposits or borrowing : The first important function of a commercial bank is borrowing money from the public. It borrows by attracting deposits of money. The deposits can be collected in the following forms: (a) Current Accounts, (b) Saving Deposits, (c) Fixed Deposits, and (d) Miscellaneous deposits like Cumulative Deposit Scheme, Cash Certificates. Old Age Pension Plan,etc. (ii) Lending o/money : The second important function of a bank is lending. It makes profit by performing this function. It lends money to merchants and manufacturers for short periods. Now-a-days, it lends even to consumers and agriculturists. It lends mostly on the security of easily releasable assists like rice, wheat, cotton, oilseeds, cloth, gold and Government securities. It makes advances to those who require them and who can pay back the loan with interest. A bank makes advances in various ways- cash credits, -overdrafts and loans.-It also discounts bills of exchange. 2. Subsidiary Functions: (i) Agency Service, and (ii) General Utility Services. (i) Agency Services: A commercial bank acts as an agent of its customers in the following ways: (a) It collects cheques, drafts and bills of exchange on behalf of customers. (b) It collects dividend and interest warrants of customers_ (c) It collects salaries and pensions of customers. (d) It purchases and sells securities on the instructions of its customers. (e) It executes standing orders like payment of rent, electricity bill, insurance premium, etc. (f) It acts as a correspondent of its customers and other banks. (g) It acts as a trustee, executor and attorney. (ii) General Utility Services: A commercial bank performs the following general utility services: (a) Safe custody of valuables like gold, jewellery and important documents.

Commercial Banks

285

(b) Provision of lockers to customers on hire basis.

(c) Collection and supply of business information. (d) Purchase and sale of foreign currencies. (e) Issue of demand drafts to remit money. (f) Underwriting of capital issues.

Role of Commercial Banks in the Economic Development of a Country: A commercial bank performs various functions and services which have already been discussed in the previous pages. Because of these services, it has acquired a place of economic significance in the economy of any country. Its role will be more clear from the following points: 1.

Banks offer attractive rates of interest for our savings. Idle savings can earn interest if they are deposited with banks. Banks encourage the habit of thrift among people. They mobiles the savings of the society. Banks are compared to rivers, as they collect the small surplus and scattered savings of the people and make them available for productive purposes in large sums of finance.

2.

Banks give safety and security of the people's savings. It is dangerous to keep money at home because of the fear of fire and theft. But it is safe to deposit it with banks. 3. Banks provide the "cheque system" which is a great convenience for making payments. Bank cheques settle transactions as Legal Tender Money. Payment by cheques economises time and trouble.

4.

Banks regulate the flow of national savings into various productive channels. While lending money, they discriminate between a genuine trader and a speculator and thus, they discourage the gamblers.

Different types of accounts by which commercial banks attract deposits from the public: Commercial Banks borrow money from the public by accepting deposits in the following accounts:

286

Commercial Banks (i) Current Accounts.

(ii) Savings Accounts. (iii) Fixed Deposit Account.

(iv) Money at Call and Short Notice. (v) Miscellaneous Deposits. 1. Current Account: It is also called demand deposit account. A businessman can open a current account with a bank. Current accounts generally do not carry any interest as the amount deposited in these accounts is repayable on demand without any restriction. The Reserve Bank directive prohibits the payment of interest on current accounts or on deposits up to 14 days or less except where prior sanction is obtained. Most of the banks charge incidental charges on such accounts. 2. Savings Fund Account: Savings deposit account is meant for individuals who wish to save a little out of their current incomes. It helps in safeguarding their future and also earns some interest on their savings. A savings account can be opened with or without cheque book facility. There are restrictions on the withdrawals from this account. Savings account holders are also allowed to deposit cheques, drafts, dividend warrants, etc. which stand in their names only. For this facility, it is necessary that account holder must be introduced by a person having a current or saving account with the same bank. 3. Fixed Deposit Account: The term 'fixed deposit' means deposit repayable after the expiry of a specified period. Since it is repayable only after a fixed period of time, which is to be determined at the time of opening of the account, it is also known as 'Time deposit'.

Fixed deposits are the most suitable form of raising resources for a commercial bank. Since they are repayable only after a fixed period, the banker may employ these funds more profitably by lending at higher rates of interest and for relatively longer periods. The rate of interest on fixed deposits depends upon the period of deposits. The longer the period, the higher is the rate of interest offered. The power to fix the rates of interest on fixed deposits rests with the Reserve Bank of India.

Commercial Banks

287

4. Recurring Deposit Account: The Recurring Deposit Account is gaining wide popularity these days. Under this, the depositor is required to deposit a fixed amount of money every month for a specific period of time. Each instalment may vary from Rs. 5/- to Rs. 500/- or more per month and the total period of account varies from 12 months to 10 years. After the completion of the specified period, the customer gets back all his deposits along with the cumulative interest Secured on them. 5. Miscellaneous Deposits: Banks have introduced several deposits schemes to-attract deposits from different types of people. These include pigmi deposit account, cumulative deposit account, Mini Deposit Scheme, Children Gift Plan and Old Age Pension Scheme.

Methods of lending money by the commercial banks: The importants methods of lending by the commercial banks are: (1) Overdraft. (2) Cash Credit. (3) Loans. Overdrafts : Under this arrangement, the bank allows its customer to overdraw his current account so that it shows a debit balance. Any businessman can enter into this arrangement to tide over a temporary shortage of funds. The customer can draw this fund as and when be requires and repay it when it is convenient for him. The customer is charged interest on the amount actually overdrawn by him.

Cash Credits: A cash credit is an arrangement under which a borrower is allowed to withdraw up to a certain limit against the security of tangible assets. Cash credit is like overdraft arrangement, but for this purpose a current account does not have to be in existence. In cash credit, a trader or industrialist or agriculturist can withdraw amounts within the limits sanctioned for meeting expenses on current operations. In such cases, interest is paid on amounts withdrawn. Loans: In this case, the entire amount is paid to the borrower in lump-sum. The loan amount may be paid either in cash or

288

Commercial Banks

transferred to the current account of the borrower. Interest is charged on the whole amount of loan. However, loan can be repaid back in installments. Types of Modern Banks: Banks may be classified into the following categories:

(1) Commercial Banks. (2) Industrial Banks. (3) Agricultural or Land Development Banks. (4) Exchange Banks. (5) Cooperative Banks. (6) Rural Banks. (7) Central Bank.

(8) Exim Bank. (9) NABARD. 1. Commercial Banks: A commercial bank may be defined as a financial institution which accepts deposits and lends money to commerce and industry. It also renders a number of other useful services to the customers and the society. Commercial banks borrow money from those who have surplus funds and lend to those who need for commercial and industrial purposes. Thus, they act as dealers in loan able funds of the society. Commercial banks receive deposits in the form of fixed deposit, savings bank account and current account. They grant loans, generally for short periods, in the form of cash credits, overdrafts and ordinary loans. They also render a number of services such as collection of cheques, safe custody of valuables, remittance facilities and payment of insurance premium, etc. 2. Industrial Banks: Industrial banks provide long-term funds to industrial enterprises. They perform the following functions: (a) Provision of long-term loans to industrial organizations for their expansion and modernisation programmes; (b) Promotion of new industrial enterprises; (c) Provision of technical guidance in the management of industries; and (d) Controlling the affairs of the industrial undertakings by securing representation of their Board of Directors.

Commercial Banks

289

In India, there were no industrial banks till 1947. The Central Government and the Reserve Bank have taken an active part in setting up industrial banks in India to finance the capital requirements of small, medium ar..d large scale industrial units. They include Industrial Finance Corporation, Small Scale Industries Corporation, Indu~trial Credit and Investment Corporation and Industrial Development Bank of India. 3. Agricultural or Land Development Banks: Agricultural banks provide long-term credit to agriculturists for purchase of tools and implements and for permanent improvement of larld. In India, these banks were set up to provide loans to agriculturists on easy terms against mortgage of land for the purpose of repayment of loans to village money-lenders and indigenous bankers. These banks were also known as 'Land Mortgage Banks'. But now the emphasis has been shifted to provide loans for permanent improvement of land. That is why they have been renamed as 'Land Development Banks'. They grant loans to agriculturists which are repayable by annual installments spread over a number of years ranging from twenty to thirty years. 4. Exchange Banks: Like other commercial banks, they also undertake the usual banking business, but they specialise in foreign exchange transactions. Exchange banks are foreign in origin, i.e., they have their head offices located outside India. At present there are sixteen exchange banks in India and these banks have a hold on India's foreign trade transactions. Since they specialise in financing foreign trade, they are called 'foreign exchange banks'. These banks also render other services incidental to financing such as acting as referees, collecting and supplying information about the foreign customers, providing remittance facilities, etc. The foreign banks have also entered the field of internal trade. They compete with the Indian commercial banks in attracting deposits of all kinds, discounting of bills of exchange and making advances to trade and industry. However, the financing of foreign trade still remains their field of specialisation. The licensing of these banks is controlled by the Banking Regulation Act, 1949. The operations of these banks have been made subject to general control of the Reserve Bank of India. Regard ing their foreign exchange

290

Commercial Banks

transactions, these banks are governed by the Exchange Control Regulations. 5. Co-operative Banks: Co-operative banks are formed on the principle of co-operation to extend credit facilities to farmers and small scale industrial concerns and promote in general the habit of thrift and self-help among the low and middle income groups of the society. The distinguishing feature of a co-operative bank is the absence of profit motive. Co-operative banks are very helpful to meet the requirements of small farmers, artisans, etc. In India cooperative banks have been the pioneers in mobilising rural deposits.

Co-operative banking has a three-tier structure. At the top there is State Co-operative Bank at the state level. This is the apex bank which governs all the co-operative banks in the State. At the intermediate level, there are Central Co-operative Banks. There is generally one central co-operative bank for each district. At the base of the pyramid there are Primary Credit Societies a t the village level. Each higher level institution is a federation of those below with membership and loan operatiOns restricted to the affiliated units. 6. Rural Banks: In India, Regional Rural Banks have been set up in backward rural areas where the coverage of the commercial and co-operative bank is poor. The purpose of these banks is to finance agricultural operations and provide employment to rural educated youth who possess the requisite orientations to look after the needs of rural folk.

Regional Rural Banks have been conceived to combine the strong points of both the co-operative and commercial banks eliminating the weaknesses of both. The Regional Rural Banks have been included in the Second Schedule to the Reserve Bank of India Act and, therefore, they enjoy the same privileges and facilities as the scheduled banks, including access to the Reserve Bank for • financial accommodation. 7. Central Bank : Central bank of a country is the leading institution created by law in its money market as it acts as a leader of the money market. It supervises and regulates the activities of commercial banks and other financial institutions. In India, this role is played by the Reserve Bank of India. The Reserve Bank acts as

291

Commercial Banks

the bank of the bankers. It manages the issue and circulation of currency and controls the creation of bank credit in order to ensure stability in the economy. It supervises, guides and controls the activities of all other banks in the country to bring them in line with the policy of the central government. The important functions of the Reserve Bank of India are as given below: (i) to issue currency notes; (ii) to regulate, control and supervise commercial banks; (iii) to regulate and control money market; (iv) to regulate and control the banking business of the country; (v) to frame policy and regulate and control the loans and advances; (vi) to implement the banking and financial policy of the Government of India; (vii) to regulate and control the foreign exchange; and (viii) to publish monetary and financial information. S. Exim Bank: The Export-Import Bank of India (Exim Bank) was set up in January, 1982 with its headquarters in Bombay. Apart from the normal banking functions connected with import arid export of goods, the Exim Bank performs several other functions. These include financing of exports from and imports to India, financing joint ventures in foreign countries and financing the export and import of machinery and equipment on lease basis. It also undertakes purchasing, discounting and negotiating of export bills. 9.

NABARD : The National Bank (or Agriculture and Rural

Development (also known as Farm Bank) parted its operations with effect from July 15, 1982 as the apex bank for agricultural operations. The Bank provides by way of refinance to banks all kinds of production and investment credit to agriculture, small scale industries, artisans, cottage and village industries, handicrafts and other allied economic activities.

•••

Chapter

19

**

INSURANCE Insurance may be defined as a mechanism for giving financial compensation for the effects of misfortune to a party out of the accumulated contribution of the parties participating in the scheme. The insurance scheme is run by an insurance company or corporation. The insurance corporation brings toget~r a large number of individuals who are exposed to similar kinds of risks. It gives them an assurance against loss in consideration of the insurance premium paid by them. Thus, under insurance, the risk which would otherwise be borne by one individual is distributed over a large number of individuals. Insurance contract is a device by means of which a man can get himself protected from .uncertain contingencies. In such a contract, the insurer undertakes to indemnify or make good the. Joss of the insured caused to him, by the happening of the uncertain event insured for, to the extent of the sum agreed upon therein. Insurance is a device by which a loss likely to be caused by an uncertain event is spread over a large number of persons. The agency which gives insurance facility is known as 'Insurer' or the insurance company. The person who gets his property or life insured is known as 'Insured' or 'Assured'. The agreement or contract, which is put in writing, is known as a 'Policy'. The consideration in return of which the insurer undertakes to make good the loss or to give a certain amount in case of life insurance is known as 'Premium.

Insurance

293

Purpose of Insurance:

The purpose of insurance is to provide financial protection against loss arising from any risks to which one may be subject. All types of risks can now be insured against. Circus company can insure against untoward incidents, a person can insure his life and his property. A captain of the ship can be insured on a specific voyage apart from his ordinary life insurance. However, the most important forms of insurance are ; Life, Fire, Marine and Accident. Advantages of Insurance:

Insurance confers great benefits on individuals and the society as a whole. Some of the important advantages of insurance are as follows: 1.

Insurance is a good device of distributing the loss of a few over a large number of persons. By paying a small premium, the insured fee is assured that he is provided for any financial loss that may arise from a specific event. This will enables him to concentrate on his business.

2.

Insurance adds to the credit-worthiness of the insured. Loans can easily be obtained on the security of life insurance policy. Life insurance is a means of promoting thrift and the insured will save by way of insurance premium.

3.

Life insurance is an effective device for making provision for old age. Life insurance also gives against risk of premature death. In case of early death, the amount of the policy is given to dependents of the insured. It he survives period of insurance, his premium goes on accumulating and he receives a lump sum amount on the maturity of he policy.

4.

Insurance gives a sense of security and safety. The insured is relieved of the worries if any loss is sustained arising from certain contingencies.

5.

Insurance premiums represent the savings of the nation and can well be used for the weaker sections of the society of the country. Thus, insurance serves the national interest also.

294

Insurance 6.

The scheme of social insurance, like insurance against sickness, old age, unemployment, accidents, etc., protect people from many hardships. In the absence of insurance, financial hardships may compel a man to theft or beggary. Insurance not only helps stopping these by providing financial assistance, but also saves the society which might have to support such people.

Definition of Insurance:

D.S. Hansell has defined insurance "as a social device providing financial compensation for the effects of misfortune, the payments being made from the accumulated contributions of all parties participating in the scheme". According to W.A. Dinsale, "Insurance is a device for the transfer of risks of individual entities to an insurer, who agrees, for a consideration (called the premium) to assume to a specified extent losses suffered by the insured". Dictionary of Accounting edited by Prof. N.K. Sharma has defined in$urance as a form of contract or agreement under which one party agrees in return of a consideration to pay an agreed amount of money to another party to make good for a loss, damage or injury to something of value in which the insured has pecuniary interest as a result of some uncertain event". Insurance is a device by which a loss likely to be caused by an uncertain event is spread over a large number of persons who are exposed to it and who voluntarily join to insure themselves against such an event. The agency which helps in entering into this arrangement is known as 'Insurer' or the insurance company. The persons who gets his property life insured is known as Insurer / ,Assured'. The agreement or contract, which is put in writing, is known as a 'Policy'. The consideration in rehlrn of which the insurer undertakes to make good the loss or to give a certain amount in case of life insurance is known as 'Premium'. Difference Between Assurance and Insurance:

The two words were used synonymously at one time, but now a fine distinction is drawn between them. 'Assurance' is .used in

Insurance

295

those contracts which guarantee the payment of a certain sum on the happening of a specified event which is bound to happen sooner or later, e.g., attaining a certain age or death. Thus, life policies come under assurance. Insurance, on the other hand, contemplates the granting of agreed compensation on the happening of certain events stipulated in the contract which are not expected but which may happen. Thus, insurance refers to those risks which are contingent in nature as fire, marine or accident. Types of Insurance Contracts: The contracts of insurance may be classified into the following important categories: (1) Contracts of Indemnity: Under a contract of the insurance, company promises to indemnity or compensate the insured in case of any financial loss suffered by him on the happening of the event stipulated in the contract of insurance. Except the life insurance, accident insurance and health insurance, all other types of insurance are contracts of indemnity as they give for the compensation to the insured for the loss caused to him because of the event insured against. Marine insurance and fire insurance are contracts of indemnity. (2) Life Assurance Contracts : Under the life or personal assurance contract, the insurer agrees to pay to the assured a predetermined sum of money on the happening of a certain event. This includes life, accident and health insurance. Since it is not possible to measure the loss in terms of money in these cases, the insurer agrees to pay a fixed amount on the happening of the event stipulated in the contract. The life insurance contract contains an element of security and investment both. The dependants or assignees of the assured get the fixed amount in case of his early death or the assured himself gets the assured sum together with bonus after the expiry of the term, if he survives. Contracts of indemnity can be further sub-classified into the following categories: (i) Property Insurance: Property insurance includes all insurance contracts pertaining to the property of any kind. Marine

296

Insurance

insurance, fire insurance, crop insurance and vehicle insurance are the examples of property insurance.

(ii) Liability InslIrance : A person liable to a third person under the provision of certain Acts. For example, Workmen's Compensation insurance and Third Party insurance involve liability, on the happening on an accident in the factory and damage to a third party due to a car accident on the road respectively. (iii) GlIarantee InslIrance : It is an arrangement whereby the insurer agrees to indemnity the insured for a fixed amount against losses arising through dishonesty, fraud or a breach of contract. Burglary insurance, fidelity insurance, credit insurance and cash in transit insurance are some of the examples of guarantee insurance. Principles of Insurance: Contracts of insurance are based on some fundamental principles. These principles are: (1) Utmost Good Faith, (2) Insurable Interest, (3) Indemnity, (4) Subrogation, (5) Causa Proxima, (6) Mitigation of Loss. Re-insurance : The insuring of a risk or a part thereof already undertaken by one insurer with another insurer is known as re-insurance. Under reinsurance, the contract is between two insurers. An insurer may resort to re-insurance either with the object of spreading his risk or to earn some profit when he is able to get re-insurance at a lower rate of premium than taken by him. When this is done, the original insured is known as re-insured and the subsequent insured, as reinsure. The contract of re-insurance does not affect the insured who is not a party to it. Neither the insured has any remedy against the reinsure. He can only make the original insurer liable for the loss caused to him under the policy taken out by him. It is the insurer who can claim compensation from the re-insurer. Suppose, a shipping company has taken a policy of Rs. 10,00,000 from an insurance company A. If A thinks the risk beyond its capacity, it can re-insure for Rs. 5,00,000 with another insurance company B. In case of total loss, A will pay the shipping company a sum of Rs. 10,00,000 and it will reimburse itself from B a sum of Rs. 5,00,000.

Insurance

297

Re-insurance is applicable to all kinds of insurance because insurer has an insurable interest in the subject-matter insured to the extent of the amount insured by him. Distinction between Re-insurance and Double Insurance: (i) The contract of re-insurance is entered into by the original insurer with some re-insurer. There is no private of contract between the insured and the re-insurer. But in double insurance, the same insured gets the subject-matter insured with more than one insurer. (ii) In re-insurance, the re-insurer is liable to the first insurer. In double insurance, each insurer is directly liable to the insured. (iii) In double insurance, loss will be shared by all the insurers. In re-insurance, re-insured will claim his part of the loss proportionate to the rist< insured by him. (iv) Double insurance in a method of assuring the benefit of insurance whereas re-insurance is a method of reducing the risk of insurer. Essentials of an Insurance Contract : Following are the essential elements of a contract of insurance:

1. Essentials of a Valid Contract: Insurance is a contract between two parties. Therefore, it must fulfil all the requirements of a valid contract like offer and acceptance, competence of parties, legal object, lawful consideration, etc. 2. Good Faith : A contract of insurance is a contract of uberrimae fidei i.e., requiring good faith between the parties. The insured must not conceal anything which is material to the subjectmatter of insurance.

3. Insurable Interest: The insured must have an insurable interest in the subject-matter of insurance, i.e., life or property insured. 4. Indemnity: All insurance contacts except the life insurance are the contracts of indemnity. Indemnity means to make good the losses to the extent of losses caused to the insured.

298

Insurance

5. Subrogation: The insurance company gets all his rights against the third party with respect to the subject matter insured after compensating the loss of the insured. The insurance company will have all the rights which the insured had against the third party. Utmost Good Faith: Insurance contracts are based upon mutual trust and confidence between the insurer and the insured. These are said to be uberrimae jidei i.e., of utmost good faith. It is a condition of every insurance contract that both the parties-the insurer and the insured-should display the utmost good faith towards each other in regard to the contract. Each party must reveal to the other party all information which would influence the other's decision to enter into the contract, whether such information is requested or not. Utmost good faith requires each party to tell the other "the truth, the whole truth and nothing but truth" about the proposed contract. The insured must also disclose all material facts related to the subject matter of insurance, even if not asked by the insurer, so that the insurer may be in a position to estimate accurately the risk that he is undertaking. The duty of good faith applies equally to the insurer, who is bound to place at the disposal of the proposer all material facts he possesses concerning the risk. Bad faith, i.e., misrepresentation or failure to reveal material information gives the aggrieved party the right to regard the contract as void. It is difficult to define material fact. It will depend upon the circumstances of each case. A material fact is one which goes to the root of the insurance contract. In other words, a fact is material if it would influence the prudent insurer in accepting or declining the risk or in fixing the conditions of insurance or rate of premium.

Some of the examples of facts which are quite obviously material to an insurance contract are: Life insurance-a person has a known lung inflection or a damaged kidney, (b) Fire insurance -a building has a thatched roof or is being used for manufacturing explosives, (c) Marine insurance-the ship has unrepaired damage affecting its handling and (d) Burglary insurance-the premises had been gurgled before. But it is significant to point out that a person cannot

Insurance

299

be penalised for not revealing facts which he does not know at all and which he cannot reasonably be expected to know.

(i) Utmost Good Faith: A contract of insurance is a contract of uberrimae fidei, i.e., requiring good faith between the parties. The insured must not conceal anything which is material to the subjectmatter of insurance. Utmost good faith requires each party to tell the other "the truth, the whole truth and nothing but the truth" about the proposed contract. The insured must also disclose all material facts related to the subject-matter of insurance, even if not asked by the insurer, so that the insurer may be in a position to estimate accurately the risk that he is undertaking. The duty of good faith applies equally to the insurer, who is bound to place at the disposal of the proposer all material facts he possesses concerning the risk.

(ii) Insurable Interest: Insurable interest means some pecuniary interest in the subject-matter of insurance contract. Hansell has defined insurable interest as afinancial involvement which is able to be insured. Existence of insurable interest in the subject-matter of insurance is a necessary pre-requisite of any insurance contract. The insured must either own a part or whole of it or he must be in such a position that injury to it would affect him adversely. For instance, a man who gets his motor car insured against accident has an insurable interest in it. If the car is damaged, it would cause him financial or pecuniary-loss. A person has insurable interest in the building he owns, a businessman has insurable interest in his stock, plant and machinery and building, a person has insurable interest in his own life. A person can also get the life of a person insured if he has pecuniary interest. For the purpose of life insurance, interest exists in the following cases: husband in the life of his wife and wife in the life of her husband, parents in the life of a child the creditor on the life of a debtor, an employer in the life of his employees and thepartners in the lives of one another. The time at which insurable interest must exist vary according to the type of insurance. In case of fire and accident insurance, the insurep must have an insurable interest in the subject-matter insured

300

Insurance

against fire or accident continuously from the time when the policy is taken out until the time when then the loss occurs. In case of life insurance, the insurable interest must be present at the time the policy is taken out but not necessarily at the time when the claim is made. In case of marine insurance, insurable interest is required to exist only at the time of loss, i.e., on the happening of the event insured against. In short, insurable interest remains in the beginning of life insurance, in the end of marine insurance and in the beginning and end of fire insurance.

(iii) Indemnity: All insurance contracts, other than those related to life, sickness and personal accident, are contracts of indemnity. A contract of indemnity may be defined as a promise to save another harmless from the loss caused as a result of a transaction entered into at the instance of the promisor. Thus, in case of fire and marine insurance, the insurer will compensate the insured for the loss caused to him by the damage or destruction of the property insured.

The principle of indemnity is of a great importance in case of fire and marine insurance. The purpose of this principle is to put the insured in the same position after the event happened (i.e., loss to property) in which he was immediately before the event. It should also be noted that the insurance company agrees to compensate the insured only to the extent of the loss suffered by him up to the limit of the amount covered by the policy. The insured is not allowed to make any profit on the happening of an event. For example, a ,building is insured against fire for Rs. 10 lack and a portion of it is burnt down. Suppose, it is estimated that an expenditure of Rs. 4 lack will restore the building to its original condition. In this case, the insured will get Rs. 4 lack only and no more. (iv) Subrogation: The principle of subrogation applies to all insurance contracts which are contracts of indemnity. Subrogation means the right which one person stands in place of another and avail himself of all the remedies and rights of that other.

Subrogation does not apply to life, accident and sickness insurance as they are not covered by the principle of indemnity.

Insurance

301

The insurer obtains the rights of the insured after he has settled the claim of the insured. The rights have to be exercised of the name of the insured unless the insured abandons the subject-matter and the insurer accepts it. The insurer is entitled to the benefits out of right of subrogation only to the extent of the amount he has paid to the insured as compensation. It is also obvious that if the insured receives any compensation from any third party for the loss incurred by him, he holds such amounts as the trustee of the insurer who has already compensated him for the loss.

(v) Contribution: Like subrogation, the principle of contnbution also applies to any insurance which is a contract of indemnity. Thus, it does not apply to life and personal acsident insurance. The principle of contribution limits the amount chainable from individual insurers so that the amount payable be each insurer is determined by his ratable proportion of the loss and set by the sum insured by him. The insured is not prevented, from taking out two or more policies on the same property. But in case of loss, when more than one policy are in force covering the same interest in the same property, the insured has no right to recove!' more than the full amount of his actual loss. However, the insured may get the compensation in proportion to the amount insured by each. Thus, if anyone of the insurers has made good the whole loss to the insured, he is entitled to the ratable contribution from the other insurers. (vi) Causa Proxima: Causa proxima is a Latin phrase which means Proximate cause or cause which, in a natural and unbroken series of events, is responsible for a loss or damage. According to this principle, the insurer is liable for loss only when such a loss is proximately caused by the peril insured against.

If the risk insured is the remote cause of the toss, then the insurer is not bound to pay compensation. This problem arises when there is a succession of causes. In such cases, the proximate or the nearest cause should be taken into account to determine the liability if the insurer. The insurer is liable to pay if the proximate causes is insured against. For instance, if the loss is the result of two census, it is

Insurance

302

necessary to look into the nearest cause and not the remote one. If the nearest cause is insured, the insurer is liable for the loss. Life Insurance:

In a contract of life insurance, the insurer undertakes to pay a certain sum of money on the death of the insured or on the expiry of a fixed period, whichever is earlier. The premium for life insurance may be paid by the insured either in lump-sum or in installments at regular intervals- monthly, quarterly, half-yearly, or yearly. Life insurance furnishes a sense of security. The person whose life is insured is called the assured. The consideration paid to the insurer (insurance company) is called the premium. The periodical payments made by the assured towards the total premium are known as installments. Usually, non-payment of any installment of premium brings the insurance contract to an end. The essential elements of a life insurance contract are as follows: 1. It is based on good faith. The assured must disclose all material facts about his health whether asked by the insurer ornot.

2.

It is based on insurable interest in the life assured. The

insurable interest must be present at the time of taking-up the policy. 3. It is not based on the principle of indemnity as there can be no compensation for the life lost. However, the amount payable will depend upon the terms of policy. Kinds of Life Insurance Policies

Important kinds of life insurance policies have been discussed below: 1. Whole Life Policy: Under this type of policy, the sum insured is not payable earlier than death of the insured. The premia on such policies may be payable regularly throughout the whole life of the assured or they may be payable for a fixed period (say 20 or 30 years) after which the payment of premium ceases. If the premia are payable throughout life, it is called 'Ordinary Life' policy. If the premia are payable only for a limited number of years, the policy is called 'Limited Payment Life Policy'.

Insurance

303

2. Endowment Life Assurance Policy: Under this policy, the insurer undertakes to pay the assured or his heirs or nominees a specified sum on the attainment of a particular age or on his death, whichever is earlier. In case of the death of assured before he attains the specified age, the sum is payable to his legal heirs or nominees. The premium for endowment policy is a bit higher than that of whole life policy. 3. Joint Life Policy: A joint life policy involves the insurance of two lives simultaneously. The policy money is payable upon the death of anyone of lives assured and the assured sum will be payable to the survivor or survivors. The most common example of joint life policy is that of a policy on the lives of a husband and wife, payable to the survivor on the death of either of the two.

4. Annuity: An annuity provides for the payment of insured amount in monthly or annual installments for a certain period. The fixed periodical payments may continue either until death or for a specific number of years. Insured in this case is asked to deposit a lump sum of money in the beginning of the policy. Insured may, at his option, get the annuities commuted again into a lump sum. These policies are generally taken with the object of making provision for old age. S. With or Without Profit Policy: Holders of with profit policies get the benefit of bonuses declared out of the profit of the corporation every two years. Bonuses shall be added to the value of the with profit policy and shall be paid on the maturity of the policy. 6. Children's Endowment Policy: The policies are taken fox the purpose of education of children and marriage expenses of daughters. The insurer agrees to pay a certain sum when the child attain a certain age. Premium is payable by the person entering into the contract. But if he dies before the maturity of policy, no further premium is payable. Fire Insurance:

Under a fire insurance contract, the insurer undertakes, on payment of the premium, to payor make good to the insured any loss or damage by fire which may happen to the property insured during the period covered by the policy, up to the amount specified

Insurance

304

in the policy. The contract specifies the period during which the indemnity is to last and also the maximum amount to which the insurer can be held liable. Generally, a contract of fire insurance is a contract from year to year only and the insurance automatically comes to an end after the expiry of the year. However, the contract can-be renewed before the expiry of the contract. The premium may be paid either in single installment (lump sum) or by way of installments. The document containing the terms and conditions of the contract is known as

'Fire Insurance Policy'. Characteristics of a Fire Insurance Contract : Following are the essential features of a contract of fire insurance: 1. It is a contract of uberrimae fidei, i.e., utmost good faith. Both the, insured and the insurer must disclose everything which is in their knowledge and can affect the contract of insurance. The disclosure by the insured regarding the risks to his property and regarding the nature of the groperty must be full and fair. 2.

It is a contract of indemnity. The insured is entitled to recover

only the actual amount of loss from the insurer, in the event of any loss or damage to the subject-matter of insurance. He cannot be allowed to make profit out of this contract. The maximum amount of compensation is limited to the value for which the policy has been taken. 3. The insured must have an insurable interest in the subject matter of insurance. Insurable interest means some pecuniary interest in the property to be insured which is capable of valuation. It must exist both at the time ofinsurance

and at the time loss. 4.

The contract of fire insur:ance is subject to the principles of subrogation and contribution. After the insurance company compensates the insured for the loss caused to him, the former is subrogated to the rights of the insured. In case of several insurance policies, each insurer is liable to contribute to the amount of compensation to be paid to the insured.

Insurance

305

5.

The insurer is liable to make good the loss only when fire is the proximate cause of damage or loss. There is generally a clause in most fire insurance policies by which the insurer exonerates his liability if the fire is caused by riot, war, and explosives. In the absence of such a clause, the insurer is liable to make good the loss caused by fire due to any reason.

6.

It is a contract from year to year. It generally comes to an end

after the expiry of the year and may be renewed, after making payment of the premium within the days of grace. 7.

The contract is personal to the insured. It is not assignable without the consent of the insurer. There is only one exception to this rule, i.e., where the insurer interest ceases by will or operation of law. However, the insured may assign the proceeds of such a policy.

Some of the important fire insurance policies are explained below: 1. Valued Policy: Valued policies are the exception in fire insurance. Under valued policy, the value declared in the policy is the amount the insurer will have to pay to the insured in the event of a total loss, and the insurer agrees to pay this amount irrespective of the actual value at the time of loss. The policy is issued only on artistic work, antiques and similar rare articles whose value cannot be determined easily. The insured knows in advance the exact amount of compensation payable to him in case of loss. He need not prove the value of the insured article at the time of loss. 2. Specific Policy: Under this policy, the insurer undertakes to make good the Loss by fire up to the amount specified in the policy. Thus, the value of the property is not taken into account. The insurer will pay the whole loss to the insured if it does not exceed the specified amount menti(lned in the policy. Suppose, a building worth Rs. 20,00,000 is insured against fire for Rs. 10,00,000. If the damage to the property is Rs. 7,00,000 the insured will get the full compensation. Even if the loss is Rs. 10,00,000, the insured will get the full amount. But if the loss is more than Rs. 10,00,000 (i.e., the amount insured), the insured wlll get Rs. 10,00,000 only. Hence, the value of property is not relevant in determining the amount of indemnity in case of a specific policy.

Insurance

306

3. Average Policy: Under a fire insurance policy containing the 'average clause', the insured is penalised for under-insurance of the property. In other words, the insurer is liable to pay that proportion of actual loss as the value of policy bears to the actual value of the property at the time of loss. The amount of claim is arrived ~t by dividing the insured sum by the actual value of the property and then multiplying it by the amount of loss. For example, a person gets his house insured for Rs. 40,00,000, though its actual value is Rs. 60,00,000. If a part of the house is damaged in fire and suppose that the insured suffers a loss of Rs. 30,00,000. The amount of compensation to be paid by the insurer comes out to Rs. 20,00,00 arrived as follows:

Amount of claim :

Insured Amount x Actual Loss Actual Value of Property

= 40,00,000 x 30 00 000 = Rs. 20 00 000

60,00,000

"

, ,

4. Floating Policy: A floating policy is used for mercantile risks and covering fluctuating stocks held in different lots and several places under one sum and for one premium. It is taken by big businessmen whose goods lie in different stations, ports and warehouses. Since with every transaction of sale or purchase, the quantities of goods stored at different places may fluctuate, it becomes difficult for the owner to take a policy for a specific amount. The best method open to him is to take out a floating policy for all the goods. Usually, a floating policy contains the 'average clause' to discourage under-insurance by the insured. 5. Replacement Policy: In such a policy, the insurer has the right to reinstate or replenish the property destroyed instead of paying compensation to the insured in cash. The modes of discharge by the insurer are alternative. If he elects one, he cannot afterwards shift to other. Thus, if he offers to pay cash compensation, he cannot subsequently claim to [reinstate and vice versa. Since this policy allows the policy-holder to obtain new goods for c d, the policy is also called "New Lamps for Old Policy".

Insurance

307

6. Consequential Loss Policy : When fire breaks out in a factory, it disrupts production because the factory has to be closed for repairs. The production suffers and so also profits of the insured. He has also to meet the fixed expenses such as rent, rates, taxes, salaries and other expenses as usual. Such considerable loss to the insured is not covered by the ordinary fire policy, in order to cover such loss by fire, the "consequential loss policy" or "loss of profits policy" has been introduced. The loss so suffered is separately calculated from the loss actually suffered. Marine Insurance: Under a contract of marine insurance, the insurer undertakes to indemnity the insured in the manner and to the extent thereby agreed, against marine losses. Marine insurance is an arrangement by which the insurer undertakes to compensate the owner of a ship or cargo for complete or partial loss at sea. Among the subject-matters of marine insurance are the ship, cargo and freight. The insured undertakes to pay a certain sum of money called the premium in consideration of the insurer's guarantee to make good the losses arising from certain specific perils which may include 'perils of the sea' as well as any land risk incidental to sea voyages. The contract is embodied in a document known as 'Marine

Policy'. The marine policy must specify the following: (a) The name of the insured or of some person who affects the insurance on his behalf. (b) The name of the insurer. (c) The subject-matter insured and the risks insured against. (d) The voyage, orperiod of time, or both, as the case may be. (e) The sum assured. (f) The rate or amount of premium.

Subject-matter of Insurance: The insured may be the owner of the ship, owner of the cargo or the person interested in the freight. Thus, marine insurance may be of three types, namely, hull insurance, cargo insurance and freight insurance.

308

Insurance

(a) Hull Insurance: A vessel is exposed to many dangers or risks at sea during the voyage. An insurance effected to indemnity the insured for such losses is known as hull insurance. (b) Cargo Insurance : The cargo transported by sea is also subject to manifold risks at the port and during the voyage. The cargo can be insured to cover against such risks.

(c) freight Insurance: The shipping company has to forego its right of receiving freight on the cargo, if it does not reach the destination safely. Freight insurance may be issued to reimburse the loss of freight to the insured in case the cargo does not reach the place of destination.

Kinds of Marine Insurance Policies: The main kinds of marine policies are discussed below: (i) Voyage Policy: A voyage policy is one by which the subjectmatter is insured on a specified voyage from the port of departure to the port of destination. Thus, the limits of risk are defined by the places. The risk which is covered starts from the departure of ship from the port and it ends when the ship reaches the port of destination. Voyage policy is suitable for cargo insurance as it covers the risk during transit. (ii) Time Policy: Under time policy, the insurance is affected for a specified period of time irrespective of the number of voyages made. The ship may pursue any course. The policy would cover all the risks: from the perils of sea for a stated period of time, say, from 1st August, 1993 to 30th April, 1994. Under the Marine Insurance Act, a lime pOlicy cannot be for a period exceeding 12 months. However, the policy may contain a 'continuation clause' providing that if at the end of the period, the ship is yet at sea, the policy 'will continue for a reasonable time thereafter till the ship arrives at the port of destination. This kind of policy is suitable for null insurance. (iii) Mixed Policy: It combines the characteristics of a time policy and voyage policy. It insures the subject-matter from and to certain places between a specified period, e.g., Bombay to New York from 1st December 1993 to 30th November'1994. In other words, it is a policy which covers the risk during a particular voyage for a specified period. It is known as 'Time and Voyage Policy' and is generally issued for ships operating over particular routes.

Insurance

309

(iv) Valued Policy: Under valued policy, the value of the subjectmatter insured is specified on the face of the policy itself. The value which is agreed upon is called the insured value. It forms the measure of indemnity in the event of loss. Insured value is not necessarily the actual value. It includes the following: (a) Invoice price of goods: (b) Freight, insurance and other charges; and

(c) Ten to fifteen percent margin to cover expected profits and other incidental charges.

(v) Unvalued Policy: An unvalued policy does not state the value of the subject-matter of insurance. In case of loss or damage, the compensation is ascertained by assessment of loss, subject to the limit of the sum insured. The value so left undecided is called 'insurable value'. It is ascertained as follows: (1) As regards the ship, the value includes its cost, provisions and stores, money advanced for wages and disbursement to make the ship fit for the voyage plus the charges of insurance. ' (2) As regards freight, the value includes the gross freight including the charges of insurance. (3) As regards cargo, the value is the cost of cargo plus the expenses of and incidental to shipping and the charges of insurance. (vi) Floating Policy: A merchant who is a regular shipper of goods can take out a 'floating policy' to avoid the botheration and waste of time involved in taking a new policy for every shipment. The floating policy stands for the contract of insurance in general terms and leaves the details to be declared subsequently. Whenever some" cargo is shipped, the, insured makes a declaration about the value of shipment ~nd the total value of the policy is reduced by that amount. With each declaration, the amount of insurance policy goes on decreasing. When the policy is fully covered, it is said to be 'fully declared' or 'run-off'.

(vii)Block Policy: It is a special type of marine insurance policy. When goods will be transported by land transport to be further transported by ship to the place of destination, a single policy, known as block policy, may be taken to cover all the risks. Types of l\.1iKine Losses:

310

Insurance

The risks to which vessel, cargo, and freight are exposed during their shipment by sea are known as marine losses. Marine losses may be divided into two broad categories: (a) Total loss, and (b) Partial loss, A total loss may be either total loss or constructive total loss. A loss other than a total loss is partial loss. That means a partial loss occurs when the articles are not destroyed totally. Partial loss may be either particular average loss or general average loss. Insurance can be taken, to cover either total loss or partial loss or Actual Total Loss: Actual total loss occurs in the following circumstances: (a) When the subject-matter insured is totally destroyed as in case of sinking of a ship or cargo being absolutely destroyed by fire. (b) Where the subject-matter insured is so damaged that .it has changed its nature and ceases to be a thing of the kind insured. For instance, sugar dissolved by sea water.

(c) When the insured is irretrievably (which cannot be recovered) deprived of the possession of the subject-matter e.g., ship or goods have fallen into the hands of enemy or pirates. In the above cases, the insured is entitled to get the full amount of loss. Constructive Total Loss: A constructive total loss occurs when'the subject-matter of insurance, though not actually destroyed or lost, is justifiably abandoned because its total loss appears unavoidable or when it is so damaged that it is commercially impracticable to repair, recover or restore it to the original position. Commercial impracticability means that the cost of recovering or repairing the subject-matter exceeds its repaired value. For instance a ship has stranded or struck against a rock and is badly damaged. If the expenses in getting the ship ashore and repairing it are likely to equal or exceed the repaired value of the ship, the ship-will be abandoned. Such loss is called a constructive total loss. Similarly, if a ship is wrecked and cargo can be saved by removing the goods from the wrecked ship and bringing them to the port, it-will not be prudent to do so if the cost of removing the

Insurance

311

cargo and carrying it to the port is either equal or more than the value of the cargo. In this case, the goods will be abandoned and such loss is known as constructive total loss. Partial Loss: A loss which does not either completely destroy or render worthless the insured property is known as partial loss. Under marine insurance, when the subject-matter is partially lost or destroyed, the loss is technically called 'average'. Thus, 'average' means loss or damage or expenses caused by a loss or damage to a' ship or its cargo. Partial loss may be either particular average loss or general average loss. (i) Particular Average Loss: It is any partial loss or damage or expense from loss or damage to a ship or part of its cargo which, results from an accident or from the normal perils of the sea. Such a loss can be recovered only if it is caused by a peril insured against, and the loss is accidental. For instance, X's goods lying on board ship are damaged due to an accident, the loss would be a particular average loss. If his goods are insured, he can recover the loss from the insurer. Here the loss is borne where it falls and not suffered for the benefit of all. However, particular charges are not included in the particular average loss. Particular charges are those expenses which are incurred on behalf of the insured for the safety or preservation of the subject-matter insured. (ii) General Average Loss: It is any loss or damage which results from actions taken by the captain or any other officer of the ship to protect or preserve the ship itself or the passengers and crew, or the cargo in general. It is an extraordinary loss, dampge or expenditure reasonably and voluntary incurred for the purpose of preserving all or any of interests, shift, cargo, or freight. General average loss is caused directly by a general average act. There is general average act when any extraordinary sacrifice or expenditure is voluntarily and reasonably made or incurred in time of peril for purpose of preserving the property imperiled in the common adventure.

The characteristics of a general average less are as follows: 1.

The loss must be caused by a necessity for sacrifice for the sake of the adventure as a whole.

312

Insurance 2. The sacrifice or expenditure must be extraordinary in nature and must be made with the object of securing common safety of the ship and cargo.

Comparative Study of Life, Fire and Marine Insurance: Basis

Life Insurance

Fire Insurance

Marine Insurance

1.

Indeminity or Not based on the Compensation principal of indemnity. The assured, if he survives or his dependents are entitled to the sum assured.

Based on the principle of indemnity The insured can claim the actual market value of the property destroyed by fire.

Based on the principle of indemnity. The insured can claim the cost of goods destroyed by perils of sea plus a reasonable margin for anticipated profits.

2.

Insurable Inter- Insurable interest est must exist at the time of taking the policy.

Insurable interest must exist at the time taking the policy and at the time of actual loss.

Insurable interest must exist at the time of actual loss only.

3.

Period

insurance Marine insurance Life assurance is Fire for a long period policy is generally policy is either for a voyage or for one ranging from 10 to for on year. year. 30 years. Whole life policy may also be taken.

4.

Assignment

Life assurance policy can be assignment without the permission of the insurance company.

5.

Measurement Not measurable. of loss

6.

Double Insur- Benefit of double or Benefit of double Benefit of doble inmulti insurance is insurance is not al- surance is not alance allowed. lowed. lowed.

7.

Contingency of Risk is inevitable.

Fire insurance policy can't be assigned without the permission of the insurance company.

Marine insurance policy can be assigned without the permission of the insurance company.

Measurable.

Measurable.

Risk is contingent Risk is contingent and uncertain. and uncertain .

•••

Chapter

20

tItI WAREHOUSING A warehouse may be defined as a place used for the storage or accumulation of goods. Warehousing is a necessary business activity to carryon production and distribution on a large scale. Warehouses help the businessmen to keep their stocks in safe custody during dull seasons. They can carryon production throughout the year and can sell their products whenever there is effective demand. Thus, warehousing creates time utility. Importance of Warehousing: Warehousing has become an indispensable service in these days. Producers, manufacturers, traders, mercantile agents, importers and exporters engaged in business have to store their goods in warehouses. Goods are produced or procured well in advance of the demand. The are stored m warehouses till they are actually Mid in the market. Thus, warehousing creates time utility. In addition, modem warehouses perform certain marketing services also, such as grading, packaging, labelling, etc. The need for storage of goods arises due to the following reasons: 1. Regular Supply: Manufacturers produce the goods in anticipation of demand; so the goods must be stored to make them available to the customers whenever needed:

314

Warehousing

2. Stock for Trade: Storage has to be done by the middlemen because consumers are not interested in storing goods (if they are easily available in the m~rket) because of limited space and limited purchasing power. 3. Seasonal Goods: Many of the products are produced seasonally while the demand for them has to be met all the year round. For instance, wheat is harvested during April and May, but it has to stored to meet the demand all through the year. 4. Continuous Production: In order to enable the modern concerns to produce on a large scale basis, it is necessary to hold raw material in stores. This will ensure continuous large-scale production. 5. Quality: Some materials take time before they are ready for sale. Therefore, in such cases, storing is necessary. In some cases, goods are stored to improve their quality and value with the passage of time. Rice, wine, tobacco, etc. are some of such examples.

6. Price Stabilisation: Storage is necessary to regulate the prices of the products. This is mainly done by the government to keep the prices within certain limits. Function of a Modern Warehouse:

A modern warehouse performs the following important functions : (i) Time utility: It removes the hindrance of time. It is not necessary that the timings of production and consumption of goods coincide with each other. Goods which are not immediately required can be stored in the warehouses.

(ii) Safety ofgoods: It safeguards the stocks of merchants and saves them from the urgency of making sales for want of supply of stored goods. (iii) Regular supply: It facilitates smooth supply of goods in the market and removes violent fluctuations in supply. (vi) Packaging: It provides the facilities of processing, packing, blending, etc. of due goods for the purpose of sale.

Warehousing

315

(v) Payment of Duties: A bonded warehouse removes the urgency of paying customs duty. An importer can postpone the payment of customs duty until he draws goods from the bonded warehouse. (vi) Financing: It helps in financing the trade. Warehouse receipt

can be used as collateral security to borrow from the financial institution. Types of warehouses:

Warehouses may be classified into following three categories: (1) Private warehouses, (2) Public warehouses, and (3) Bonded warehouses. (1) Private Warehouses: These warehouses are owned by the manufacturers (traders) to store the goods manufactured or bought by them until they are, sold out. Manufacturers generally hold goods back until the conditions are suitable. Merchants also find it more convenient to deliver goods directly from their own warehouses. Big manufacturers and traders generally have their own warehouses in the rural or suburban areas where space is available at cheaper fates. : (2) Public Warehouses: Public warehouses are organized to give storage facilities to the traders, manufacturers, and agriculturists in return for a storage charge. Anybody can keep his goods in the public warehouse by paying the necessary charges. The owner of a public warehouse stands as an agent of the owner of goods. He is required to take as much care of goods kept in his custod y as he would have taken of his own goods.

Public warehouses are licensed by the Government and are subject to Government regulations in respect of method of operation. The Government gives encouragement to start public warehouses in the cooperative sector. Public warehouses provide useful services to the businessmen. They provide for full safety of the goods. They provide transport facilities for receiving and shipping the goods. Traders or manufactures can borrow funds on the security of

316

Warehousing

warehouse receipts. Buyers can be taken to the warehouses to inspect the guods. The public warehouses also provide certain services for the sale of the products such as packaging, branding, etc (3) Braided Warehouses: Bonded warehouses are located near the ports and are run under the supervision of the customs authorities. These may be owned by the dock authorities or private persons. But m either case, they have to work under the close supervision of customs authorities.

They provide invaluable services to the importers. An importer can make use of bonded warehouse facilities by getting permission of the customs authorities. The goods deposited in such a warehouse are said to be in bond. The importer can withdraw the goods from the warehouse in installments by making the proportionate payment of the import duty. Thus, he need not block his funds before he requires the goods for consumption or industrial use. Moreover, the goods stored in a bonded warehouse can be branded, blended, packed and repacked in the warehouse itself. The _importer is also allowed to take buyers to the warehouse for the inspection of goods. Packaging: Package means a container, case, wrapper or other receptacle for packing the goods. Packaging is concerned with designing and producing of appropriate packages for a product. Packing means wrapping, filling or crating of goods for the purpose of protection of goods and their convenient handling. Bulky materials like cotton and jute are compressed into bales, liquid materials like wine and squash are placed in bottles and cans. Heavy goods are crated and fragile goods are placed in boxes or special containers. Packing is essential for placing various kinds of goods in appropriate packages. Good packing not only means greater attention of the customers but also increases the durability of the product. Another concept which has gained popularity along with packaging is labelling. Labelling means putting identification marks on the package. The label is an important feature of a product.

Warehousing

317

It is that part of a product which contains information about the

producer of the product. A label may be a part of a package or may be a tag attached directly to the product. The label is used to communicate brand, grade and other information about the product. Significance of Packaging: In the present age of consumer oriented marketing, the need for packaging is felt more than ever before. Thus, packaging has become one of the essential services of modern marketing. Packaging acts as a multi-purpose arrangement. It gives protection to goods on its route from the manufacturer to consumer. It even protects the goods during its life with the user. Packaged goods are generally more convenient to handle. Packaging also gives individuality to a product. It makes it easier to identify a product by looking at its package.

Packaging facilitates the sale of a product. It acts as a silent salesman of the manufacturer, particularly at a place where there is widespread of self-service, automatic vending and other selfselection methods of retail selling. Sometimes, packages are duly sealed to ensure products of right quality to consumers. In the absence of sealing, duplicate products may be distributed to the consumers by the unscrupulous dealers. Packaging increases the utility of branding a product. The brand name and mark can be printed on the packages and it may be used for advertising the product. The packaged goods also do some sort of self-advertisement. The package advertising copy lasts as long a§ the product is used in its packaged form. The user is every time exposed to the message on the label whenever he uses the product. Packaging can also be used for giving information about, the benefits and uses of the product. Utitlity of Packaging in modem business: The functions of packaging in modern business are as follows:

(1) Protection of Goods: This is the basic purpose of packaging. Packaging protects the goods during its transit from the manufac~rer to user and its use with the user.

318

Warehousing

(2) Easy Handling: Packaged goods are easy to handle. Handling instructions can also be mentioned on the package to ensure safe handling of goods e.g., "GLASS, HANDLE WITH CARE". Moreover packaging is a must for many of the goods such as Rice, Ghee, Butter, Acids, etc. (3) Preventing Loss and Wastage: Packaging is necessary to prevent evaporation of gaseous articles such as spirit and acid. It is also necessary for preventing liquids flowing out such as drinks, oils, fruit, juice, milk, etc. (4) Maintaining Quality: Some goods are perishable in nature. In order to maintain their freshness and quality, they have to be packed in airtight containers. (5) Preventing Adulteration: Packaging is also necessary to prevent adulteration of goods by the unscrupulous traders. For instance, Ghee, Oils, Cheese, etc. need sealed packaging to prevent any possibility of adulteration. (6) Publicity to Product: Packaging gives individuality to the product and this acts as a device of publicity. Manufacturers choose attractive packages so that the users are able to remember and identify their products. (7) Sales Device: Packaging helps in pushing up the sales of a product. It beautifies the product so as to attract the customers. A customer may be ready to pay a higher price of a product because its package is very attractive and reusable. For instance, coffee jars and pickle jars are reusable. If they are attractive, they will draw the attention of customers very quickly. Thus, packaging acts as a silent salesman.

Advertisement: Advertising is used for communicating some business information to the present and prospective customers. Advertisements usually provide information about the advertising firm, its product, product qualities, place of availability of its products, etc. An advertisement provides information to the prospective buyers and helps the producers to inform the prospective buyers about .their products.

319

Warehousing

Advertising is any paid form of non-personal presentation and promotion of ideas, goods or services of an identified sponsor. The message which is presented or disseminated is known as advertisement'. All activities necessary to prepare the message and get it to the intended people are part of advertisement'. I

I

Characteristics of Advertisement: The important features of advertising are discussed below: (i) It is a non-personal form of presentation and promotion of ideas, goods or services. There is no face-ta-face direct contact with the customers. It is also described as nonpersonal salesmanship. (ii) It is a paid form of communication. The advertiser has to

pay for the message. (iii) It is done by a sponsor, usually a producer, dealer or trader.

Functions of Advertising: Advertising is beneficial not only to the manufacturers, traders, but also to the consumers and the society. The role of advertising in a competitive economy will be clear by going through the following functions it performs: (i) Advertising promotes the sale of goods and servjces by informing and persuading the people to buy them. (ii) Advertising facilitates the introduction of new products in

the market. (iii)

Advertising facilitates production on a large scale because the advertiser is able to distribute the product on a large scale. When production is carried on a large scale, the cost of production per unit is reduced. The benefit of low Cost may be transferred to the consumers.

(iv) Advertising helps a business enterprise to communicate its achievements and its efforts to satisfy the needs of the society. This builds up the reputation of the advertiser.

320

Warehousing (v) Advertising educates the people about the availability of new products and their different uses. It stimulates the people to adopt new ways of life and increase their standard of living.

(vi) Advertising provides employment to the people engaged in designing and disseminating advertisements. It also generates employment by facilitating production and consumption on a large scale. (vii) Advertising sustains the press. Advertisements are an important source of revenue to the newspapers and magazines. Benefits of Advertising to Manufacturers and Traders : 1. Generates Demand: Advertising creates demand for the products of a company. It helps to build a favourable image of the product in the minds of customers. It arouses interest and desire to purchase. ' Brand loyalty is built up through repeated advertising. This helps in stimulating the demand for the product. 2. Creates Good Image: Advertising helps in creating a good image of the firm and its products. Consumers are persuaded to patronise the new products developed by the firm from time to time. Repeat orders could be secured easily through advertising. 3. Less Cost: Advertising reduces the cost of production by making large-scale production possible through creation of demand. The large-scale production reduces the total cost per unit of production. 4. Easy Distribution: Advertisement creates demands for the products and simplifies the distribution work of the manufacturer. Middlemen themselves offer their services and demand lesser incentives, which reduces the overall cost of distribution. 5. Introduction of New Products : It creates demand for new products by informing people about the availability and suggesting them about the use of such goods.

Advantages of Advertising to Consumers and Society: 1. Easy Shopping: Advertising facilitates purchasing by educating consumers to select correct brands of commodities which increase their satisfaction.

Warehousing

321

2. Educates Consumers: Advertising educates the consumers about the new products and their uses. In this process, it introduces new "ways of life to the people at large and prompts them to give up their old habits. Advertising thus paves the way to better standards of liVing. 3. Elimination of Unnecessary Intermediaries: By advertising his goods, a manufacturer may seek to establish direct contacts with the consumers. In this process, the number of middlemen whose profits increase the price and reduce the manufacturer's margin of profits may be considerably reduced. This will mean large profits for the manufacturer and cheaper products for the consumers. 4. Good Quality: It ensures good quality ofproducts. Advertising encourages manufacturers to produce better quality products which boosts the confidence of the consumers and ensures them availability of good quality products. 5. Economic Growth: Advertising promotes healthy competition and provides better quality goods at cheaper rates to the society. It encourages healthy growth of the business and acts as a barometer of nation's economic growth. Media of Advertisement: There are various advertising media available to the advertiser. Each medium has its own advantages and disadvantages. So the advertiser has to choose a medium suitable for the situation. The selection of a particular medium is determined by the nature of the goods, the types of customers sought, the marketing conditions and the cost, the circulation and the life of the medium. The important media of advertisement are described below: 1. Newspapers: Newspapers are the most common medium of advertisement. They have certain advantages. They are: (i) Because of their wide circulation, the advertising message can be carried to a large number of people at less cost. (ii) Through newspapers, advertisement can be made at the

right time and to the right place.

322

Warehousing (iii) Advertising message can be changed daily to suit the needs of advertisers.

2. Periodicals and Magazines : These provide for higher quality of printing of advertisement. They are more attractive and colourful than the newspapers. Selective appeal to specific segments of the market is possible. For example, magazines of general interest (Illustrated Weekly. India Today, and Caravan) could be Used for advertising products of common use, Households goods, garments, cosmetics could be advertised through fashion magazines like Eve's Weekly, Film fare, Femina, etc., Magazines like Sports Week, Sports Star could be used for advertising's port5 goods. 3. Posters: Posters include advertising message printed on paper, cardboard, cloth, wood or metal and displayed in prominent localities such as roadsides, railway stations, etc. Posters must be sufficiently large in size. They must contain each headings in bold types. They must be impressive. The advertising message must be short. 4. Radio Advertising: Radio broadcasting is highly suitable for various consumer goods having a mass appeal such as movies, electric fans, refrigerators, sewing machines, leather good, travelling bags, etc. It has a wide appeal and all types of people including illiterates can be approached easily. 5. Television Advertising: Television makes its appeal through both the eye and the ear. Products can be demonstrated as well as explained as in film advertisement. Advertising may take the form of short commercials and sponsored programmes. T.V. advertising has greater effectiveness as the message is conveyed at their homes to the people. 6. Direct Mail Advertising: Direct mail is used to send the massage directly to the customer. For this purpose, the advertiser has to maintain a list which can be expanded or contracted by adding or removing names from the list. But a severe limitation is posed by the difficulty of getting and maintaining a good mailing list. 7. Outdoor or Moral Advertising: Outdoor advertising in the from of posters, bill boards, neon signs, wall writings and handbills

Warehousing

323

is another popular medium of advertising. Posters are pasted on walls at important public places to convey product messages to the general public. Slogans on the walls in bold letters are also used for this purpose. Large sized hoarding or bill boards are fixed at important street crossings; signboards are displayed on buses, railway coaches; attractive neon signs are fixed at important buildings. Factors relevant for selection of advertisement media: The following factors influence the selection of media by any advertiser: (i) the message to be conveyed and the mode of presentation (oral, written, etc.); (ii)

the circulation of media,

(iii) the necessity of repetition of advertisement; (iv) the category of consumers to be reached; (v) the funqs available for advertisement; (vi) the media used by competitors. Sales promotion consists of all promotional activities other than advertising, personal selling and publicity that stimulat the demand for products. The basic purpose is to stimulate on the spot buying by prospective customers through short-term incentives. Incentives such as samples, price concessions, prize contests are offered to customers to encourage buying. The promotional activities are used for the following objects; (i) Introduce new products. (ii) Attract new customers.

(iii) Increase sales in slack season. (iv) Create good public image. Techniques of Sale Promotion 1. Samples: Many businessmen offer samples of their products to the selected people in order to popularise their products. Distribution of samples is popular in case of books, drugs, cosmetics, perfumes and other similar products.

324

Warehousing

2. Price-off Offer: This tool involves offering a product at a _ price lower than the normal price, e.g. off season discount may be offered on ceiling fans, coole·rs and refrigerators. 3. Coupons: A coupon is a certificate that enables the consumer to a specified saving on the purchase of a product. Subscription coupon of Reader's Digest entitIes the reader to save substantially. 4. Contests: A business house may hold contests for increasing the enthusiasm of salesmen, for securing the support of dealers and for arousing the interest of consumers. These contests are held either through radio or through newspapers, magazines, etc. 5. Fairs and Exhibitions: Trade fairs and exhibitions are held on a local, regional or international basis. Fairs are generally held regularly, say every year at some centrally situated places which have historical or religious importance. Both fairs and exhibitions provide in important means of s promotion. These provide opportunities to the manufacturer and traders for demonstrating their products, explaining their special features~ usefulness, etc.

•••

Chapter

21

--

PRICE DISCRIMINATION AND MODERN ENTREPRENEUR We know the taxonomy of price discrimination, as well as the theory underlying the various forms of discrimination. In this chapter, we wish to look in more detail at the ways in which companies engage in the various practices of price discrimination. First of all, we'll look briefly at Machlup's classification of price discrimination methods. Then we'll turn to a more detailed examination of traditional price discrimination, looking at movie theaters, telephone service, air fares, medical services, congressional information services, and college scholarships. In the next major section, we'll look at tie-in sales as a method of metering demand and charging accordingly. Next, we'll discuss multipart pricing by utilities and movie distributors. Finally, we'll examine the sale of hardback versus paperback books, different labels on physically similar items, sale of drugs, and trading stamps. Classification by Type: Machlup has propounded a somewhat different set of discrimination classes: (1) personal, (2) group, and (3) product. Within each class of discrimination, he gives examples of many different actual types of discrimination. In Table 1, we recreate some of Machlup's categories.

326

Price Discrimination and Modem Entrepreneur

Types of Price Discrimination: Personal discrimination Size up customer's Income Customers are charged what the market will bear, depending on how wealthy the customer is. Presumably wealthier customers have inelastic demands and are charged a higher price Examples-medical and legal services. Give in if you must Secret shaving off list prices is done when necessary to capture a sale. Haggle every time Each exchange is a separately negotiated transaction. Examples-bazaars in the Middle East, open-air markets in Latin America, and many private deals, such as purchases of used items through the classified sections of newspapers. Measure the use Those buyers who use the good or service more intensively are charged more, even if marginal costs of servicing are the same. Examples-Xerox machine rentals based on the number of copies made: the increased rental charge exceeds increased maintenance costs; IBM's rental of machines and sale of computer cards at above marginal cost per card Group discrimination Dump the surplus Sales are priced lower in foreign markets than in domestic markets in order not to depress the domestic price. Examples-drugs, TV sets, steel, free food for the U.S. Food for Peace program. Absorb the freight Freight is either absorbed or overcharged to customers who are located at varying distances from the production site.

Kill the rival Prices are reduced only in markets served by a rival who, it is hoped, will be driven out of business; otherwise called predatory pricing. Examples-alleged practice of Standard Oil before 1900 and of American Tobacco. Promote new customers New customers are offered lower prices than old customers. The goal is to promote brand loyalty. Examples-magazine subscriptions. Divide them by elasticity Group discrimination exists whenever the group can be classified by occupation, age, or sex. Examples-children's versus adults' haircuts, student versus non-student rates at cinemas, professional discounts at motel chains and with national auto rental firms. Protect the intermediary Large retail buyers are charged the same price as small retail buyers who buy from wholesalers even though large retail firms do their own warehousing and distribution. This protects wholesalers from competition with retailers that might otherwise turn to vertical integration Favour the big ones Large buyers are given price reductions that exceed cost savings normally associated with quantity sales

Price Discrimination and Modem Entrepreneur

327

Product discrimination Pay for the label Manufacturers distribute homogeneous products under various brands. Better-known brands have higher price tags. Examples-clothing, food, paint.

Appeal to the classes Price differences are greater than differences in marg;nal cost when quality is upgraded. Examples-hardback versus paperback books, first-class versus tourist-class fares on airplanes.

Differing Demands: One specific type of price discrimination in Machlup's classification involves peak pricing where demand may shift during peak and off-peak periods. In Figure 1, we show a rising marginal cost curve and two demand curves, one for off-peak, DD, and the other for peak, D'D'. We see that marginal cost is low in slack periods and high during boom periods. It is not clear to what extent an increase in price from P to P' really is true price discrimination, because demand may be considered at different times for different products. Other Qualifications: Some of the forms of price discrimination are merely a statement of the conditions necessary for price discrimination. For example, under personal discrimination both" size up his income" and "give in if you must" may be translated into conditions necessary for identifying differing demand curves and recognizing the noninfinite elasticity of demand. In other cases, forms under product discrimination, such as "pay for the label" and "appeal to the classes," may create differential goods in the eyes of consumers. It is difficult to separate the differences in price attributable to the product from those caused by price discrimination. Methods of Price Discrimination: Movie Theaters: Most movie theaters in the United States do not differentiate price on the basis of the seat in which one sits in the theater. On the other hand, most movie theaters do engage in an obvious form of price discrimination. There are usually two and sometimes three or four different prices for the same movie at the same time. At a minimum, there is a higher price charged to adults

328

Price Discrimination and Modem Entrepreneur D'

~ Me D'

D Q

Q' ,?utput per unit time period

Fig. 1 : Peak pricing

than to children 11 and under. Presumably, the price elasticity of demand of children for movies is numerically higher than that of adults. It is basically cost-less to monitor the separation of the two groups because physical appearance will be roughly sufficient evidence of age. However, cheating clearly does occur when children who are 12 or older but look younger get in at the lower price. Many movie theaters, particularly those around universities, offer special student prices upon presentation of either a student 1.0. card or a specially obtained student pass issued by the movie theater or its chain. Again, monitoring of the two groups is relatively cost-less, although some cheating undoubtedly occurs. Many movie theaters price-discriminate in favor of senior citizens, presumably because they have a numerically higher price elasticity of demand. Upon presentation of proof of age or a special senior citizen pass similar to a student pass, those people age 65 and over enter the theater at a lower price than younger adults. We see in Table 11-2 a _ typical example of the varying rate schedule.

329

Price Discrimination and Modem Entrepreneur

Changing Rates by Time of Day: Many movie theaters also engage in peak-load pricing that may constitute price discrimination, although more properly this pricing can be viewed as a means of exploiting unused capacity during off-peak hours. Movie theaters are rarely filled early in the day. In order to induce individuals to see a movie at off-peak times, theaters may reduce their rates to attract customers. We cannot consider this a form of pure price discrimination because the product being sold is clearly different. (A movie seen at a 7:30 P.M. showing is not exactly the same product as the same movie shown at 2:15 P.M.) Most people prefer movies in the evening, particularly since during the week fewer individuals have the leisure time available for daytime movie viewing. Price discrimination may be necessary for industry survival given film owners' exclusive copyright. Telephone Services: Various rate schedules are utilized by the telephone company. In brief, they involve charging higher prices for business phones than for residential phones and higher prices for big-city users than for small-town users. In fact, telephone pricing TABLE 1

Sample Prices for Movies, N.K. Theater, September 2009 Matinee (2:00-5:00 p.m.)

Evening (after 5:00 p.m.)

Children (under 12)

Rs.70.00

Rs. 100.00

Adults

Rs. 100.00

Rs. 150.00

Senior citizens

RS.75.00

Rs. 100.00

has often followed a "value-of-service" format, attempting to discriminate on the basis of the value of the service or of the relative inelasticity of demand of some users. The ability to discriminate derives directly from the exclusive telephone franchise.

Business versus Residential: Rates Table 2 shows a typical rate schedule for business and residential phones. It can be argued that, although the higher price charged businesses is ndt fully reflective of j~st price discrimination, it may involve 50me price

330

Price Discrimination and Modem Entrepreneur

differentiation. Business people typically are more intensive phone users and thus they may impose higher marginal costs on the system than residential users do. If, however, high volume users create economies of scale, the opposite may be true. This is an empirical question that would have to be answered by looking at the degree to which business phone use actually causes the system to reach capacity sooner. Otherwise, the marginal cost for phone calls by businesses will be essentially zero. In principle, peak-load pricing of local telephone calls could also be utilized. Currently many cities have flat-rate monthly charges, which essentially make the marginal price zero to the individual user no matter how many calls are made and no matter how long they last. Since it has been estimated that the peak cost per threeminute call is at least five times that of off-peak cost, peak loads involve relatively high capacity cost to the system. Flat monthly rates discriminate in favor of users who make frequent calls during business hours and against users who infrequently make calls or who frequently make calls after business hours. Even in those cities where message rates are charged (for example, 50 or 100 per call) after a certain number of calls, the problem is not completely eliminated. Such a system of message rates still discriminates against off-peak callers. It is only when calls are charged by time of occurrence and by duration that such discrimination against offpeak calls can be eliminated.

Long- Distance Rates: Long-distance rates typically differ by time of day and day of week. Again, it is not clear to what extent such differential pricing is reflective of price discrimination or merely is similar to movie pricing at different times of the day-a system that expands the use of unutilized capacity at off-peak periods. We do know that the price elasticity of demand for telephone services is numerically quite low for calls during normal hours of business operations, as Table 3 shows. Air Fares: Prior to the current era of deregulation, the United States airline industry was severely regulated by the Civil Aeronautics Board (CAB). Entry was typically limited to one or two carriers between most cities. All passenger fares had to get CAB

331

Price Discrimination and Modem Entrepreneur TABLE 2

N.K. Telephone Monthly Charges, December 2010 One private line,

One private line,

one phone

three phones

Private residence

Rs.300.00

Rs.600.00

Business phone

Rs.500.00

Rs. 100.00

approval. Basically, airlines were not allowed to compete on the basis of fares, at least not in terms of first-class and regular coach fares. Competition, therefore, took on various forms, including preferred take-off and landing times and better service in the form of free champagne, free movies, bigger sandwiches, more hors d' oeuvres, and so on. Additionally, each airline sought to attract a larger clientele by lowering prices to special groups that had less elastic demand elasticity'S than other groups. The price elasticity of demand is certainly different for an expense account executive than for a student traveller who is deciding between an airplane flight and sharing driving expenses to go home for the summer. Given TABLE 3

Initial Price and Usage Data Route

Period

Initial

Initial usage

Elasticity

price Intra -

day

5

445

-0.1

Chicago

evening

5

486

-0.1

night

5

210

-0.1

after midnight

5

10

-0.1

Chicago -

day

65

73

-0.15

Peoria

evening

50

78

-0.37

night

40

27

-0.36

after midnight

40

3

-0.30

Chicago -

day

140

2570

-0.23

New York

evening

100

3873

-0.57

night

70

1940

-0.57

after midnight

70

148

-0.56

332

Price Discrimination and Modern Entrepreneur

such differing demand elasticity's, much price discrimination existed in airline travel until recently. When we look at the typical fare schedule prior to deregulation, we find that the fare structure fits our ideas about relative price elasticity's of demand. The difference between a first-class round trip between New York and Los Angeles and a travel group charter between those same two points was more than 50 percent. The businessperson paid the full fare, and the student vacationer, for example, took the steps necessary to obtain a lower fare. Not all the difference was due to price discrimination, because clearly the products are different. The first-class passenger, or even the full-fare coach passenger, need not reserve in advance or pay in advance, can change reservations quickly, is almost always guaranteed an available seat, and so on. Nonetheless, even accounting for differences in quality, it is probably true that the price per constant unit of quality is higher for the business traveller than for the student traveller. Youth Fares: Many airlines have offered youth fares at different periods. Passengers under a certain age, usually 22, were allowed to purchase youth fare tickeLs, particularly on flights to Europe. These tickets were lower than the price that adults had to pay for full-fare tickets. In the past, however( the youth-fare ticket holder was not guaranteed a seat on a particular flight. Rather, he or she had to accept seating on a stand-by basis, that is, arrive at the gate prior to the plane's departure and stand by until 10 minutes before flight time. If at that time empty seats were available, then the ticket was accepted and the youth could board the plane.

This is a form of third-degree price discrimination (although we are referring to different quality products, because youth fare tickets involve uncertainty). There is probably a difference in the relative elasticity of demand of young adults and that of adults and businesspeople. The demand of young adults is more elastic than the demand of businesspeople. However, the analysis does not end there. Young adults have more elastic demand curves because their time is usually less valuable than that of businesspeople. That is to say, the opportunity cost of waiting in a stand-by system is less for most young adults than for businesspeople. The total price of a trip by aeroplane is the money price of the ticket plus the opportunity

Price Discrimination and Modem Entrepreneur

333

cost of going to the airport, waiting in line, boarding the plane, sitting in the plane, and so on. Holding the number of hours constant, the lower the opportunity cost of time is, the greater the percentage of the total price of airplane travel is accounted for by the money price. Say that the money price of a plane flight is $85 and that the total time involved in waiting, boarding the plane, and flying is five hours. If a young person's opportunity cost is $3 per hour, then the total price to the young adult for the plane flight is $85 + (5 x $3) = $100. The money price of the plane flight expressed as a fraction of the total price is equal to $85/$100, or 85 percent. Thus, for those with a low opportunity cost, the observed demand curve for air travel in terms of the money price of the ticket may be more elastic. Hence, it makes sense to charge a lower price for youths than for adults. Their relative differences in opportunity cost lead to differences in the relative money price elasticity's of demand.

Children's Fares: Children under the age of 12 have been eligible for special fares that in some periods are one-half the adult coach fare and currently are often two-thirds the adult coach fare. This is a form of price discrimination because the cost differences to the airline are nonexistent between the adult and the child. Further, the opportunity cost of a child is considerably less than that of an adult. A child occupies a full seat and is given a full meal and the same service that an adult is given. Price Discrimination under: Deregulation In many respects, under the more flexible pricing rules in existence since 1977, more rather than less price disparities exist. In December 2010, for example, a typical round trip between Miami and London was as follows: first class, $2,372; economy (full-fare coach), $856 with 7180 day stay and advanced purchase; excursion, $509; budget and stand-by fares, $197 (one way); and Laker Sky train, $187 (one way). Again, we are not comparing exactly similar products. Firstclass and economy seats are almost always available, so the purchaser is buying not only the air transportation, but also flexibility in his or her air travel scheduling. The 7-180 day fares require a predetermined stay. Advance purchase tickets require a definite date of departure and return, with a penalty assessed

334

Price Discrimination and Modern Entrepreneur

(usually to full fare) for every change. Stand-by fares require just tha t-standing by withOllt absolute certainty of boarding on a given da y. Laker's Sky train fares are often obtained at the expense of long waits in ticket lines. Medical Services: Since Kessel's seminal article on price discrimination in medicine, pricing of medical services has been used as a classic example of price discrimination. Basically, doctors have been able to price discriminate in the past, not only because of restrictions on entry, but also because the American Medical Association was sometimes able to monitor and punish price cutters by banning them from hospitals. Physicians are able to charge different prices to different patients for the same medical services because individual patients are unable to resell services-separation of the markets is possible. Local medical associations that operate under the AMA have been known to impose sanctions on doctors that engage in price cutting. Further, since the AMA can influence the number of internships a hospital will receive, this association is in a position to impose costs on hospitals by restricting the availability of low-cost interns. Doctors who are members of their local medical societies are often given preferential treatment in hiring. Further, doctors who engage in price cutting have been expelled from local medical societies. On the other hand, where price cutting could have no appreciable effect on physicians' incomes, there have been no barriers. For this reason, and because of the possible savings in income taxes, physicians frequently do not charge one another for their services and sometimes offer such professional courtesy to members of other physicians' families. Charging Price on the Basis of Income: Typically, wealthy individuals have been charged a higher price than poor people for similar medical services. There is, of course, some disagreement about whether poor people have received exactly the same medical care services, but let us assume for the moment that they have. Given that the marginal cost of servicing these two groups is the same, the price differences are indicative of third-degree price discrimination based on differing price elasticity'S of demand. In essence, we can apply our analysis given in the previous chapter in Figure 1. Simply

Price Discrimination and Modem Entrepreneur

335

substitute Group I and Group II for patient-group I and patientgroup II. We now ask the question, Why do we expect wealthy individuals to have less elastic demand for medical services than poor individuals? In the first place, the opportunity cost of being sick for a wealthy person is greater than for a poorer person, which translates into a higher demand for preventive medicine. Second, the time-cost analysis example that we presented for youth fares above also applies to medical services. Time costs, as a percentage of the total cost of medical care, are directly related to the wealth of an individual. As wealth increases, that portion of time costs attributable to to~al cost increases. Thus, any nominal price change will be a lower percentage change in total price (induding time costs) for a richer person. For any given change in money price, the relative change in quantity demanded will be less for the richer person than for the poorer one. Hence, a rich person's price elasticity of demand for medical services will be numerically lower. Finally, because medical services are empirically a normal or superior good,

D1

D1

Q1 Output per unit time period

Fig. 2 : Rich versus poor people's delllatld curve for medical care

336

Price Discrimination and Modem Entrepreneur

higher income groups will demand more of them at each and every price. Look at Figure 2. Here we show demand curve for medical services to be 0 10 1 for poor people and 0 20 2 for rich people. At any price, the price elasticity of demand for medical services will be numerically less for the rich than for the poor since 0 20 2 intersects the vertical axis at a higher point than 0 10 1. [Alternatively, remember that at any price the price elasticity of demand is defined by the reciprocal of the slope of the demand curve times the quantity P IQ. Thus, at any price, since 0 20 2 is farther to the right than 0 20 2, the quantity P IQ will be lower for rich people than for poor people and, hence, the reciprocal of the slope times that quantity will be numerically smaller (if the slope is the same). Thus, a smaller numerical price elasticity of demand exists for rich people.

Congressional Infonnation Service: Information services often engage in a form of price discrimination based on the affiliation of the subscriber. We show an example in Figure 3 of the Congressional Fig. 3 : Sample order form-Congressional information Service: (] iliO per ~nl if It-e annual N10k 111(1 re:riodical b~Jttl of the .. "Iirf" in)!,hlIKm ii len th:l.n S"lO.OOO. Our "\.Idlet 1~ _ _ _ ,

Urdu Form Wt .. j .. h ,... ~ .. t-,..:p~t '0 tht (1~. lnd.. , 1',-" LIne y«:.iH btG,nn,", .... ,Ih ,he: 0 J"nu .. ,\" 1910 hi lle Ok the __ _ _ _ . ~ _ _ - ''''ie' Ir!c"~ ~pc'clf) I ,.'u'C: 0 d" lJ d,· nut CO:'l\..Jrr It.•,. .a ~."" n, or.ju. So.xi \.r.lil (;ancell;:,j. ",;,h .lMUll 1"l1ir.g 1t-'''Il'j{\11 U I ' !f'a~( tnltr our ).u!)1oCriptu.)" at SJ':O, the b.a~~ Ule ... hi~h a . 'pht~ to

• All Hffice. iln..! hhraru::i m:un: .. int,1 by cMroorati.m,..... )(). (:'01(''>'11. ",IV;"I!' bw firm ... and 1Ilhe'r ;trillillo: and 'iCm:-pn\"alC: or:aniJ.llll.lm . • nod all .~ htt ,,,.:(/,11 :,t-r .•,;I''' • All X.lI'lC1Tli.;. pill-lie, \:aw 01 J,.".t"f:'lmtnt h!-r:Ulh annuil l t-.>uli. lOll rcriodl~al bt,hlgtt , in ClCtn \J{ S.aOO,,"IIM,) • All li~nll(" In II~ C S. itnJ ("a":·I.I:. ·... !'!;("h au' m.int;uneJ by f"rc"n ,-" ... elnmenh. • AIlIit>ullCs o,,:"-k lhe U.S anJ (:l.nada ItscqA thooC m:.:n lained by the U.s, (io\'nn;-ne:nl .

";ov,n.

NOTE : For"i," IIt-Ulin ,.h.)uIJ .wd S50 to thi\ rate if Air M;ullln-eceisdcsired . Please 0 40 C) do nuc ~ntl ... i", OH~, j.n, .airma,1. ~".· I 1.\1.

o

,\lInl"l'IO:"lO \1 ~t ; n~UHnl0,"~ AJ.tihon al ~ut>~ripti""s Ife p"ccJ !II S200 per lear for all s"kcr iton"s an.! rn:l\' M ("fI!efeJ II Ihat rll .. ody if .M: billint a,J"rc,~ " Ihe urne I~ 011 Ihc on«in:..1 order. '~W! Hclilionll ~ub~CliJl1,on!lo r.'I;tV be lna.l"J 10 oln~ atldre",

C

o

~!6n per )C"3f

if IhI: annual hook. 3nd rt"riodi.. :d bud,et of ,ntin institut,en i, hclw~en S!lk),OOO Ind S':OO,OI)O. Our bt.aJect

:J

'::-100 ~r }C':lf the annUli booL. a;"IJ pcriodiul buJ~1 uf :he ""Iiflt ,",hlu:n'" j. kn Itt:!." ~:'()II .OUO. Our btld&,;cl i .. _ _'

S!OO each.

Dv

nc.t send bounJ volume\.

Monthly and qUIr1erly i"uCi of .he C IS':lndcc menutc 8 ';\~ ), J 1~ anJ arc hole , p.aMhed for con ... enient ,torlglt )'nd 11"e. A

n \TF."'i

(1

\I1Mcllrtw;'n~.1

DI:,\Dt-:R~

s tUfdy sci of t-indcn hlll' tonn dui,ncd to twl,J .. ye:..r's inub.

Wt 3rc tli,iblt filr 3 !treeia! ule . ;.s iftJio:31ed below Ilutihtttolllli Libnrkt fbc:w ~atc~ l~ply onlr to :IIuJeml1: r,ut.1ic. bw and co ...ern,"t"llit-ru iu in the U .S. and Can..d3

rnler our m.tu fnl" ______ :.Jd.tionai

..\~'l : \I . IIUV'" \Ol.l:\U-' F.:u;h )e:.r Cn""n\lon~1 Inlo,)l"TT\,uilln Scf'\'lo:e o!mulat~ both the .bW:u;l, and tJw Jnde),c~ in I~H rl.,t ht'Oand \'olume~. 1 hc~ rerma"(nt dilio~~ arc tlffl:itd I" rlS l lnlcl )u .. \(,il1el'> al the sp«iaJ rli.:e of ~1tO ref Ul. The pr;':e for non ·'ub,;;.libc'.~ 1\ $160. [J Pka~ wond U5_ _ _ \eI\s) .at the aprropriate: nte

F.:&ch I:-indn is equ,pped ""Ilh I sp,nlt po<.kel o f e~car acetalC for ellliosill, pul""pO'«.

o o

Pluse wel'ldll\ _ _ On nIX

~fld

'>C*./ of blnJ r-u at SI8, Ihe ~E I

t-irnkf\.

n~;' lInm!-'I("Ht UK~ \f('

,r

~:l1I

Colle'lt aM; PIiWie- l .ik3rie\ These ~:ar~~ MC re~r,"el.l fUf ~mllrl c,'I1~'«h .. nrl pub!,;.- I,brlrits ,.nly l.hrM,.'\ \ohic!'! are hf:!r.chc\. dl ... i... ,III\. t.lI Jcpallnc:nts .. ( blrer Itl~ilUtjoa' oUe no: di~ihk br this rz:o::

rJ '1.;0 ref It"ftlt

),;~r if tl,e ,,"rou31 h("l~~;'; ~r.J re';'.J'CJl bu"I~C"t ~.f Ihl: ilHCillllo\ln I' bt:"'cen 5)(10\)0 3nd S15,OOO Our but!s":

C P lnse ~cnJ infor:n:I\,(,n ab.,.ut lhe CIS.' M"'rnfichr l:~rary.

-.;;Jd;,-,,-- - - -- _.------ - - - - CtCr. Si;-t-;-~i -7;;C~,J~:

.- -- - -- - -- - - -

Price Discrimination and Modern Entrepreneur

337

Information Service, which is an index to publications of the U.s. Congress. You will notice that in 1970 there was a basic rate of $320 per year, which applied to all private offices and libraries, all academic public law or government libraries that have a large enough budget (in this case an excess of $400,000), all libraries maintained by foreign governments, and all foreign libraries outside of the United States except those maintained by the U.S. government. Rates are lowered if the subscriber is a library with a small budget. The lowest rate, $80 per year, is given to small colleges and public libraries whose entire annual book and periodical budget is less than $30,000. In this case, the product is exactly the same, the cost of servicing each subscriber is presumably exactly the same, but the price charged is different. Other information services such as microfilm copies of congressional reports have similar pricing structures. Professional Journals : Professional journals practice price discrimination in basically the same manner as the Congressional Information Service. We recreate a series of 1981 price schedules for the American Economic Review (Table 5) to show that there are different rates to libraries, students, and other parties. Of course, some cheating goes on. In order to obtain the student rate, the student usually has to have a note signed by a professor, a practice that will discourage some, but not all, from cheating. College Scholarships and Fees: Each year some eight and onehalf million students go to colleges and universities throughout the United States. Most, if not all, colleges and universities do not and perhaps cannot charge different prices to different groups, except perhaps on the basis of residency in state-financed institutions. It is possible, nonetheless, for colleges and universities to reduce the price to those students with numerically higher price elasticity's of demand by awarding them grants, scholarships, and fellowships. For example, in many cases, financial aid decisions are made on the basis of "need." In other words, colleges and universities price on the basis of wealth. The most financially impoverished individuals are offered the largest awards, while richer students get relatively little. We have already pointed out why price elasticity

338

Price Discrimination and Modem Entrepreneur

Table 4: Exhibit 0/2009 Price Schedules THE AMERICAN ECONOMIC REVIEW including four quarterly numbers, the Proceedings of the annual meetings, the Directory, and Supplements, is published by the American Economic Association and is sent to all members six times a year, in March, May, June, September, and semi-monthly in December. Dues for 2009, which include a subscription to both the American Economic Review and the Journal of Economic Literature, are as follows : $30.00 for regular members with rank of assistant professor or lower, or with annual income of $14,400 or less; $36.00 for regular members with rank of associate professor, or with annual income of $14,400 to $24,000; $42.00 for regular members with rank of full professor, or with annual income above $24,000; $15.00 for junior members (registered students). Certification must be submitted yearly . Subscriptions (libraries, institutions, or firms) are $100.00 a year. Only subscriptions to both publications will be accepted. Single copies of either journal may be purchased from the Secretary's office, Nashville, Tennessee. In countries other than the United States, add $5.00 to cover extra postage.

of demand is inversely related to income for medical services. At least one argument dealing with the fact that education is a normal or superior good still holds. Thus, it is rational for colleges and universities to attempt to charge more to wealthier students. In Figure 4 we show a sample form from the Graduate and Professional School Financial Aid Service. It is a financial statement for students applying for financial aid. It collects information about the student's resources and liabilities, as well as those of the student's spouse or prospective spouse, in addition to the spouse's employment history, and financial information about the student's parents. Presumably, none of this information relates to the candidate's academic qualification, ability to perform in graduate school, or ability to succeed. One can surmise that the financial statement required by colleges and universities giving financial aid is merely a means of metering price elasticities of demand and making awards accordingly. Traditl8 Stamps: In the 1880s, Schuster's Department Store in Milwaukee, Wisconsin, began to issue stamps to its customers. Since

Price Discrimination and Modem Entrepreneur

339

then, we have seen the proliferation of approximately 250 trading stamp companies. Forty percent of the market is controlled by S&H (Sperry & Hutchinson) Green Stamps. Only about 5 percent of S&H Green Stamps and those of other large trading companies are unredeemed. Let's now try to answer the question of why stores give trading stamps. The full price of the product includes not only the monetary price, but also the implicit opportunity cost of the time that went into searching out the product and purchasing it (and the time needed to consume it) . We can assume that the higher one values time released from shopping, the less one will engage in seeking out lower-cost shopping arrangements. In other words, a person who values time more relative to money income will substitute more money income in order to save shopping time. That person will use less time to discover lower prices. Therefore, the person who values time highly will exhibit a less elastic demand curve in any given store than the person who does not value time so highly. Charging More to the Richer Person: Let us assume that there is a strong correlation between the value of time and the relative wealth of a person. We are assuming that richer people place a higher value on time than do poorer people. It follows, therefore, that in a particular store, a richer person's relative price elasticity of demand will be less than a poorer person's. Now the retailer is confronted with two classes of consumers, those with relatively less elastic demands and those with relatively more elastic demands. The retailer's problem is to separate these two classes and charge the richer customers a higher price than the poorer customers. One way this is done is to offer a rebate only to those customers willing to incur a time cost to obtain that rebate. The rebate is in the form of real goods that are obtainable in exchange for blue, green, or gold trading stamps. However, the person who wants the rebate must collect the stamps, preserve them, and redeem them at a redemption station. All of these activities require time. Thus, poorer people, whom we are assuming can be used as a proxy for the relatively more elastic demanders, effectively pay a lower price for their food because they obtain goods when they redeem their trading stamps. The richer customers, with a relatively less elastic demand, refuse

•

-.

.'~

.~ .

P •.

II

,.

'~ $.~ "

.

··c·--- '",,-__ .ji!--l ..,.. , g=. ; .. ) - .~ ..:.;.:.­

-:..- "1_

;

f~~;;-i'J~ -- - _._ . - ----_ ---_.. _. . _.•. "" - -- --"--_.,

:_.. __." ~:~.~~J .~~~-:-"~

- -.. - .. - -.. - - - ., ........ .... . ...... ~ -

~~

...

'"0

....

ri"

rtl

_ ~..l

0

. ~='1r :

Vi" ....

n

..

s" !:r

.... =--=-=::.;:.:..'"'::!'..::.~-

~

'

..

~

o· ::3 III

::3

0-

s:::

0

0rtl

3

m

::3 ..... .... rtl

'"0

....

rtl

Fj€i\!f~,-.

~ifi~*"iIlfocmeti0llI141qlt&M . form

, ,:-

~ ~

....

Price Discrimination and Modem Entrepreneur

341

the stamps because of the time cost involved. They get no discount at all. Thus, the gross money price of groceries is the same to both classes of buyers, but the poor get a rebate equal to the value of the trading stamps' redemption exchange rate.

Some Implications: If the above trading stamp model is useful, it presents us with some testable implications. These are: 1.

We predict that trading stamps will be used [by a seller] relatively less often in cases where the total value of a single purchase is large. In such instances, the receiver of the stamps from a large purchase incurs a small enough time cost in redeeming a large quantity of stamps to make the redemption worthwhile. In other words, not enough differential time costs are imposed to discourage relatively low elasticity demanders from collecting the stamps. This " implication is consistent with the fact that trading stamps are used by grocery stores. One does not usually obtain them when purchasing an automobile or a home.

2.

We predict that in cases where the commodity is personal service, relatively fewer trading stamps will be used. The differentiation of quality of services rendered is used as a substitute for the price discounting implicit in the trading stamp system. This implication is consistent with beauty shops and barbershops, which do not offer trading stamps.

3.

We predict that owner-operated stores will use relatively fewer trading stamps than stores employing a large number of sales personnel. In the case of owner-operated stores, the owner can attempt to figure out relative price elasticities and alter the service given to the customers accordingly. Employees, on the other hand, have less incentive and less authority to figure out customer characteristics and therefore won't treat customers according to their relative price elasticities. Therefore, we predict more trading stamp use in large grocery stores than in small "mom and pop" stores. This use seems to be consistent with casual observation.

342

Price Discrimination and Modem Entrepreneur

Multipart Pricising: Multipart pricing involves charging successively lower prices for the marginal unit of a commodity as more of the commodity is purchased. Multipart pricing occurs, for example, in supermarkets when you are allowed to buy one can for 200 and two cans for 390. In other words, the first can is 200 and the marginal cost of the second can is 190. A uniform price of 19.50 is charged to all those who buy two cans, and so on. There is a difference between multipart pricing, which is seconddegree price discrimination, and perfect, or first-degree, price discrimination. Multipart pricing is an imperfect way to extract as much consumer surplus as possible from each consumer. It is a way of dealing with broad, discrete intervals between quantities purchased and charging appropriate revenue-maximizing prices for each additional unit purchased, without ever selling any unit belowMC. We expect to observe second-degree price discrimination, or multipart pricing, rather than first-degree price discrimination because of the higher costs of negotiating, monitoring, and enforcing exchanges for the latter. It is difficult to determine what the actual price elasticity of demand is for different classes of buyers. It is even more difficult to prevent the resale of goods by buyers who bought the product at a lower price to those who would be charged a higher price if they purchased the product from the monopolist. Sliding Scales for Public Utilities: It is often asserted that public utilities engage in price discrimination. It turns out that we can, indeed, analyze some of their pricing policies in terms of seconddegree price discrimination. Public utilities do use multipart pricing, or what they callI/declining block pricing."

Consider Figure 5. If the electrical utility wanted to sell the quantity Q3' it could do so by charging the uniform price of P3. Its total revenues would be represented by the rectangle OP3CQ3' However, if the utility engages in multipart pricing, or second-degree price discrimination, it might charge P 2 for the first QI of kilowatts sold per month. It could charge P2 for kilowatts sold between 2, and

343

Price Discrimination and Modem Entrepreneur

Q2' and then finally it could charge P3 for kilowatts sold between Q2 and Q3' The revenues it would receive would be the sum of the rectangle of OP1AQ1 plus Q 1DBQ2 plus Q2ECQ3' or OP1DBECQ3' The sum of these three rectangles exceeds the rectangle given by uniform pricing of P3 times the quantity sold, Q3' (Moreover,

P, ~

P3

I _________ LID __ _ 1

I

I

IE

1

1

---------f----:---1

o

1

1

1

I I

1 1

I I

I I

1

:

d

0, Rate of consumption (kilowatts per months)

Fig. 5 : Declining block pricing. Public utilities often use declining block

pricing in which separate "blocks" of electricity can be purchased at declining prices. If the electric utitlity charges a uniform price of P 3, its revenues will beOP3CQ3' If, however, it charges a price ofP l for the first Q1 kilowatts used and then P2 for the next "block" used up to quantity Q2 and then price P3 for the next "block" up to Q3' its total revenues will equal OP lAQ l + Q l DBQ2 + Q2EC03 = OP1ADBECQ3'

multipart pricing yields more revenue than charging the weighted average price.) Declining block pricing. Public utilities often use declining block pricing in which separate "blocks" of electricity can be purchased at declining prices. If the electric utility charges a uniform price of P3t its revenues will be OP 3CQ3' If, however, it charges a price of PI for the first 0, kilowatts used and then P2 for the next "block" used

344

Price Discrimination and Modem Entrepreneur

up to quantity O 2 and then price P3 for the next "block" up to 0 3, its total revenues will equal OP1AQ + QIDBQ 2 +Q2EC03= OPIADBECQ3.Some Differences in Cost Not all the differences in electricity prices on the sliding scale constitute price discrimination. There are some differences in cost. Industrial customers consume power at higher voltage and on a more predictable basis. Also, there is usually a smaller connection cost. Basically, however, declining block pricing is a form of price discrimination. The reason that industrial users receive a lower price is because they have more elastic demand. Their options are greater than residential users' options are. If electricity reaches a high enough price, they can generate it themselves. Also, particularly for electric-intensive firms, users can decide to build a plant in a different location where electricity prices are lower. Since electricity prices constitute a larger fraction of their total operating budget, and the cost of alternative sources is relatively lower than that for individual households, industrial users are more pricesensitive to electricity costs than residential users are. Metering Demand and Tie-in Sales: One industrial practice that has been associated with price discrimination involves tying contracts, or tie-in sales. A typical tie-in contractual arrangement requires that a buyer can either purchase or lease one product from the seller only on the condition that the buyer also agrees to purchase something else called the "tied good." Tie-in arrangements are normally illegal under section 3 of the Clayton Act if the effect "may be to substantially lessen competition or tend to create a monopoly in any line of commerce." However, the courts' usual understanding of tie-in arrangements and monopoly power has often been misguided. Under most circumstances, it is impossible to extend monopoly power by a tiein agreement. Consider the following example. Xerox has a monopoly in the sale and lease of Xerox machines. It does not have a monopoly, however, in the sale of the paper used in the machines. Suppose the XYZ firm rents the Xerox machines and purchases 1000 sheets of paper a month. The competitive price for the paper is

Price Discrimination and Modem Entrepreneur

345

$100. Now assume that the total value to the user of the Xerox machine (including the use of the paper) is $900. If Xerox required the tie-in arrangement whereby the rental of the machine was contingent upon purchase of the paper from Xerox, it could charge any combination for one month's rental and paper as long as it equaled $900. Thus, it could charge a competitive price for the paper of $100 plus $800 rental, or it could charge $600 rental and $300 for the 1000 sheets of paper. In all cases, Xerox would end up with the same profit. An $800 or other high rental fee, however, would preclude use by customers with low total demands for the machine. Basically, if Xerox truly has monopoly power in the copying machine market and there is pure competition in the paper market, the supposed extension of Xerox's monopoly into the paper market will not alter its profits. The tie-in between the Xerox rental and the paper cannot be construed to extend Xerox's monopoly power. What is important here is looking at the combined price of the rental plus the paper to yield the price paid per constant quality unit of services, since the machine cannot be used without the paper. The same would be true if we analyzed a company that had monopoly power in selling cameras and decided to tie-in the film. . Tying Arrangement as a Means of Metering Demand- The IBM Case" : Intema tional Business Machines Corporation has been the leader in the computer field since that industry began. For many years, IBM would only rent its computing and tabulating ntachines to users; it would not sell them. The rental agreement was generally expressed as a fee per shift per unit time period (one month, for example). Until the 1950s, IBM required that the users buy tabulating cards only from IBM. If the machines broke down and IBM's technicians found that the renting firms were using someone else's cards, IBM imposed a penalty by charging for repairs. This was the method the company used to police its requirement that no one else's cards be purchased. We may not immediately understand why IBM required that its own cards be purchased and why it policed such an agreement. However, if we think of IBM in terms of a monopolist, then we arrive at a prediction from a price-discriminating monopoly model

346

Price Discrimination and Modem Entrepreneur

that is consistent with past IBM-pricing practices. We know from the theory in Chapter 10 that higher profits can be obtained by price discrimination; however, it is necessary to have information on the different price elasticities of demand for different classes of users. One way that IBM could approximate its users' consumer surplus was by intensity of use-those who used their machines more presumably had a relatively higher total consumer's surplus for computing services. One of the ways to monitor intensity of use is by knowing the number of tabulating cards used. That is exactly why IBM required that only its cards be used. The cards provided an index of use intensity and, hence, the size of consumer's surplus. This argument would make little sense if IBM had not charged those who used more cards a higher price per unit of computing services than those who used fewer cards. The company did just that; it charged a price for cards that was in excess of their marginal cost. Its price per unit of computing services was effectively higher to those with the lower elasticity of demand, that is, those who used more cards. IBM chose this method of price discrimination rather than charging a higher rental fee to different users. Perhaps this latter pricing technique was deemed too overt a form of price discrimination and was, therefore, subject to antitrust prosecution. In addition, higher rental fees would require ex ante determination of high and low demanders. Nonetheless, various antitrust actions against IBM have resulted in the discontinuation of this particular pricing practice. Under Justice Department pressure, IBM agreed to" cease and desist" its dual practice of only renting hardware and of requiring the purchase of its own cards. United Shoe Machinery: Another case of price discrimination using tie-in sales as a metering device involved United Shoe Machinery. Prior to 1956, the company was convicted under the Sherman Act and its tie-in practices were forbidden. Customers of United Shoe Machinery Corporation (shoe manufacturers) had been required to use only United Shoe Machinery if they wanted to use any equipment made by that company. Actually, there were seven separate types of tie-ins. The most mentioned one involved the

Price Discrimination and Modern Entrepreneur

347

requirement that the lessees of United Shoe Machinery heel applicators were required to buy United Shoe Machinery staples. We can use the same analysis presented above for IBM and IBM cards. If we assume that total consumer's surplus is directly related to intensity of use, which can be measured by the number of staples used per unit time period, then United Shoe Machinery was able to meter demand. As long as it charged above marginal cost for the staples, it was able to effectively charge a higher machine price to low demanders than that charged to relatively high demanders. Cable TV Equipment: A cable TV system receives signals at one large antenna and then feeds them to subscriber households, usually by a network of underground wires. The first cable TV firm was started in 1951. It began by servicing remote small towns. By the early 1960s, cable had spread to larger towns and the industry was booming. The first firm in that industry was Jerrold Electronics. From the onset, Jerrold required all subscribers to install the entire Jerrold system plus purchase a five-year service contract. In other words, subscribers were not allowed to use non-Jerrold parts between the cable line and the TV set. This tie-in between the cable and the television set provided a way of metering demand. Presumably, the greater the number of television sets in the home, the more intensive the demand and thus the lower the price elasticity of demand. Provided that Jerrold charged above marginal cost for the connecting devices, it was practicing a form of price discrimination. Eventually, the Antitrust Division sued Jerrold for anticompetitive practices. In 1961, the courts declared that Jerrold could no longer require tie-ins. Other Reasons for Tie-in Sales: There are numerous other reasons why firms might engage in tie-in sales. We will discuss these other reasons in more detail in Chapter 12. Briefly, though, tie-in sales are used to avoid price controls, to take advantage of economies of scale, to protect goodwill by preventing cheating on brand names, to capture some consumer surplus, to reallocate risk bearing, and to create a barrier of entry because of increased capital requirements.

348

Price Discrimination and Modem Entrepreneur

A Variation on Tie-in Sales-Block Booking: One variation of tie-in sales that allows for price discrimination without overtly engaging in that practice is block booking. Block booking is an arrangement under which purchasers are forced to buy all of a firm's output each period or get none of it. In other words, block booking involves an all-or-none arrangement not dissimilar to the example we used in Chapter 10 concerning the purchase of diamonds at an option of all at the stated price or none at all. In the famous Loew's case in 1962, the issue of block booking came up.14 Six distributors were charged with violating section 1 of the Sherman Act. They made the sale of one or more feature films to television stations conditional on the purchase of other films. In order to get The Treasure of Sierra Madre, Casablanca, and several other winners, a Washington television station, WTOP, also had to purchase such grates as Gorilla Man and Tear gas Squad. In ruling on the case, the court found that the distributor's market power resulted from the copyright on the tied goods. The court further explained that given this monopoly power, the distributors had economic leverage sufficient to induce their customers to take the tied good along with the tying good. Speaking for the Supreme Court, Justice Goldberg considered each copyrighted film block a unique product, and thus block booking, according to Goldberg, had adverse effects on competition. Stations were forced to buy unwanted films and therefore denied access to films marketed by other distributors. As with the IBM case, it is certainly not clear that the courts were correct in their interpretation. How could the tying arrangement allow the distributors to increase their monopoly power? The court was saying, in effect, that the block of movies was worth more than the value of each movie added together. Consider a simple example. Paramount Pictures has two movies, Winner and Dog. Clearly, they have a monopoly on these two movies because they own the copyright. The value of Winner to a prospective movie house is nebulous if the movie theater won't take the block. If both movies must be purchased, what does it matter to Paramount if it charges

Price Discrimination and Modern Entrepreneur

349

$500 for Dog or $600 for Winner, or $1,100, for Dog and $0 for Winner, or any combination? The most it can obtain is the maximum value of the block to the movie house. Stigler has suggested that block booking, a form of tie-in sale, may be inspired by the desire to price-discriminate. A Numerical Example: In order to see how block booking allows for price discrimination, we will use a simple numerical example involving two movies that were indeed block booked by the distributor-Star Wars and The Other Side of Midnight (henceforth called Midnight). There are two theaters, X and Y. The maximum prices they will pay per week for the films are as follows:

$12,000 = PXstar Wurs

$ 8,000 =

$ 3,000 =

$ 4,000

pXMidnight

pYstar Wars

= pYMidnight

Therefore, we know that cinema X will pay more for Star Wars than cinema Y will, but will pay less for Midnight than cinema Y. Consider the possibility of the distributor's simply selling each movie separately at a uniform price. He or she will have to charge the minimum price or $8,000 per week for Star Wars and $3,000 for Midnight. Thus, total revenues will equal 2 x $8,000 plus 2 x $3,000, or $22,000. Now consider the possibility of block booking. The.distributor will charge a uniform price to both theaters, but they have to take both films. The maximum block-book price will equal the lowest combined valuation of each firm for the two films taken together times 2, or $12,000 x 2 = $24,000. Thus, with block booking the firm can capture $2,000 more a week in revenues, which translates into $2,000 higher profits assuming no additional reproduction costs in the block-book case. Also assumed is no reduction"in the summed maximum values for the two movies due to the theater owners having their choice reduced under the block-booking arrangement. Note that in order for block booking to result in price discrimination and higher profits, the relative value of the films must be different for different theaters. Also note that price discrimination arises only in the context of the implicit prices paid

350

Price Discrimination and Modem Entfepreneur

for each individual film. For example, from the $12,000 fee we know that cinema Y, with a higher demand for Midnight, is paying $4,000 for the rental of that film. This amount is $1,000 more than the maximum amount cinema X would pay for Midnight. Different Goods: One common way of engaging in price discrimination involves selling physically different goods at prices that are not reflective of differences in marginal cost. In this section, we'll look at two examples: the sale of books and the sale of retail items with different labels. Different Book Editions: Hardbacks are sold at a higher price than paperbacks. The difference in price does not, however, reflect simply a difference in production cost. On an industry average for trade books, the price of a hardback is only $5 to $8 more than the price of a paperback. In Table 6 we list a number of best sellers, giving their hardback price and their paperback price. Part of the difference in price reflects economies of scale in the mass production and perhaps in the distribution of paperbacks. Further, paperbacks are often associated with a lower risk because they may be established best sellers. Undoubtedly, though, a large part of the difference is due to price discrimination. Those who want to read best sellers as soon as they come out presumably have a numerically lower price elasticity of demand than all other readers. They end up paying the higher price for a hardback. Those who can wait for the soft back to appear presumably have a numerically higher price TableS Price o/Hardback and Paperback Best Sellers, Fall 2010 Price Hardback

Paperback

$10.95

$3.50

Donahue

10.95

2.95

Portraits

11.95

3.50

Ordinary People

7.95

2.75

The Complete Scarsdale Medical Diet

7.95

2.95

Title Smiley's People

Price Discrimination and Modem Entrepreneur

351

elasticity of demand. The increased price for the hardback does not dissuade large numbers of best seller readers, whereas the reduction in price to paperback readers increases quantity demanded greatly Total profits will rise. Library Editions: Price discrimination in book sales was clearly being practiced with so-called library editions. Library editions were specially bound books that presumably would last longer. The differences in price between the library edition and the regular hardback edition, however, were never equal to the differences in cost; the price difference was considerably greater than the cost difference. Different Labels for the Same Product : Sometimes manufacturers will sell goods of similar grade and quality at different prices. In such cases, the major difference between the products arises from a brand name or label. In 1966, the Supreme Court ruled that Borden's practice of selling homogeneous canned evaporated milk at different prices, that is, charging a higher price for cans sold with the Borden label than for the cans to which other firms applied their own brand names, was price discrimination.

Chapter

22

--

LEADERSHIP IN MODERN ENTREPRENEUR

In any economical aggregate some people are bound to be more active than others. There is a differentiation of roles in economical groupings that gives a structure and function that, while it may not always be the same, emerges from the situation. While it may be an oversimplification to state that in groups there are people who turn out to be leaders and others who turn out to be followers, for this chapter it serves a satisfactory beginning. It is virtually impossible to discuss behaviour, especially economical behaviour, without including something about the process and nature of leadership. There are few, if any of us who remain unaffected by the activities of leaders-assembly line workers have their foreman, college professors have their dean, Indians have their chiefs, and all of us as citizens have a president.

What is leadership? Attempts to define leadership or describe a leader have been many and varied. In the past some reviewers have focused on outstanding personal characteristics and have defined leadership around those personal traits. Others, recognizing the complexity of the economical situation in which we all operate, have taken into account the many economical variables that are present and interacting. Definitions of leadership depend, then, on

Leadership in Modern Entrepreneur

353

the focus of attention. Interest in the influence process might develop the definition of a leader as one who either influences others or who causes the group to reach certain objectives. Attending to leadership as a selection process might define the phenomenon as the result of sociometric choices. A simpler representation of an accomplished fact would characte~'ize the leader as an individual in a specified office, while a more arbitrary characterization depicts a leader as one who engages in "leadership behaviour". A further identification system is one that concentrates on certain descriptive functions of a leader. The symbolic leader has prestige but no power, the administrative leader" gets things done," while the expert or the theorist stands out because of his special qualifications. The charismatic leader has power on a supernatural or mystical-emotional basis. Some attempt may be made, however, to focus this diversity of information toward a shorter verbal definition of leadership based on a unitary conceptual framework. The concept of role, for example, is one that may be useful in a description of leadership. In this view, leadership, quite simply, is a role that is occupied by a person. Defining leadership in this way identifies a leader as a member of a group where he is assigned a certain status by that group and engages in the behaviour that is associated with the position he oc.cupies. Leadership also has been viewed basically as an influence process. A leader may be defined as that person who stands out in influencing the activities of a group in setting goals and making progress toward achieving those goals. It should be recognized that we usually assign to the category of leaders those whose influence on the group is outstanding. This is important because each member of a group exerts some influence on another; leadership is more a matter of degree than anything else. This definition distinguishes between actual leaders and the formally designated leaders who may have very little influence on the group. This is the same distinction that Kimball Young makes when he distinguishes between "leadership" and "headship." The latter category includes those who are placed in the position by

354

Leadership in Modem Entrepreneur

virtue of authority or historical accident and who have little control over circumstances. Sometimes the activity of an individual operating under formal or legal authorities is called supervision to distinguish between it and actual leadership. Supervision is most often used in an industrial setting but it need not be limited to organizations of that type. There is also no real reason why we should call a supervisor at the higher organizational level an executive except that the latter term has by now acquired certain positive connotations that give it certain emotional motivational value. Supervision, as used here, should include the exercise of formal or legal authority at all levels in the organization; the notion still persists, however, that supervision consists of rather "lowlevel" activities while the executive is concerned with more exacting duties. In this chapter leadership will refer to the wide range of influence processes that occur in group interaction. Headship or supervision are aspects of this broad economical phenomena or leadership. These variants may differ from true leadership, but since those invested with formal authority often have, to some extent at least, the power to influence by virtue of their position, this is still leadership. And so it will be discussed. General Approaches to Study:

Leadership is a topic that has fascinated people down through history, sometimes to the virtual exclusion of all related areas of human behaviour. It seems that we are vitally concerned (especially in Western society) with the question of "who's who" and "who's in charge." There are many general ways of approaching the study of leadership. From the past we can identify a basic dichotomy arising from an analysis of leaders. The most common conceptualization has been to focus on a single leader apd his characteristics. In ancient Greece and Rome, Herodotus, Tacitus, and other historians. concentrated on outstanding men as ~ontributing significantly to: the stream of events. More recently, Thomas Carlyle remains the chief proponent of the" great man" theory, the notion that men make the times. Others have followed in the same or similar

Leadership in Modern Entrepreneur

355

channels; even most of those who have taken psychological approaches to this problem area have concentrated on the clinical histories of great men or, somewhat the same, basically, have tried to determine if there have been any traits that have been peculiar to leaders or that have been present in them more frequently than in others. The results of such endeavors have been disappointing, regardless of the scientific level of the approach. The other main approach to the study of leadership starts with a framework representing the converse of the "great man" theory, namely, that the times make the man. This view has been called the "situational" or the "sociological" view of leadership and history. Under this organization of thinking, the researchers look to the group instead of concentrating on the leader, seemingly an incongruous way of approaching leadership until we realize that the situational theory (at least in its newer forms) calls for a closer look at interactions between individuals in the group (a casual way of showing the validity of this way of thinking might be to answer the question, "What does it take to be a leader?" With the not too facetious response-"followers"). Extending the situational view to encompass large aggregates would explain events in a fashion like 'the temper of the times"-such factors as inflation, frustration, the personality structure common in the German family, and the search for a father image were responsible for the rise of Hitler. If not he, someone like him would have fitted into the pattern which permitted an authoritarian individual to come to the fore. The focus here is, of course, on the interrelationships between the members of the group under study. It is conceivable that the importance of particular traits varies from one leadership situation to another. If this were so, it could be that the results of the approach concentrating on the characteristics or traits of a single individual would nut explain leadership completely. Traits:

The concentration on personal traits or characteristics has occupied the attention of a significant number of researchers in the past, and the interest, in one way or another, continues to the present day. The measurement of the abilities of individuals who are classed

356

Leadership in Modem Entrepreneur

as "leaders" and a comparison made with others represents, at least partly, a trend in study that is influenced by the" great man" approach. Physical Factors: It is not surprising that physical factors such as height and weight should have been studied; the interest shown in this aspect down through the years is evidenced by the folklore and stereotypes existing in our day-to-day contacts. The main stereotype has the leader as a tall man. Gilmer tells of the three windows in the wall surrounding a construction site. The lowest was labelled "Junior Superintendent," a higher one" Assistant Superintendent," and -the highest window, "General Superintendent." References in common speech such as "being head and shoulders above the crowd" contribute further to the stereotype.

In his extensive survey of leadership studies, Stogdill determined that nine found leaders taller, two found them shorter, while one other suggested that the type of leadership activity is the important feature. Similarly equivocal findings appear for weight, physique, and health. Mental Ability: Historically, even more interest has been maintained in studies of the relationship between intelligence and leadership. Most shldies agree that, in this respect, leaders are superior to non-leaders. Certainly, if the group functions in a problem-solving situation and any activity which contributes to that problem solving is seen as desirable, those who can contribute come~o the fore more easily.

A study of college leaders indicated that they scored higher on the American Council on Education Psychological Examination, a well-established test of scholastic ability, than did non-leaders on the campus. In a study in the United States Army, Gibb found that officer candidates were clearly superior to a general army sample; 99 percent of those selected were above the general population mean. There may be upper limits, however, though these point to the situation more than to the attributes. For instance, Holling-worth found that 30 I.Q. points was the maximum tolerable spread between the leaders and the led; otherwise the relationship either does not take hold or maintain itself.

Leadership in Modem Entrepreneur

357

Verbal Ability: Stogdill's survey found that fluency in verbal communication was a factor to be considered in identifying characteristics of leadership. It might be intuitively stated that the ability to talk, particularly where the task is a verbal one, would be an important variable in leadership. This has since been supported in the jury studies of Strodtbeck et al. where it was noted, inter alia, that those who participated more in the discussions were more influential and when they spoke up at the beginning, were most often chosen as foremen.

Personalit-:I Traits: Leadership and self-confidence have been found to be related in most cases, though not all. Drake (1944) reported a high correlation between these factors. Richardson and Hanawalt similarly found higher scores on the Bemreuter selfconfidence scale among leaders than among those who did not display leadership behaviour. In a finding that is representative of the variation in results of studies in this area, Hunter and Jordan (1939) did not find a difference in their college group. They did find, however, that there was a difference between leaders and nonleaders on the Dominance Scale of that same personality measure. It seems that leaders may be more dominant in economical situations, all although here, as with intelligence, there may be outer limits in a situation with respect to acceptability by others in the group. Too much dominance may lead to rejection. For instance, Jennings found that dominant and aggressive leaders were rejected by the group, although the result may have been partly the result of the special circumstances; the group was made up of girls in a closed community, sent there under court order.

Leaders may be more perceptive of ability and personality differences in themselves and others. In an industrial situation, Fiedler found that effective supel'visors were ,better able to differentiate between their best and poorest workers than were the less effective supervisors. Such individuals are more psychologically distant from the other members of the group they lead. The area of introversion-extroversion has received a great deal of attention generally. Apart from the popular and misleading approaches to this factor (the categories are not discrete and may be

358

Leadership in Modem Entrepreneur

situationally related), there seems to be little evidence that extroversion and leadership are related. A review of studies on this factor by Mann confirms the well-known earlier review by Stogdill in stating the lack of relationship. Evaluation of the Trait Approach: While some information about traits in leadership has been gained from the many studies that have been made, there still remains a lack of substantial agreement in the results, particularly when the studies have focused on characteristics in specific situations. The most significant outcome from this approach may be the inability to generalize the findings from one situation to another.

Presentation of the findings in capsule form might be made by reiterating the results of the well-known survey by Stogdill, one which is still useful though some time has elapsed since it was made. Stogdill surveyed studies of personal factors involved in leadership and found that leaders were higher in self-confidence, intellectual adaptability, and verbal facility. In age, height, weight, and dominance the picture was not as clear though there was some superiority here as well. The above, Stogdill found. represented only fair agreement between investigators; there were too many departures from the main findings. A further complicating factor concerns the limitations placed on our thinking by a concept of a single and unitary leader. Even casual observation (though it is backed up by substantial evidence) demonstrates the fallacy of the notion, the leader. At least some groups function with more than one person emerging as a dominant figure, a situation that shows a good deal of fluctuation with time and place. It seems clear that while there is no such thing as a "general leadership trait" or any trait that seems to be necessary in all situations, there may be generality or transfer of characteristics from one situation to another. As might be expected, the more alike the situations, the more the composition of leadership remained the same. Even more, Katz et al. found generality across different tasks, but many of the traits in their studies were of a general kind, those which pointed to leader behaviour in economical situations rather than to specific personality traits.

Leadership in Modern Entrepreneur

359

Cartwright and Zander express a trend to the study of behaviour as the result of deficiencies in the trait approach. They put the focus on the interactional aspects. "Leadership is viewed as the performance of those acts which help the group achieve its preferred outcomes. Such acts may be termed grou? functions." Gibb may have set the stage best for us in his statement that "a person does not become a leader by virtue of his possession of anyone particular pattern of personality traits, but the pattern of personal characteristics of the leader must bear some relevant relationship to the present characteristics, activities, and goals of the group of which he is leader." The need to focus on the situation and the part individuals play in it emerges clearly from most studies. Roles and Functions:

One of the more precise approaches to the situational approach to leadership is that which focuses on roles as more descriptive of the basis of leadership. Some researchers even define leadership as "a role which an individual occupies at a given time in a given group" Gouldner. Using the concept of roles not only moves the observer away from traits and the difficulty that individual traits may not carry over from one specific situation to another, it also recognizes that even a description of a situation or the statement of a role being occupied is insufficient to encompass all the complexity of economical situations that take place. A "leader" plays more than one role or his behaviour serves many purposes. In addition, different individuals may emerge at different times to provide for more or less influential models or to channel the activities of others in those specific situations. One of the most extensive classifications of leadership roles has been shaped by Benne and Sheats in which they list 27 different roles. These various roles can be grouped into three general categories: (1) group task-definition and solution of problems, (2) group building and maintenance, and (3) individual rolessatisfaction of individual needs. These are all considered by the authors to be in the general description of" group required roles." Another description of leadership patterns is that given by Krech et al. in discussing the many functions of the position. They place

360

Leadership in Modern Entrepreneur

the various descriptive classifications into two main categoriesthose which are primary functions and those which are merely accessory. The primary functions are those considered essential to leadership, while the accessory functions may be assumed by the leader or assigned to him by the group by virtue of his position. All the various functions can be woven into a practical situation, especially in an on-going complex and dynamic economical situation. We might be able to see a little of each type to one extent or another. More complexity may emerge when the functions of a leader that are accessory in some situations may become primary in others. A religious leader, for instance, may act as exemplar or symbol, and these may be very primary in this particular setting. A more conceptual and integrative view of roles in leadership is part of what Schutz calls his Fundamental Interpersonal Relations Orientation (FIRO) theory. In this formulation there are three fundamental interpersonal needs-inclusion, control, and affection. Inclusion is contact or interaction with people or things; control is power over economical environment, while affection is economical closeness. An individual functions at an optimal level when all three areas are functioning in a proper relationship. The focus is on the individual ego and its development by integrating outer reality; leadership is viewed as functioning in the same way in that the leader operates to integrate the needs of the group with reality. The Table 1. ClaSSification of Member Roles A. Group Task Roles 1.

Initiator-contributor

2.

Information seeker

3.

Opinion seeker

4.

Information giver

5.

Opinion giver

6.

Elaborator

7.

Coordinator

8.

Orienter

9.

Evaluator-critic

Leadership in Modern Entrepreneur

361

10. Energizer II. Procedural technician 12. Recorder B.

Group Building and Maintenance Roles I.

Encourager

2.

Harmonizer

3. Compromiser 4. Gatekeeper and expediter 5. Standard setter or ego ideal 6. Group-observer and commentator 7. Follower C. Individ ual Roles

1.

Aggressor

2.

Blocker

3. Recognition seeker 4. Self-confessor 5. Playboy 6. Dominator 7.

Help seeker

8. Special interest pleader function of the leader is to complete any of the process of integration that the group does not perform. Other studies of leadership patterns of behaviour have used statistical methods to determine the specific factors that are important and independent dimensions of leadership behaviour. In one such approach using the technique of factor analysis, the researchers found that a high percentage of the differences in leader behaviour could be accounted for by two dimensions. "Consideration." was that behaviour designed to motivate and provide satis-factions for members as harmony was being maintained in the group. "Initiating and directing" behaviour

362

Leadership in Modem Entrepreneur Table 2. Primary and Accessory Functions of the Leader

Eight Primary Functions of the Leader Six Accessory Functions of the Leader 1. Executive

1. Exemplar

2. Planner

2. Symbol of the group

3. Policy maker

3. Substitute fo'r individual responsibility

4, Expert

4. Ideologist

5. External group representative

5. Father figure

6, Controller of internal relations

6. Scapegoat

7. Purveyor of rewards and punishments 8. Arbitrator and mediator

coordinated goal-directed activities Leadership behaviour on the "consideration" factor stresses participation in planning an acceptance of suggestions from members and, in general, is oriented toward member satisfactions. Leadership behaviour under the "initiating and directing" dimension includes definite indications by the leader of his attitudes and role in the work task and the nature and level of performance he believes is called for by the members in the work situation. Leadership Styles:

In a classic description of the climate developed by leaders, White and Lippitt (1960) describe three types of styles they believe emerged from their research studies. In several experiments they systematically varied the leadership climate in which groups of ten-year-old boys worked pursuing their hobbies. Three leadership styles were postulated and produced-the authoritarian, democratic, and laissez-faire. In the authoritarian style the leader developed all of the policy and most of the procedures. Not much went on in the group without the knowledge or personal direction of the leader himself. Under the democratic procedure, group activities were pursued after the establishment of policy through initial group discussion and decision making. Participation of members of the group was encouraged; there was, however, a need for the leader to act as a guide or controller of the discussion. The

Leadership in Modem Entrepreneur

363

laissez-faire climate allowed opportunity for an extensive range of behaviour, often at cross-purposes, in that complete freedom for individual and subsequent group activity was promoted. This set of studies included the highly relevant question of performance of groups operating under the three types of leadership styles. The researchers noted that output of work was at high levels much earlier in the authoritarian climate than under the democratic atmosphere. The authoritarian approach presumably allowed better coordination of activities to provide the initial high level of performance. In the long run, however, the output under democratic situations closely approached the levels reached under the authoritarian style of leadership. A finer analysis of performance over the entire period revealed a most significant fact. Performance under the authoritarian approach varied considerably with the presence of the leader. When the leader was absent, performance decreased significantly while it was maintained at regular levels when he was present. Under the democratic climate, it made no difference whether the leader was present or not; performance of the group was fairly even, whether the group was on its own or not. The group operating under laissez-faire arrangements was characterized by the uncoordinated horseplay that contributed little to effective performance. Output was consistently very low in this group. Performance of the group represented only one of the two major aspects considered in this series. The authors considered the resulting emotional responses and the feeling tone of the group to be fully as important as the quantitative measure of performance. The authoritarian climate generated a lot of hostility in the individuals comprising the group. This hostility was not directed at the leader, of course, nor was there much venting of these feelings through aggression toward fellow members. Aggression was dirct ted primarily toward members of other groups or other outsiders. An inventory of feelings after the experiment indicat¢d lower levels of satisfaction of performance under the authoritariAn discipline. Hostility and aggression was low in the groups operating under democratic atmosphere; individuals reported feeling more

364

Leadership in Modem Entrepreneur

satisfied throughout the democratic sessions and aggression toward others was at a minimal level. The laissez-faire group did not provide much satisfaction either, in spite of the fact that individual and group freedom in activity was almost unbounded. It must be noted at this point, however, that the above represent general findings; there was some variation on an individual basis. Not all subjects, for instance, were content with the democratic approach nor did all function most effectively in that climate. The fact that some individuals apparently feel a need for a highly structured situation and do not do well without it is one of the significant factors t? be taken into account in the evaluation of this classic study.

Other cautionary statements need to be made as well, since this set of studies has served as a focal point for countless discussions of leadership and the factors associated with it. There even may be some temptation to generalize results as far away as the international scene in order to promote ideological positions, at least partly, on the basis of studies such as this one. However valid these results may be, it must be remembered that the subjects consisted of a group of ten-year-old boys in an experimental situation. It seems likely, however, that the results can transfer to other organizational <>ettings such as industrial work groups. For instance, a study by Baumgartel (1957) assessed the leadership style of directors of 20 research laboratories. The directors were divided almost evenly between the classic three styles of leadership. Scientists in the laboratory were then asked to discuss the leadership climate conducted by the director. The directive style (authoritarian) provided the lowest ratings of satisfaction or orientation toward research and creativity. The participatory climate (democratic) engendered greater satisfaction on the part of the scientists who seemed to enjoy the opportunity to contribute to the development of original work. In the same way, Pelz found that scientific researchers in a large government organization performed better under a democratic approach that allowed them to make their own decisions in a climate that was neither strongly directive nor completely without any guidelines.

Leadership in Modem Entrepreneur

365

It may be misleading, however, to suggest that an authoritarian climate necessarily leads to a condition where a superior lacks concern for the welfare of the subordinates. Blau and Scott (1962, p. 163) found that supervisors who commanded the loyalty of their subordinates wer~able to promote productivity even if they were authoritarian in approach. Stanton also found that an authoritarian approach need not limit concern for employees. He compared two companies, one authoritarian and the other democratic, and found that supervisors did not differ in their attitudes toward consideration of the welfare of employees.

Other ways of characterizing leadership styles exist, of course. Knicker- bocker, for instance, identifies four climates: (1) force, (2) paternalism, (3) bargain, and (4) mutual means. Force is the direct use of restrictive control while paternalism is characterized primarily by loyalty of followers in a warm and cohesive setting. Bargaining involves an exchange in which certain satisfactions are gained by leaders and followers alike. Mutual means represent a fusion of individual and group goals and activities or, at least, attempts made in that direction. Perception of Leadership: As has already been noted with frequency in earlier chapters, much of human behaviour is determined not as much by what is "out there" as it is by what happens to the material when it gets inside the human processing system. The perception of the situation is usually much more important in determining behaviour than is the objective reality of that situation. The attitudes and views of individuals involved in all phases of group activity are important to note; this is true as well in discussions of leadership. If an individual serves as a leader of a group, it is quite probable that he is perceived by the members of the group as belonging to the grou p and sharing with other members the characteristic attitudes and values of that group. It is not likely that he would function effectively as a leader otherwise. This factor was stated very early by Brown as "membership-character" in the group. At the same time, the members probably have certain expectations, from the very minute behaviour patterns, perhaps, to the general image the leader

366

Leadership in Modern Entrepreneur

may radiate within the group and outside it. He will probably require those skills that are judged to be critical for the task at hand and, even more, will need to excel other members of the group in this respect. Yet, as we have seen above from Holling-warth's study, the leader cannot be too far ahead of the group, particularly in intellectual ability. The values and norms of the group will influence that group's expectations vi how the leader should behave. Blau, for instance, noted that superiors in a governmental organization slipped into a directive form of leadership behaviour and subordinates became submissive very readily. All this happened despite clear-cut attempts by the supervisors to develop a more equalitarian leadership climate. It was obvious that all members basically insisted that individuals follow the roles prescribed by the ideologies of the group in its functioning in the bureaucratic structure of the organization to which they belonged. College professors, too, may have their expectations of the behaviour of department heads or deans. Some campus climates may foster a directive approach by academic superiors, although it is quite likely that present trends in academe are away from a directive approach as an increasing number of academicians expect more equalitarian procedures to prevail. In this climate the dean is merely Primus inter pares. Many observers of the business and industrial scene have suggested that the kind of leadership expected among American businessmen is that which we have labelled autocratic or authoritarian. Individuals who are aggressive and forceful are, under this set of expectations, ones who are originally selected to come to the fore as captains of industry. Perceptions of oneself and others are reinforced, particularly if one is well placed, by the tendency to see that an existing situation has something that is "proper" and also to believe that one possesses the traits or requirements for the position one holds. Porter (1958) found managers seeing themselves as decision makers with independence of thought and high degree of initiative, while line workers perceived of themselves in a way that reinforced a general

Leadership in Modem Entrepreneur

367

image of follower ship with less independence of action. And, since the two aspects of human functioning mesh together neatly, perceptions and behaviour were closely related. Bowers, in noting a similarity in patterns of behaviour between supervisors close together in the organizational hierarchy, indicated some reasons for the similarity. Either the lower level supervisors imitate the behaviour of their superiors because this is where the payoff comes, or all supervisors have a tendency to think alike because only those who do are promoted by their superiors. There is, of course, an organizational tendency to perpetuate the organization in the way the individuals found it and to select other members of the organization that are like the existing members of the group. Followers: It might be expected, in view of the important place of motivation in human behaviour, that understanding of leadership behaviour couldn't be complete unless some knowledge is gained of the "why" of "leading." The same holds true of "following" as well. What needs is served in the specialized interaction involved in leadership and follower ship is an important aspect of motivation. A simple answer to the question of why people act as they do in the group situation can be based easily on the general model of motivation sketched earlier in Chapter 8. We might state simply that certain needs are present in individuals and that they engage in some behaviour that will be goal directed. Upon reaching that goal, the needs are satisfied. In the economical context this implies that some needs are satisfied for people in a leadership role, while other needs may be stronger for those who playa less active or less influential role in the group activity.

It has been stated earlier in this chapter, somewhat facetiously, that what it took to make a leader was followers. Aside from the obvious fact that leadership cannot exist without a group, a study of the characteristics of followers and the conditions under which they follow is of importance, not only to an understanding of the dynamics of their behaviour, but also for the need to study followers in order to gain a better understanding of the leaders themselves. In the emphasis on leaders and their characteristics, the nature of

368

Leadership in Modem Entrepreneur

follower-ship has been ignored. Consequently, all too little exists in the research literature. One such study by Sanford surveyed a sample of individuals in Philadelphia. After using a scale to differentiate between authoritarian" and "equalitarian" personalities, the researcher asked the subjects in each of the two categories questions that would elicit their views of Franklin D. Roosevelt and what made him a good or poor leader. The responses were categorized into four classes-whether there was an emphasis on functioning as a democratic leader, an emphasis on material dependency (the gaining of material benefits), a stressing of power or strength and, finally, an emphasis on personal warmth or concern for humanity generally. In a comparison of the two groups, equalitarians more often emphasized the function of democratic leader and almost all of the responses focusing on personal warmth also were given by equalitarians. The emphases on material dependency were made by authoritarians. It might be expected that the authoritarians would emphasize strength of power more than the other group. Interestingly enough, however, there was no significant difference between the two groups with respect to their concentration on the factor of power as being important in their evaluation of the leader. The study indicates that the response to a leader may be either positive or negative on the part of followers, but the reasons for the reactions can differ according to the personality characteristics of the followers. This has important implications for leadership and its development. II

Hay thorn et al. used the same scale to measure the personality dimension of authoritarianism and set up experimental groups composed of leaders and followers on both dimensions. Ratings were made after a series of experimental tests. As might be expected, authoritarian leaders were rated as less oriented to others and more autocratic. Authoritarian followers were also rated in the same way in comparison to equalitarian followers. In groups led by equalitarians there was more opportunity for various members, authoritarian or equalitarian, to participate in the activities of the group and to exercise some influence. In groups with equalitarian leaders, the followers were more secure and conflict among individuals seemed to be reduced.

Leadership in Modem Entrepreneur

369

There may be a tendency, especially because of our casual references to people as leaders or followers, to believe that there are consistent and real differences in personality or other traits between the two types we have established. This is reinforced by following the trait approach toward leadership behaviour. That some caution needs to be exercised might be recognized from the fact that conditions and circumstances differ and, therefore, differing group requirements may call for various individuals to exercise leadership behaviour at various times. Not only is the concept of one individual (the leader) dominant in all situations to be avoided, the hard and fast distinctions between leaders and followers should be carefully stated. There may even be a high relationship between leadership and follower-ship roles. In a study of choice behaviour in leadership situations, Hollander evaluated sociometric choices of a group of naval aviation cadets. The cadets were told that they were to assume that a critical and stressful mission were facing them. They were asked to choose those fellow cadets whom they would most or least like to have as a leader of the group; then each was asked to choose those he would most or least like to have in his group if he were the leader. Finally, each cadet was asked to list his best friends. There was an extremely high relationship between the lists of leaders and followers that each cadet chose. The same people were chosen as both leaders and followers, while friendship choices were quite different. The much lower correlation's with friendship indicated that, while friends were chosen at times, this was not the same as an evaluation on other bases and tends to indicate that individuals will select other members of the group, whether as leaders or followers, on attributes that are considered to be important for the task at hand. This would 'confirm casual observation of events like choosing up sides for games in the primary neighborhood group. Friends seem to get chosen for one's group, but the skillful players get chosen first. Formal Structure and Behaviour: The nature and extent of the organizational hierarchy playa significant role in the emergence and maintenance of leadership.

370

Leadership in Modem Entrepreneur

By virtue of one's placement in the group and its channels of communication, opportunities to exhibit leadership behaviour appear to a greater or lesser degree. A position wherein an individual transmits all orders of a superior to those below and passes information upward to that superior represents a locus of power, whether the job description formally specifies or recognizes this or not. Whisler (1960) studied the "assistant to" personnel in several organizations and found them particularly influential where top officers were being rotated frequently. The reliance on the subordinate in these circumstances is readily understandable. (Whisler also found that the success of the assistant was related more to how closely he resembled the boss in economical, educational, ethnic, and political background than to specific job performance.) The reliance on others may be, as Miner and Culver state, a mark of the greater feeling of helplessness on the part of the executive in his meeting of complex job demands. Communication patterns in a group may, as the result of previous success become perpetuated so that these patterns remain one of the main determinants of the leadership function (Klein, 1956). Concomitantly, power, authority, and status are reinforced by the simple fact of positioning in the communication chain or net. Klein also found that centrality in the communication structure was important for two reasons. There is greater access to information in the central position, and this alone may provide influence and control. In addition, the occupant of the central slot is more visible and apt to be more in demand. Further, since "nothing succeeds like success," the very fact that one has had an opportunity to practice leadership skills or at least engage in "leadership behaviour" gives him a later advantage over those who have been deprived of a chance to do so. Michels notes further that the exercise of leadership activity contributes to the motivational structure of the individual. The reinforcement makes him more likely to act similarly in the future. This is, of course, consistent with all our information on learning. Parsons, Bales, and Shils found that the status of leaders can carryover to a new task. Success with one task enhances the status of the person who

Leadership in Modern Entrepreneur

371

contributes to the successful completion of that task and makes it more likely that the contributor transfers his status to some new situation. In management circles some of the most frequently occurring questions with respect to the organizational hierarchy and the impact on leadership has to do with the concept of span of control. Span of control refers to the number of subordinates directly responsible to the superior. Much of the activity in this limited area revolves around the fixing on a specific number in the span of control on the assumption that the time and abilities of single individuals impose certain constraints on their functioning with subordinates. Since the superior and all subordinates are not interacting constantly, this assumption may not be warranted. However this may be, the search for the" magic number" continues. Entwisle and Walton report a span of five as being the median number in their survey of two different types of organizations. They found that the presidents of small business companies and the presidents of colleges or universities had, on the average, a staff of five people reporting directly to them. They also indicate that, as the size of the organization increases, the number in the span of control is also likely to increase. It might be sufficient to say at this point that no set figure exists with respect to the number of subordinates a manager ought to have. Much depends on the internal conditions in the organization, the type of task, the extent to which interaction is necessary for the completion of the task, the abilities or capacities of the subordinates, the communication channels, and virtually any other condition that affects the functioning of the leader and the organization. Leadership in Change Situations:

Since change is one of the more ubiquitous features of human behaviour it should occasion no surprise that change must be considered in the light of its impact on leadership. Change affects individuals and groups and, therefore, leaders as well. Changes in leadership may come about as the result of changes in group functioning induced by either internal conditions or by those arising from the external factors. Even groups that look fairly stable or appear

372

Leadership in Modem Entrepreneur

to be in or close to equilibrium undergo change induced by both internal and external factqrs. All of the forces generating conflict in groups and organizations have their implications for leaders. Attitudes of individuals toward the organization or the leader may be such that friction exists. Competition among subgroups for scarce resources or a lack of identification with group goals can upset the equilibrium far beyond the ability of the leader to reestablish it. Changes can also occur within the group as people come and go, and the membership of the organization changes. Forces from outside the group playa role as well. Input from the environment, can alter leadership behaviour in many ways. Attacks or threats from the external situation can result in a change of leadership or leadership techniques to counter the external threats. Some external attacks may provide, however, an occasion for group unity rather than act as a divisive force in the group or organization. A change in technology, for instance, may force an industrial organization to reevaluate its position and go so far as to change not only its leadership but its entire structure. The challenge arising on this basis may force other companies out of business if they cannot adapt their functioning to the levels or procedures required. The challenge implicit in change is even more pertinent for the individual in a leadership situation. Since his role usually calls for more activity than is expected of others in the group, some positive steps are required in most situations. As he is the prime influencer of group action, the effectiveness of the leader in dealing with the conditions of change assumes utmost importance. There seems to be little doubt that personality factors more than abilities or knowledge are responsible for most of the turnover in organizations, particularly industrial ones. Success of managers, in the eyes of many corporate executives, is traceable to those same factors and, more specifically, to the ability to evaluate economical situations or delegate some of the responsibility in the task. The unsuccessful executives were less perceptive of their own attributes and those of others with whom they worked.

Leadership in Modern Entrepreneur

373

Another characteristic of successful leaders may be their avoidance of conforming behaviour, although this may be limited to individuals higher up in the hierarchy (nonconformity at lower levels is not often tolerated). The researchers found that the executives who scored higher on a measure of conformity were rated lower by their superiors on a measure of performance in their jobs. Effective leadership is also, according to Selznick, responsible leadership. The main task of the leader is to set goals, or determine what has to be done in order to achieve what must be. "Leadership is irresponsible when it fails to set goals and therefore lets the institution drift. ... In addition to sheer drift stemming from the failure to set institutional goals, opportunism also reflects an excessive response to outside pressures. To be sure, leaders must take account of the environment, adapting to its limitations as well as to its opportunities, but we must beware of institutional surrender made in the name of organizational survival. There is a difference between a university president who takes account of a state legislature or strong pressure groups and one who permits these forces to determine university policy". But even responsible leadership often is not enough to meet the most challenging situations an organization will face, Selznick adds. What is called for in addition to responsibility is creative leadership, a concern for constructive change in all facets of organizational functioning.

***

Chapter

23

--

ORGANISATION OF FOREIGN TRADE BY MODERN ENTREPRENEUR Foreign or international trade means trade between citizens of different countries or between the countries themselves. Foreign trade can be bilateral or multilateral. It is bilateral when it is between any two nations. It is multilateral when each country buys and sells with whatever other country it wishes. The important feature of foreign trade is that one country sells goods or services to, or purchases goods and services from, another country, where goods or services of a country are sold in a foreign country, it is said to be engaged in export trade. Where it buys goods or services from one or more foreign countries, it is said to be engaged in import trade. There is a third kind of foreign trade, known as entrepot trade. In entrepot trade, goods are impo.rted into a country not with the object of use within the country but for re-export to some other country. Growth of Foreign Trade: The earliest trade between countries took place when they were able to supply one anoth!,!r with goods which they were unable to produce for themselves. But if foreign trade had only followed this,

Organisation of Foreign Trade by Modem Entrepreneur

375

it would not have cached its present proportions. The real reason for its tremendous growth is that countries now-days import many things which they could produce themselves, in the same way that individuals purchase many things they could make for themselves. Division of labour and specialisation, followed by exchange, result in a greater output of everything and this same thing applies to foreign trade as well. The principle underlying foreign trade is that a country should specialise in the production of those things for which it has the greatest advantage over others. Breaking the barriers: Foreign trade recognizes no traditional national boundaries. It is freely carried on even between nations which are poles apart in many respects. Even if any two countries have adopted different political and economic systems, this does not have much effect on trade between them. Take the U.S.A. and U.S.s.R., for example. One is a firm believer in free economy. The other advocates State control over everything. Neither of them misses any opportunity to criticise the other's role in various international developments. But when it comes to trade between them, they give the impression as if they never had any political or ideological differences. What does this show? One, the satisfaction of human wants is given top priority by all nations. Two, that modem methods of production have introduced a sharp division of labour so that each country now produces only those goods which it can most profitably produce; and what it does not produce, it conveniently gets from other countries. Lastly, that developments in the field of transport and communications have made nonsense of the traditional national boundaries. The net result of all this is that today no country can boast of being self-sufficient in all respects. Practically every country is dependent on one or more countries for one thing or another. Advantages of Foreign Trade: If foreign trade has been able to break geographical and even ideological barriers, it is because of the following advantages offered byit:

376

Organisation of Foreign Trade by Modern Entrepreneur

(1) Mutual give and take: Because of foreign trade, each country can avail of the goods that it does not produce itself. Likewise, a country with surplus of certain foods can make it available to a country of countries the:, t need it. (2) Specialisation and efficiency in production: Foreign trade enables a country to concentrate on production of only such goods that it can most efficiently and economically produce. This results in reduction or costs and increase in profits for it.

(3) Increase in total world production: Because each country produces only such goods as it can produce at the lowest possible cost and sell' at the maximum possible profit, it is able to avoid wastage of its productive resources. All factors of production can thus be used to their maximum capacity.

This results in increase in total world production which would be an impossibility in case each country had been required to produce everything needed by it irrespective] of whether or not it was profitable for it to do so. (4) Higher standards of living: There are not many countries which have resources to produce everything they require. As such, if each country were to produce everything it needed, it would not be able to do it economically as a result of which standards of living of its people would remain low. Because under foreign trade it is possible to obtain all kinds of goods from abroad, a country can assure better standards of living for its people. (5) Optimum use ofnatural and human resources: Foreign trade enables a country to make best use of its natural and human resources. Take Japan, for example, It is best equipped for manufacturing industrial goods. For a large part of its requirements of foodstuffs and raw materials, it depends on other countries. If there had been no-foreign trade, it would also have to produce its requirements of foodstuffs and raw materials a task for which either it does not have proper resources or, even where it does, it cannot make optimum use thereof.

This way, not only the country concerned but all those who could benefit from its specialisation in the production of certain goods would stand to lose.

Organisation of Foreign Trade by Modem Entrepreneur

377

(6) Difficulty ofnwvement of resources : Foreign trade makes it possible for each country to attain fullest and most profitable utilisation of its productive resources. Were there no foreign trade, these resources would remain unutilized or under-utilized. Even iL would not be p08sible to shift such resources to a country which could use them profitably because while capital and labour are normally shy of leaving their homeland, in the case of land such movement is physically impossible. (7) Equalisation of prices between countries: Foreign trade serves to equalize prices in all the tradiJ;lg countries. without it, a country having appropriate resources to produce a particular commodity in abundance would face a situation of glut and such commodity would fetch a low price when sold internally. As against this, in a country lacking in resources to produce such a commodity, it would be in short supply and this would make it very expensive there.

With foreign trade, the supply of such goods in the first country is reduced (through exports) so that its price goes up and the producers are enabled to get fair return on their produce. In the second country the supply of such commodity is increased (through imports) so that its price in that country is lowered. Thus, the prices of internationally traded goods tend to be the same everywhere, the slight difference between them being due to transport costs.

(8) Miscellaneous advantages : Besides gains from specialisation and exchange, foreign trade also offers several other advantages. For example, it enables induction of latest technology, new ideas, social changes and liberal attitudes. Problems of Foreign Trade: Even though both in volume and value foreign trade has achieved an enormous success, it has still a long way to go. Some of the problems of foreign trade are as under:

(1) Obstacles in free movement of goods: Full advantages of foreign trade can be availed only when there are no obstacles in the

378

Organisation of Foreign Trade by Modem Entrepreneur

movement of commodities between countries. Such obstacles may be of two types: natural and man-made. Natural obstacles, such as long distances and high transportation costs, can be easily got over. But what can not be so easily got over are man-made obstacles, such as, customs barriers raised by govern~,ents to restrict or prohibit free flow of trade between countries. (2) Monopolistic competition : Foreign trade can produce benefits only under conditions of perfect competition i.e., where a country is free to buy or sell in any country it likes. Then only total output can be maximized, costs and prices can be minimized and maximum consumer welfare ensured. But in practical life, we have conditions of monopolistic competition where a few economically advanced nations with their powerful multinational companies have neatly divided the world market among themselves. (3) Dissimilar economies of scale: Trade between any two nations can flourish only when they have similar internal and external economies of scale. It is only by attaining economies of scale in a particular line that a country may secure enough cost advantage to neutralize high labour and transport costs, In reality, however, only economically advanced countries can achieve such levels of economies so that the world market -has come to be monopolistically dominated. (4) Language barriers: Each country has its own language and also often its own script. This creates problems of communication between countries. (5) Independent currency system: Each country has its own independent currency system and this creates problems in regard to payments as between nations. (6) Greater exposure to risks: People tmdertaking foreign trade transactions are separated by long geographical distances, This creates problems of transportation of goods from one country to another. Yet another problem is that goods transported from one country to, another are subject to several risks because they remain in transit for long periods.

Organisation of Foreign Trade by Modem Entrepreneur

379

(7) Blocking of capital for Ions periods: because there is a long interval between the time when the goods are dispatched and when the same are received and paid for by the foreign importer, the exporter has to invest a large capital in his business to provide for slow turnover. (8) Other problems: In the absence of direct contact between the seller and the buyer, it becomes a difficult task for the seller to inquire into the credit worthiness of the buyer and for the buyer to inquire into the reliability of the seller.

This is not all. Foreign trade transactions entail preparation of a large number of documents and compliance wi th several legal and customs formalities. How Orders are Received from Abroad: Selling goods in foreign countries is not an easy job. It is rarely that a foreign customer would send in his order to an Indian manufacturer or exporter without any effort on the letter's part. There has to be continuous, systematic nurturing of the export market for local goods. First of all, the manufacturer Qr exporter should study the markets from where he hopes to receive orders for his goods. He should gather information as to population, standards of living, customs duties and other relevant regulations in those markets. Then, he should obtain details as to the nature of demand in those markets, the extent of demand at different price levels, any other factors likely to affect demand, such as, economic, social, or religious, and the degree of competition to be faced there. Likewise, if dealers in those markets have any special preference for a particular kind of packing or dispatch of roods, it should also be carefully noted. It is only after undertaking such detailed study into the functioning of various foreign markets that a local manufacturer or exporter can hope to establish a foothold there.

To convert such foothold into a stronghold, the manufacturer or exporter would have to do a number of things, important among which are as follows;

380

Organisation of Foreign Trade by Modem Entrepreneur

1. Advertising: Advertisements in newspapers and magazines having international circulation should be liberally given. Special preference should be given to those newspapers and magazines which are widely read in the countries to which goods are proposed to be exported. 2. Personal visit: A representative of the business may personally visit such markets to establish contacts with dealers there. Needless to say that relations established in this way pay richer dividends than those borne of correspondence or other indirect means. 3. Advertising letters and leaflets : Letters and leaflets introducing the manufacturer or exporter to dealers in foreign markets may also be sent. 4. Visits to buyers from foreign firms. Representatives of foreign firms visiting the country may also be contracted to explore the possibilities of exporting goods to their respective countries. 5. Salesmen: Though appointing salesmen to visit foreign markets from time to time is a costly proposition, it helps a lot in promoting exports. But care should be taken to ensure that such salesmen possess good knowledge of the countries to be visited by them and that they are armed with sufficient publicity material, such as, samples, literature, etc. 6. Agents or foreign representatives: These can prove to be a good source of information about their respective markets. Goods can be sent to agents or representatives on consignment basis and they may be paid commission on sales effected by them in their respective countries. 7. Foreign branches: In case·the manufacturer or exporter is resourceful enough to afford it, he can set up branch offices in foreign countries. But this should be done only when there is already a good market in those countries for the goods produced by the manufacturer or exporter. S. Middlemen: Establishment of foreign branches or appointment of agents or representatives in foreign countries cannot be done by all manufacturers or exporters for the simple reason that

Organisation of Foreign Trade by Modern Entrepreneur

381

this costs money. For medium or small-scale firms, middlemen can prove to be of great help. These middlemen assist in establishing business relationships between exporters and importers for a small fee or commission. Such middlemen can be classified as under; (a) Export agents: They operate in the exporting country. They buy goods in their country from different manufacturers and dispatch these to their principals in importing countries. (b) Import agents: They are appointed to obtain supplies from abroad for importers, i.e., their principals. They operate in the importing country but maintain establishments in various countries from which goods are imported. They are paid on a commission basis. (c) Indent houses: Also known as Indent Firms, these can be found at every important port town. They combine the functions of export and import agents. They buy floods in local markets for their foreign principals and arrange to dispatch these to them. Similarly, they also tea buy goods in foreign markets for ~eir local principals and arrange for their import. They are also said on a commission basis. (d) Forwarding agents: They specialise in the collection of goods from the premises of the sender and pass them on to the main carrier which is to take these to their destination. (e) Clearing agents: They specialise in attending to the formalities at the Customs while taking delivery of the imported goods at the port and then forwarding them to the importer's place of business.

Types of Foreign Trade Transactions: Foreign trade transactions may take various forms. These depend on the type of contract that is entered into between the parties concerned. Based, on this, foreign trade transactions may be classified as follows: (1) Direct business : When importer or exporter does not make use of the services offered by middlemen and enters the foreign market all on his own, he is said to be engaged in direct foreign trade business.

382

Organisation of Foreign Trade by Modem Entrepreneur

But an importer or exporter will do so only when he has the necessary capital or credit to finance shipments to, or from, overseas parties. Also, it will depend on the degree of specialisation possessed by the person concerned in this field. (2) Consignment business: In co~signment business, goods may be exported either in response to definite orders or a whole cargo may be consigned to a foreign agent or representative with instructions to sell either at a fixed price or for the best price he can obtain there. An agent or representative receives and sells the goods on behalf of his principal. For the services rendered by hire he is , paid commission on sales. From, time to time, the agent submits particulars of the sales made by him and remits the proceeds after deducting his commission and expenses. (3) Merchant shippers: They supply their foreign customers with goods which they themselves purchase from different local manufacturers. They operate their business at their own risk. (4) Indent houses : Indent firms are like other middlemen operating between exporters and importers. They maintain their offices at every important port town, like Bombay, Calcutta, Madras etc. For the s~rvices rendered by them, they charge commission from the importer on whose behalf they buy goods from foreign businessmen and get them shipped here. Indent houses perform many useful functions for importers, some of which are as follows:

(i) They assist importers in getting over the intricate problems involved in importing goods from foreign countries. (ii) Through their agents in foreign countries, they ensure that

the goods shipped jn response to importers orders are of the right quality and standard. (iii) They help in sorting out complaints and grievances of

importers in respect of goods received from foreign dealers. (iv) Since indent houses command good reputation, their client importers can cash on it and get credit facilities from banks and other financial institutions. (v) They keep importers informed of any change in tastes and fashions in the- foreign markets.

Organisation of Foreign Trade by Modem Entrepreneur

383

(vi) They help importers in obtaining favourable terms from foreign dealers.

Need for Government Control: The need to have a favourable balance of trade and payments has made it obligatory for the government to regulate foreign trade. This is as it should be. Because, in the long run, a nation may stand to lose if it imports more than it exports. Considering the scarcity of foreign exchange resources, no country can manage its economy well if the payments for its imports exceed its export earnings. Likewise, imports cannot be allowed to pose a threat to local production units. If anything, imports need to be so organized that they provide an impetus to production within the country. And of course, import of inessential goods needs always to be curbed. If governmental action is necessary to control imports, it is no less so for the regulation of exports. Exports cannot be allowed for the fun of it. For example, it would serve no purpose to allow exports of goods which are in short supply in the country. Then, there is always a need to use the precious export earnings for the good of the nation. Further, conscious efforts need to be made to channalise our exports to countries whose currencies are difficult to obtain. Last, but not least, exporters have to be so organized that they help production within the country.

How control is exercised: Control over exports and imports is exercised as per the provisions of the Imports and Exports Control Act, as amended from time to time. Accordingly, commodities included in Schedule I to the Exports Control Order, 1962, cannot be exported without an export license. As for commodities which are included in the O.G.L. (Open General License) List, these can be exported without any export license if their export is not regulated by any other law. For example, exports of tea are regulated by the Tea Board under the Tea Act and those of coffee by the Coffee Board, under the Coffee Act. Similarly, imports are also subject to governmental control and importers are not free to import anything they want, they have to

384

,Organisation of Foreign Trade by Modem Entrepreneur

apply for import licenses to the Controller of Imports and Exports who grants their, such licenses within the framework of the existing import policy of the government. Commodities which are in short supply in the country are allowed to be imported without any import license. Such commodities are specified from time to time in the Import Trade Control Orders. The list that contains these commodities is known as the O.G.L. List. Commodities not placed on this list can be imported only under an import license. For grant of Export and Import licenses, applicants are divided into three categories, i.e., (i) Established Exporters or Importers. (ii) Newcomers.

(iii) Producers or Manufacturers.

Exchange Control: Besides control over import and export of goods, the government also exercise control over the foreign exchange involved in it.

For example, an exporter of goods to foreign countries, except Nepal, Tibet and Bhutan, must furnish to the Collector of Customs (or any other authority specified by the Reserve Bank of India) a declaration that he will surrender the foreign exchange representing the full value of the exported goods, to the Reserve Bank of India within the prescribed period. Similarly, foreign currency required to be paid in case of import of goods is released after proper scrutiny by the government or the Reserve Bank of India. Such foreign exchange is not directly released to importers.

***

Chapter

24 tItI IMPORT DECISIONS BY MODERN ENTREPRENEUR

Basically in every transaction two parties are involved i.e., the seller and the buyer. One offers the goods and services and the other who accepts, pays for them. On the face of it, the operation appears to be simple. It is simple in the case of local transaction when the buyer goes to the seller and pays for the goods purchased. In international trade things are not so simple except where the foreign customers comes to the seller and does the whole job of taking goods to his country. The seller has to send goods to foreign countries by rail, steamer and air. Shipping companies or other carriers of goods have to be approached; customs and banking formalities have to be complied with; every care has to be taken that the goods reach the destination in safe and square condition; payment has to be obtained from the overseas buyer to the satisfaction of the Reserve Bank of India; and a number of other steps have to be taken which make international trade somewhat complicated. Overseas market is not merely an extension of domestic market. Apart from the basic principles of sound business in domestic as well as foreign market, selling abroad needs specialized knowledge regarding certain matters such as detailed market surveys, shipping, marine insurance, customs and foreign exchange formalities etc.

386

Import Decisions by Modem Entrepreneur

Various techniques of export marketing which an exporter must know are dealt with in the paras to follow. Knowing the Goods: Detailed information regarding the goods intended to be exported is a must for every exporter. The exporter should study where the goods are produced, are they available for export, what are factors governing their production, what are the prices obtained in India and abroad, what is the tendency of the prices to fluctuate, what is the pattern of trade in regard to the goods, what are the probable markets, changing tastes and consumer preferences, what are present sources of supply, are there any difficulties in storage, preservation and transportation, and last but not the least, what are the relevant regulations and import duties in force in buyer's country. Information regarding matters stated above can be obtained from Export Promotion Councilor Goods Board concerned or the Director General of Commercial Intelligence and Statistics or the Export Promotion Officers posted at various important cities of the country. The functions of these agencies are fully dealt with in separate chapter. In case the exporter himself is the manufacturer of the goods intended to be exported, he should, in addition to the matters mentioned above, have a clear cut idea of uniqueness of his product, maintenance of a consistent standard of quality to meet the needs of foreign customers, enough production capacity, supply of service or maintenance, if required, adaptability of the product to differing foreign) needs and tastes, sales literatures, handling instructions or service manual printed in a foreign language or languages, cost of shipping etc. Assessing the Competition: Overseas markets are highly competitive and, therefore, it is necessary for every exporter to assess degree of competition. For assessing degree of competition, he should have a clear idea about the competitors, their products, prices, marketing techniques, terms of business etc. so as to enable himself to offer a product to foreign buyer with a bargaining edge in order to capture the foreign market.

Import Decisions by Modem Entrepreneur

387

Once the competition is assessed, exporter should know his position regarding: ' (a) the approximate price at which product can be offered; (b) the terms of credit etc. to be offered;

(c) the packaging, transportation, storage and distribution methods to be adopted; and (d) the marketing support to be offered in the term of publicity literature, visual publicity advertisement, gifts, etc., depending on the product. Market Intelligence: Marketing is more a science based on precision and methodology rather than on mere experience and intuition. In the absence of actual inquiries from the foreign buyers potential exporter has to explore market potentialities for his goods and locate foreign buyers. The task of finding markets and buyers is done either by seeking the help of market research already conducted by different agencies and institutions specializing in the field or by conducting fresh market surveys where no such survey reports are available. As a preliminary step for locating foreign markets, the potential exporter should examine the export statistics put out by India as well as other countries over a few years, talk with experienced exporters, make good use of the trade association, chambers of commerce, association of trade and industry or export association, if any, contact foreign or international departments of the commercial banks, examine trade directories from various countries or study foreign telephone directories. Alternatively, expert help may also be sought from the government export promotion agencies. However, for the convenience of potential exporters, different sources along with names of publications published by them and periodicity there of from where a preliminary idea of products in demand and places where they are in demand can be had are listed in Appendix I. However, if survey reports or lists are not available, the potential exporter should have survey conducted through his own

388

Import Decisions by Modern Entrepreneur

organisation or though a specialized agency. In this connection, he may contact the Indian Institute of Foreign Trade which is engaged in market research abroad and which coordinates the markets survey programmes undertaken in the interest of export promotion. For conducting such surveys, the Government of India provides assistance through the Market Development Fund. In investigating sales prospects for a product in a particular market, following information is to be gathered and assessed:

Basic Factors: (i) Area of the country, climate, distances between main centers, and other geographical factors that may influence the demand for the product. (ii) Size, age distribution, and concentration of population.

(iii) Level of income, distribution of income and what sectors of the population might use the product. (iv) Natural resources (limited, potentially rich); importance of agricultural or other products in earning income. (v) Extent and stage of industrial development, plans for further development; amount of foreign investment coming in. (vi) Present economic situation, trade balance, credit standing

availability of foreign exchange.

Access to Market: (i) Import restrictions, such as licensing or quotas. (ii)

Rates of customs duties and whether goods from the country receive preferential treatment.

(iii) Method of calculating the value of goods for duty purposes. (iv) Marking and labelling regulation: need for health certificates for animal, plant and fisheries products; testing procedures for pharmaceuticals etc. (v) Convertibility of currency, any currency controls, controls on remittances. (vi) Added value or other Internal taxes.

Import Decisions by Modern Entrepreneur

389

(vii) Bilaleral trade or barter agreements that favour imports from particular sources.

Marketpotential: (i) Current and potential demand for product. (ii)

Domestic production of product or one closely related to it. Major producers and location, investment plans, etc.

(iii) Statistics on imports of the products by volume, value and

country of origin. Are these increasing or decreasing? (iv) Dominant price and quality ranges of imported and domestic product; range with the largest current and potential sales. (v) Prices at the importer, wholesale and retail levels. (vi) Control of market by traditional suppliers, acceptability of new products.

Market Requirement: (i) System of measurement used, imperial, metric etc. (ii) Preferred basis for price quotations: CIF, FOB, C&F., etc. (iii) Terms of credit considered normal: letter of credit, sight draft, etc. If credit is necessary, what are the standard terms? (iv) Preferences in styling, quality, etc., because of national characteristics or interests as they differ widely from those in the exporter's country. (v) Need to conform to certain standards such as electrical standards, and the procedure for approval; also grading . system, if any. (vi) Need for special packaging because of climate, shipping conditions, government regulations, or local tastes and prejudices.

Distribution: (i) The normal importer of the product, whether manufacturer, commission agent, merchant, stocking distributor or other. Commissions expected in each instance. (ii) Normal distribution pattern.

Import Decisions by Modem Entrepreneur

390

(iii) Should one firm have the exclusive agency for the whole market or should a number of representatives in various locations be preferable? (iv) Do importers normally carry large stocks to supply the trade or!re frequent small shipments common? (v) Will the representative expect advertising support?

Sales Promotion: (i) What media are available for advertising the product e.g. newspaper, trade magazines, radio, television, cinema etc. (ii)

What is the cost of advel'tising space or the in the media best suited to advertising this product?

(iii) Are there any suitable trade fairs or exhibitions in the area and what is the cost of participating in them? For successful completion of market surveys and for having a I continuous knowledge of the ever-changing situation in foreign markets., an uninterrupted flow of information, intelligence and statistics on a meaningful basis would be required. This information can also by obtained from trade representatives of Government of India in different countries. This market research tells that markets to avoid are those in which the chances of success are negligible. In general, a market should be avoided if : (a) the product is not likely to appeal the customers taste there; (b) the product needs more adaptation than the demand

warrants or more than what can be really afforded on this point; (c) import restrictions and/or high tariff in effect reduce or eliminate the demand; (d) shipping cost will be too high; (e) too much money will have to be spent on pulling out the sales literature and catal9gues in other language or languages; (f)

offering service and maintaining a stock of spare parts will not be easy.

Import Decisions by Modem Entrepreneur

391

Another method of establishing contacts with the foreign buyers is to visit foreign markets. Visits to foreign markets can be undertaken either as a member of trade delegations sponsored by different agencies or individually. However, this is costly method and a prospective exporter intending to visit foreign countries is required to know quite a few things about the general socio-economic and political set-up of the countries which he intends to visit, the price structure, banking and shipping facilities, import-export and exchange control regulations, customs regulations, foreign exchange requirements of the proposed visit etc. The Director of Commercial Publicity has brought out a few booklets containing such information on some countries. The Engineering Export Promotion Council, Calcutta has also brought out a few similar publications. If an exporter wants to know something more about the country, which he intends to visit he is advised to write direct to the commercial representative posted in the country concerned. Still another way to find a market is to exhibit the product in one or more trade fairs. This the exporter can do either on his own or in a section of the fair taken over by the Government. At a trade fair, exhibiting can study the reaction to his product, compare it with the products of his competitors from other countries, make contract with possible agents or customers. Even attending a trade fair only as a visitor can be useful in granting contracts. What has been discussed above relates to finding of new markets as distinguished from maintaining existing markets. Export organizations have to be management minded market oriented with programme flexibility adapting with changing world treating packaging, advertising and public relations as an integral part of marketing plan, keeping in close touch with distribution channels and changes thpreto and putting marketing operations into these new emerging pattern of distribution and providing for other sales service ensuring that the company's warranty obligations are' met. Selecting Channels of Distribution:

In exporters own cotmtry, there are two types of channels (a) Direct channels including own export organisation subsidiary export company or allied export selling company.

392

Import Decisions by Modem Entrepreneur Though having own export department is economical and effective, decision with regard to it depends upon financial and managerial resources at the disposal of the concern. (b) Second type of channels include confirming houses, merchants exporters, export houses-and group selling.

The confirming house acts as a broker between the buyer in one country and the seller in the other. India's trade in individual items is generally carried out through this method. Merchants exporters specialise in acting as merchants for business in overseas market. The export merchants generally purchase goods from local concerns and sell them abroad in their own account. Thus the supplier is paid promptly in local currency and relieved of the work relating to expensive overseas surveys and visit, shipping and packing details, legal formalities and international risks etc. However, the supplier loses control over prices, places where he wants to sell and even the manner in which he wants to sell. Moreover, commission paid to the merchants exporters adds to the cost of product making the product lmcompetitive in the highly competitive overseas mark~ts. Export houses imply concerns engaged in international business. Export houses have a number of departments each as financial department, billing and invoicing department, cables, mail and shipping department. These houses generally buy goods on cash from the local manufacturers and extent credit to foreign buyers. They often perform their own freight forwarding services and through bulk exports economies in ocean freight. Goods are also exported by export houses on mutually satisfactory terms. In group selling technique which is not prevalent in India, a few small firms producing non-competitive but complementary products join the group by pc Jling the resources and co-operate in one or more than one field vf marketing information, market research, sales promotion, joint channels of distribution abroad etc. Theoretically, this is a very economical and effective method of selling abroad. But subject to co-operation among different units this method depends upon availability of trained and experienced >:.. personnel in the field of export trade.

Import Decisions by Modern Entrepreneur

393

In case, the potential exporter decides to sell directly in foreign market, he can have a much closer contact, control over local customers and be far more in command of the market. In the country of import the exporter has to select channels of distribution. Channels of distribution of goods in foreign countries mainly include commission agents, wholesalers and retailers. The foreign commission agent obtains order on behalf of the exporter and sends them to the exporter who arranges shipment to the actual purchaser. The foreign commission agents are of vital importance for handling goods like machinery's, equipment's, etc., which are manufactured against order only. There are agents who carry stocks for a product on behalf of the exporter on consignment basis. An exporter avails of all the agents importing facilities and his position to push sales. But this is a risky method as the agent may lack both the ability and staff to distribute the products to the best advantage. Foreign wholesalers or importers who often buy and sell on their own account, specialise in imported goods and can develop sales of almost any product. For developing sales of any products, wholesalers abroad insist upon sole importing rights in their respective territories. Before entering into any agreement with foreign wholesalers to this effect and matters relating to territory, kinds and description of goods, price and terms, commissions and other remuneration, mode of payment, method of packing and marketing, the method and agency for Inspection before shipment, agency for settlement of disputes including arbitration arrangements, other duties and responsibilities etc., the exporter should satisfy himself that wholesalers abroad ace merchants of repute with high market standing in their respective territories. "Goods which lend themselves to wide consumer appeal can be handled through foreign retailers, thus eliminating commission, otherwise payable to wholesalers. This method is particularly suitablE in dealing with large departmental stores or super bazars which import large quantities. Starting Correspondence: It is not that the buyer buys the goods. But it is that he has been sold the goods. Good and effective correspondence is a key to start

394

Import Decisions by Modem Entrepreneu r

successful export trade. Before starting to write a letter, the potentia I exporter should give due consideration to the paper to be used i.e., the letter head is attractive enough, it shows company's name, address, telephone number, cable address or telex number, city, province or state or the equivalent and country. The idea is that the prospective customer before reading the letter should feel that the exporter is well established and well managed. The first and foremost ingredient of good letter is politeness. Politeness includes not only the manner of writing and form of address, but its language also. Letters should be written in the language of the man to whom the letter is written or in language widely used in business, e.g. English, French, Spanish, German or Italian or on its cwn language thus avoiding possible misunderstanding. The most satisfactory procedure is to write in customer's language for which services of a translator can be avoided of, if required. For this, export promotion agencies, trade associations, chambers of commerce and the language departments of the universities can assist in putting in touch with a good translator. However, if the exporter intends to try correspondence in any of the commercial languages internationally used, the following publication would prove useful: (i) Export Import Correspondence in English, German, French, Spanish published by Gower Press Ltd., London. (ii) La Correspondence due Commerce International Buroter,

S.A. Madrid (Spain). It is a comprehensive guide to commercial correspondence in aforesaid five languages. (iii) Bilingual Guide to Business and Professional Correspondence (English & French) published by Pergama Press Oxford (U.K.). Second foremost rule is be precise while writing to on agent or prospective importer abroad. While replying an agent, instead of sending hire a form letter with a sheet tom out of catalogue, he should be told something about the firm and its standing, the major uses of the product and the types of firms to which it is already selling. In case the letter is destined for the potential buyer, he should, be told whether the exporter is selling through agencies or direct,

Import Decisions by Modem Entrepreneur

395

his export prices, usual credit letters and in what foreign market he is already selling. The exporter should also be precise a& to product as well as price. If F.O.B. price is'quoted, approximate cost of shipping should also be given enabling correspondent to know Just about how much the product will cost to him. Third rule is to be prompt. It means write letter even when the exporter has no definite news to give or when no business will result. It also includes acknowledging an order at once, especially if it will take time to fill it. Besides, letters should be dispatched air mail and should be fully stamped Cable telex and telephone can also be employed for urgent business. Last but not the least, rule is to be persistent which also means that every inquiry about the product and every request for more information should be followed up. Answering Trade Enquiries and Sending Quotations: Once contact between exporter end importer has been established the potential exporter may expect to receive trade inquiries from abroad. The first and foremost thing that he should take P'lrticular care to do is to reply promptly and courteously to these inquiries. Trade inquiries often relate to the price at which the exporter can deliver the goods at the port of the destination. However, while quoting the price, the prospective exporter should also forward to the prospective buyer a copy of the standard contract form, if any, which the trade community to which he belongs has evolved. In the absence of standard conb;act form, the exporter should send various details of his terms and conditions as forming part of the quota tion to be sent by him to the prospective buyers. The terms and conditions of sale should specify the following: (i) The price to be charged; (ii) The quantity and specification of the goods;

(iii) The method of packing and marking; (iv) The place and date of delivery;, (v) The method and agency for inspection before shipment;

396

Import Decisions by Modem Entrepreneur

(vi) The commission and discounts, if any; (vii) The tine and method of payment; (viii) The responsibilities and rights of the parties; and (ix) The agency for settlement of disputes, including arbitration

arrangements. It is also advantageous to send along with the quotation and the terms a Performa invoice as in some countries the importer may have to produce license. In such cases it would be advisable to have the Performa invoice countersigned by a Chamber of Commerce or association to which the exporter belongs.

Ensuring Buyer's Credit Worthiness: Before entering into actual contract with foreign buyer, the prospective exporter should ensure himself regarding the credit worthiness of the prospective buyer. Reference regarding the buyer's credit worthiness can be obtained from one or more of the following sources: (i) Exchange Banks, (ii)

Director of Commercial Intelligence and Statistics, Calcutta.

(iii) Export Credit & Guarantee Corporation of India. (iv) Firms dealing with importer. (v) India's GovemmentTrade Representatives abroad. (vi) Other sources such as Chambers of Commerce, Trade & Industrial Associations. Knowing Foreign Government Regulations and Trade Agreements: In order to be in a position to prepare or arrange for the preparation of shipping document correctly, the exporters are supposed to know foreign government regulations relating to certain matters such as consular invoice, import licensing, protection of trademark patent and copyright etc. In this connection, the exporters are advised to consult" A Hand Book of Import Regulations" which details out trade regulations in 79 countries. This Book is published by the Engineering Export Promotion Council. Further details may be ascertained from any Chamber of Commerce or Export Promotion

Import Decisions by Modem Entrepreneur

397

COlIDcil functioning in India or from Consular representative of the country concerned. The exporter should also be fully conversant with trade agreements, payment agreements and General Agreements on Tariff and Trade. Some of there are briefly discussed below. General Agreement on Tariff and Trade: The member countries to GAIT share about 80% of the world trade. The objective of the agreement is to lay down a common code of conduct in international trade, to provide machinery for lowering the rates of tariff to obviate frequent changes in the' rates and to provide facilities for regular consultation on trade problems and disputes. International Trade center which acts as a Secretariat of the GATT provides assistance to developing countries with commercial intelligence, market surveys for their products and similar activities. Generalized Scheme of Preferences: As a result of decisions reached at the UNCTAD various advanced countries have agreed to preferential rates of tariff for imports from developing countries. This is known as "Generalized Scheme of Preferences" details of which can be had from Export Promotion Council concerned. European Economic Community: soils countries of Europe have formed the organisation 'European Economic Community which is also known as the European Common Market, the main objectives being:

(1) Full economic union of the member countries, which allows for the free movement of labour, capital and services within the member countries and harmonized economic, financial, fiscal and social policies. (2) A common external tariff for the member countries applicable to trade outside the area and a customs union of the member countries which is to be formed by the gradual elimination of customs duties and quotas. The E.E.C. has also an Associate Agreement with various African countries for preferential entry of the goods of all these countries into S.E.C. market and also for financial help .

•••

Chapter

25

--

BILATERAL TRADE AND RUPEE PAYMENT AGREEMENTS

India has entered into Rupee Payment agreement with some European countries which are Soviet Union, Czechoslovakia, Yugoslavia, Rumania, Hungry, Democratic Republic of German, Bulgaria, South Korea and Poland. Under these agreements all payments on both sides should be made in rupee only and all contracts concluded on that basis. India has also entered into bilateral trade agreements with many countries of the world. The important objectives of the bilateral trade and payment agreements are: (i) Opening up of direct trade contract with centrally planned economies; (ii) Obtaining capital goods and industrial raw materials

without additional drafts on foreign exchange resources of .convertible currency; (iii) Stabilising the prices of traditional exports;

(iv) Utilizing imports for automatic expansion of exports; (v) Reducing the dependence on traditional export market; (vi) Opening up of markets for non- traditional products.

Bilateral Trade and Rupee Payment Agreements

399

The Directorate of Exhibitions & Commercial Publicity in the Ministry of Commerce has published a book titled "India's Trade Agreements with other Countries" which gives condense of the trade agreements entered into by India with countries. Costing and Calculating Price: Export pricing has a great role to play in effecting the buyer's decision to buy in highly competitive international trade market. Every effort, therefore should be made to keep the cost as low as possible. Economy in export pricing is possible if the following broad features are kept in mind: (i) Economic procurement and utilisation of materials of right quality. (ii)

Time scheduling for orders and Inventory control.

(iii) Choosing appropriate techniques of production and

pressurizing sequence to minimize wastage and to ensure optimum quality. (iv) Making due provisions for spare tools and accessories to avoid time loss due to break downs .

.

(v) Taking advantage of locational economies offered by Free Trade Zones; and (vi) Fuller utilisation of capacity with the help of multiple shifts to reduce overhead costs. Many factors creep into while calculating export price for the goods. Export being a national necessity Government grants concession and assistance in various matters so as to make the product competitive In overseas market. Therefore, while calculating export price following matters should also be taken into consideration: (i) Fiscal incentives, like special tax concession for production of export goods, drawback of duty. (ii)

Financial assistance like cash subsidy to off set competition in foreign markets.

(iii) Special incentive schemes like import replenishment licenses; end

400

Bilateral Trade and Rupee Payment Agreements

(iv) General incentives like providing institutional arrangements for export promotion and training in exports, rewarding export performance etc. Price is quoted in various terms which are explained below: Ex Works (or Ex-factory, Ex-Mill, Ex plantation, Ex Warehouse): In Ex works contract, the seller places the goods at the disposal of the buyer at the time specified in the contract. The delivery of the goods is taken by the buyer at the seller premises and all the risks and expenses thereafter are borne by the buyer. Ex-works price usually means the price of the goods plus packing. In certain cases, it may not include packing charges. While quoting ex-works price, it is necessary to specify whether packing charges are included or not. Where ex-works price includes packing charges, it is quoted as 'Ex-works packing included' and where it does not include packing charges, it should be quoted as 'Ex-works packing extra'.

Ex-works contract is usually used for sale of plantation goods such as coffee, tea, cocoa. F.O.B. (Free on Board) : Free on Board price includes ex-works price, packing charges, inland transportation cost, warfare and porterage, customs dues, export duties, and cost of checking operations like checking of quality, measure, weight or quantity, if any. In an f.o.b. Contract, the responsibility and liability of the seller does not end until the goods nave actually passed the ships rail. In an F.o.b, contract, seller must-

(1) Deliver the goods on board the vessel named by the buyer at the named port of shipment, in the manner customer at that port, and on the date or within the stipulated period. (2) Provide at his expense for the customary preparation and packing suitable to the nature of the goods and to their carriage by sea. (3) Bear all costs payable on or for the goods until they have effectively passed ships rail at the port of shipment.

401

Bilateral Trade and Rupee Payment Agreements

(4) Give the buyer (at his own expense) such notice of shipment of the goods as may enable him to insure them. (5) Provide at his expense the customary clean" document in proof of delivery of goods board the vessel. A clean" document means that the bill of lading (or mate's receipt) does not bear any superimposed clause stating that either the goods or the packaging are defective in some way. /I

/I

(6) Bear the costs of checking operations (such as checking the quality, measure, weight or quantity) necessary for the purpose of loading the goods on board at the port of shipment. (7) Bear the cost of all dues and taxes payable on the goods for

the purpose of loading them on board. (8) Bear all risks of the goods until such time as they shall have effectively passed ships rail. (9) Provide the buyer at Ms request and expenses, with the certificate of origin and the consular invoice; and (to) Render the buyer, at the latter's request, risk and expense,

every assistance in obtaining a bill of lading and other documents, other than in (9) above, issued in the country of shipment and/ or of origin and which the buyer may require to import the goods into the country of destination (and where necessary for their passage in transit through another country). In tum under an F.O.B. contract, the buyer must: (1) At his own expense, charter a vessel or reserve the necessary space on board a vessel and give the seller due notice of the name, loading berth of and delivery dates to the vessel. (2) Bear all costs and risks of the goods from the time when they shall have passed the ship's rail effectively at the named port of shipment and pay the price as provided In the contract. (3) Bear any additional costs incurred because the vessel he names has failed to arrive on t~le stipulated date or by the

402

Bilateral Trade and Rupee Payment Agreements end of the period specified or was unable to take the goods or closed for cargo earlier than the stipulated date or the end of the period specified and all the risks of the goods from the date of expiration of the period specified. This is provided, however, that the goods were duly appropriated to the contract, i.e., is clearly set aside or otherwise identified as the contract goods. (4) Should be fail to name vessel in time, or if he has reserved to himself a period within which to take delivery of the goods and/or the right to choose the port of shipment, should he fail to rive detailed instructions in time, he shall bear all the additional costs incurred because of such failure and all the risks of the goods from the date of expiration of period stipulated for delivery provided, however, that the goods shall have been duly appropriated to the contract. (5) Pay any costs and charges for obtaining a bill of lading, if incurred, under article (10) above. (6) Pay all costs and charges incurred in obtaining the documents mentioned in article (9) and (10) above including the cost of certificate of origin and consular documents.

F.A.S. (Free Alongside Ship): Free Alongside Ship price includes all costs incurred in delivering the goods alongside the vessel at the port of export or other place named, but does not include charges for loading the goods on board the vessel. Nor does nit include ocean freight charges and marine insurance premium. Under a F.A.S. Contract the exporter is required to deliver the goods within the specified period; produce clean dock or ship receipt; shoulder the responsibility for any loss or damage incurred or caused before the goods are delivered alongside the vessel; or the dock; and assist the buyer for documents issued in his own country. C. & F. (Cost & Freight):

Cost and Freight price covers F.O.B. value of the goods plus freight charge of transporting goods to the port of destination. The

Bilateral Trade and Rupee Payment Agreements

403

C. & F. price is quoted where COlmtries want that buyers must insure the goods in their own countries so as to encourage local insurance companies. In such type of contract, the buyer is responsible for taking out the marine insurance, as opposed to the C.I.F. contract where the seller must obtain an insurance policy that covers the c.1.F. price plus 10 per cent. If the seller is willing to assume the risk of the exchange rate fluctuating between the time that the contract is accepted and the date of payment the terms are C.I.F. & C.C.I.F. & C. means that the commission charged by the middleman is included in !he price and also the interest charges that accumulate in indent transactions. C.I.F. (Cost Insurance and Freight) : This type of contract includes F.O.B. price plus cost of ocean freight and marine insurance up to the port of destination. In C.LF. quotation care must be taken to state the name of the port to which the goods are intended to be shipped. However, if the C.LF. contract is applicable all over the world, the quotation should be C.I.F. Main Port. Under the C.LF. contract and also C & F contract the risk of the goods is transferred to the buyer once they have been loaded on board the ship. But he seller has to pay the expense of transportation for the goods up to the port of destination. The exporter often prefers these terms because he can channel all his exports through the freight forwarder of his choice to the port of export and ship by the vessel that he se~ects. For the importer, these terms mean fewer responsibilities, because (there is a suitable clause in the contract), it is the exporter who has to gamble on fluctuations in the freight and insurance rates. However, it may be pointed out that when the quotation is C.I.F., exporter has to ensure the goods from were house to warehouse and if the quotation is C & F, he should see to it that the buyer has insured the goods from the warehouse. But to be on safer side exporter should insure goods from his warehouse to the ship, this will be sufficient if the goods are exported against Letter of Credit. If the goods are exported against "Documents on Acceptance"

404

Bilateral Trade and Rupee Payment Agreements

or "Documents on Payment" the exporter is advised to take out an insurance policy from warehouse even if the contract is C & P. The seller while quoting a price should ensure that in contracts '~f sale these terms are clearly defined and that both he and customer understand them. Moreover units of weights and measurement used in a contract should also be clearly stated as these differ from country to country. An English ton, for example (sometimes called a long ton) is 2240 pounds, a metric ton is 1204.62 pounds, an American or short ton is 2000 pounds and a Spanish ton is 2271.64 pounds. A hundred weights are 112 pounds in Britain but 100 pounds in America. In this connection, reference is made to a useful book titled World Weights and Measures published by the U. N. Department of Economic and Social Affairs in New York.

•••

Chapter

26 tItI EXPORT TRADE

Once an export order is received from the foreign customer, the receipt of the same should be confirmed'and the customer should be given an opportunity to check that every fact recorded meets with his satisfaction. This is done by presenting the customer with the confirmation in the form of a contract. He is invited to signify his assent by signing the foot note to the contract. There is no hard and fast rule as to terms to be contained in an export contract. However, the contract should contain details in respect of goods, quantity, price, delivery period of delivery/shipment, packing, terms of payment, licenses, insurance, marking instructions, documentary requirements, commission, etc. Obtaining Export License:

Goods specified in schedule I of the Export (Control) Order 1%8 can only be exported under a valid export license. While obtaining a license for that purpose certain formalities have to be complied. Finance and Credit in Export Trade:

From a banker's point of view, there is difference between credit and finance. Credit means the agreement of a seller of merchandise to accept payment from the buyer. after a stipulated period after shipment or actual delivery. Financing on the other hand means

406

Export Trade

the provision of financial assistance either to the seller or to the buyer by an outside source such as a bank for a period during which the goods are in transit and any additional period that may be arranged to cover special circumstances. Methods of obtaining and institutions extending financial and credit facilities are dealt with in separate chapter. Preparing Goods for Dispatch: As soon as the exporter communicates his acceptance of the orders, immediate steps should be taken for the manufacture of the goods, if they are not already in stock, according to the specification and/ or samples. If the exporter is not a manufacturer, he should have either certain standing arrangements with a manufacturer for supplying the goods or established relations with a manufacturer which would enable him to enter into individual contracts with such manufacturer for supplying the goods which he contracted to export.

In case the transaction relates to unmanufactured goods, the exporter should normally have a purchasing organisation to collect the produce at different convenient centers. This organisation should be geared to the task of collecting the material contracted for in time. Without the backing of an effective collecting organisation, it may not be safe to enter into large contracts for supply of goods which have to be collected over large areas. In the case of an exporter who is himself a manufacturer of the goods the problem is of a different nature. He has to arrange for the necessary raw materials for production and packing and to lay down a tide schedule for the manufacturing process. Most of the indigenous raw materials would be available in the normal course, but same of them are in short supply, Arrangements for prompt supplies of selected indigenous raw materials (such as iron and steel, aluminium, plastics and chemical raw materials, sugar etc.) to manufacturing units producing goods for export have been made under a scheme of 'Green From Allotment'. Once the arrangements for obtaining raw materials are completed, manufacture should be taken in hand and the factory manager should be given particulars of:

Export Trade

407

(a) Specifications; (b) Quality;

(c) Packing specifications; (d) Marking specifications; (e) Name and Address of the Consignee;

(f) Port of shipment;

(g) Port of destination; (h) Name and Address of shipment;

(i) Terms of payment;

G)

Shipping instructions.

Contracting Shipping Companies:

As soon as the order is placed and the steps for preparation of goods for dispatch are taken, the exporter should contact the shipping companies, which have sailing's for the port to which goods have to be sent. The shipping companies have usually their agents who accept the cargo on their behalf end similarly there are clearing and forwarding agents who work for exporter on commission basis. A complete list of important shipping clearing agents and freight brokers at major towns is given in Appendix III. Since an exporter has to apply for space in the ship, he can get necessary information about sailing from the Daily Shipping Intelligence. It is better. If a freight broker is employed for the purpose. The freight broker does not charge anything in the matter of keeping informed as to when a ship is sailing and form which port. On an application for applying space in ship, the shipping company issues a shipping order if the space applied is accepted. There are following two kinds of acceptance: (1) Shipping Advice. (2) Shipping Order to Dead Freight.

In the case of former, the shipping company is not bound to accept the cargo. It is only an intimation to the party that the goods may be tendered on the ship - these mayor may not be accer>ted. In the case of the latter, the shipping company binds itself to accept the cargo ansi on its failure it can be sued for loss or damages.

408

Export Trade

The original shipping order is handed over to the party and a copy thereof is sent to the commanding office of the ship where the commanding officer is instructed by the shipping company to receive the goods on board as per details given in shipping order. In case of any difficulty regarding availability of shipping space,

the exporter may approach the Director of Shipping Freight Investigation Bureau through concerned export promotion council. Where the difficulty relates to anamalous freight rates, applications can be made by Association or Chambers of Commerce only and not by individual exporters. However, the individual exporter may make application directly to the regional authorities under advice to Freight Investigation Bureau and Export Promotion Council. Packaging and Packing: Though the primary objective of packing and packaging is safe delivery of a goods to the final consumer, packing differs from packaging. Packaging refers to the container in which the product reaches the ultimate consumer whereas packing refers to external containers used for the safe transportation. Since the word packaging is used to describe the protection of goods destined for a consumer, the form of packaging is important as a means of helping to sell the goods in question. Therefore while packaging the goods, it should be kept in mind that packaging serves the purposes of protecting the production, attracting the product facilities utilisation of the product and economizing the expense in reaching the product to ultimate consumer. In order to achieve these objectives of packaging, there are some other aspects of packaging such as size of the packaging, shape of the package, material for the package, making of the package, package closure, design of the package etc. which should never be lost sight of Good packing is important not only from the view point of safe transportation of the goods to the overseas buyer, but also from the view point of covering insurance. Moreover, if the goods are not properly packed the shipping company may refuse to accept the goods for shipment. There is no hard and fast rule as to packing of the goods. However, it may be stated that packing should be carried cut strictly

Export Trade

409

in accordance with the instructions received from the foreign buyer. If no instructions are received, packing should be of the recognised customary standards for that particular country or should be in accordance with certain specifications laid down by the shipping companies for highly dangerous goods. For example, the Indian Standards Institution has prescribed packing standards for certain items. Apart from this, 'British Standard Packing Code' published by British Standard Institutions and Exporters Encyclopedia published in U .5.A. give detailed packing instructions. Besides packing standards, there are following points regarding good packing, which should be always kept in mind: Firstly, the packing should be durable as the goods meant for export have to undergo severe hazards in transit, and they are to be loaded and unloaded at various stages. In order to make the packing durable so as to stand enough handling and hazards of rough weather, extreme heat, excessive moisture, vermin and theft, etc., strong and durable containers should be used. Of what material the container should be made of depends upon the product in question. For example, liquids in bulk are normally shipped in drums; consumer products are packed in wooden cases or some form of fabrate cartons are used; capital equipment is protected by some kind of material and paint, and for delicate goods special forms of cushioned packing may be used. In addition to several methods discussed above for protecting a product against dampness and erosions during voyage plastic films in the market and asphalt coated paper can also be used. Moreover, in order to protect the product from bumping, rubbing or tossing because of rough weather

at sea or because of vibration -within an aircraft straw can be used in addition to slacking strength outside. In this connection it is important to note that packages containing straw cannot be sent to many overseas countries unless a certificate of health is produced from the health authorities. Secondly, the size of the case should be minimum as marine freight is frequently charged according to the space occupied. Thus,

410

Export Trade

the packing should be efficient and also economical because the packing charges form a part of the cost of the product in question. The exporter should also keep a record of the goods packed in each case in order to enable the buyer to check easily that he has received all the items in all the cases sent to him. For this packing note or content note may be prepared for each separate case and a packing list may be prepared of consolidated statements of contents for a number of cases. Marking the Goods: The major object of marking of export packages is to identify the cargo. Normally, ships carry a large number of consignments belonging to various exporters. If there were not adequate identification marks for goods, it would be really difficult to identify the consignment of each exporter Marking is also essential for facilitating the inspection of goods by the Customs authorities and the quick and effective delivery of the goods at the destination by the railway and shipping authorities. The marking should include shipping marks of consignee, port of destination, gross, net and fare weight and cubic measurements, country of origin and any other special marks requested by the buyer. In the absence of specific instruction from the buyer, the exporter can choose his own symbol. The port of destination should be given below in the symbol whereas the name of the country of origin should be given as one of the symbol as many countries may insist on this Below the name of the port of destination, number of each individual container of a particular lot should be given and below the number of individual container, gross weight, net weight and the cubic measurement etc. should be given. In addition such other marking as are req¢red under the regulations of the country of destination should alBo be made. The International Cargo Handling Coordination Association has set out for the use of exporters and carriers a number of recommendations for the marking of goods carried by ocean going vessels. Many of these are equally useful for the marking of goods

Export Trade

411

being forwarded by other firms of transport. Important rules of good marking procedure are as follows: (1) The marks should appear in a certain order. Essential data should be placed in oblong frames with lines 1.5 Centimeters thick, and subsidiary information should be placed in another type of frame. (2) Declarations on large packages should be placed on two contiguous sides and for consignments bound together on a pallet also on the top. Handling instructions should be placed on all four sides. Scalier packages such as goods in sacks should be marked on two opposite sides. (3) Lettering should be at least 7.5 Centimeters high for essential data, and at least 3.5 Centimeters for subsidiary data. If the package is too small for such lettering, other sizes may be used but in the same ratio. The size of the symbols should only be in proportion to the size of the package of other markings. (4) Only fast dyes should be used for lettering. Essential data should be on black and subsidiary data in a less conspicuous colour. Red and orange lettering should be reserved for dangerous goods only. For foods packed in sacks, only harmless dyes should be employed, and the dye should not come through the packhlg in such a way as to effect the goods. (5) Stick or labels should only be used on individual packages or parcels and all the old labels should be removed. (6) Marking should be made by a stencil or by branding or by pencil or brush without a stencil. If stencils are used, care should be taken that the letters and figures are perfectly legible to prevent confusion. (7) The surface to be marked should be smooth and clean. If packages are to be branded, they can be marked before this is done; the hoops should not, however, cover the markings. (8) The figures should indicate the total number of packages making up the consignment and the consecutive number

412

Export Trade of the individual packages. For example 1520/15/1 identifies the first package of a total number of 15 and 1520/ 15/15 the last one. (9) The name of the ship and the bill of lading number should be shown when this is possible.

The exporter should also keep in view that some countries such as Argentine, Chile, Spain and Philippines, the United Arab Republic, the United States and Uruguay require that all products imported into them bear a mark of origin. Countries like Australia and France require a compulsory mark on a fairly large number of products whereas some others like Finladd require it only on a few products. Countries like Czechoslovakia and Jamica have no regulations covering such, marks. Quality Control and Pre-shipment Inspection:

Supply of quality goods is must for penetrating into international markets, winning new markets and consolidating the position in existing markets. In a bid to avoid complaints from overseas buyers about the quality of the goods exported from India and with a view to promoting exports on a long term and permanent basis, the Government of India has launched a comprehensive programme of quality control and preshipment inspection under the Exports (Quality Control and Inspection) Act, 1963. The Act empowers the Government to : (a) notify goods which shall be subject to quality control or inspection or both prior to export; (b) specify the type of quality control or inspection which shall

be applied to a notified goods; (c) establish, adopt or recognize one or more standard specification to a notified goods; (d) prohibit the export in the course of international trade of a notified goods unless it is accompanied by a certificate issued under Section 7 that the goods satisfies the condition rela ting to quality control or inspection or it has affixed or applied to it a mark or seal recognised by the Central

Export Trade

413

Government as indicating that it conforms to the standard specification applicable to it under sub clause (c). No consignment of a goods so nof..fied can be exported under the Act unless accompanied by a certiHcate on the article of package carries a mark indicnting that it conforms to the recognised specifications. These certificates are issued by the inspection agencies duly authorized for that purpose by the Government. Applications for inspection should be made in the prescribed form giving the details of the shipment to the inspection agency. Following documents should also accompany the duly filled application form : (a) Commercial invoice giving evidence of the f.o.b. value of export consignment. (b) A crossed cheque for the amount of inspection fee.

(c) A copy of the export contract. Certificate of inspection is issued by the agency on the completion of the preshipment inspection at the exporter's factory or warehouse, by the inspector deputed by the inspection agency. The certificate has to be presented by the exporter to the Export Department and Customs House at the tine of seeking customs clearance of export cargo. The Act has provided for the establishment of the Export Inspection Council to advise the Government in regard to the measures to be taken for quality control and preshipment inspection and the exportable goods, such as standard specifications to be recognised details of quality control and inspection and methods and other related matters. There also exist arrangements in Export Inspection Council for voluntary preshipment inspection for goods not so for covered by compulsory quality control and pre-shipment inspection details regarding which may be obtained from Export Inspection Council of India (Ministry of Commerce), Government of India, World Trade Center, 14-1B, Ezra Street, Kolkata-l. Goods carrying 1.5.1, mark can be exported without lmdergoing the formalities of preshipment inspection unless the exporter wants

414

Export Trade

goods of specifications other than those laid down by 1.5.1, or insist on having the goods inspected. Shipping the G.9ods : Goods can be exported to foreign markets by post, air or sea. Shipping by Post: Subject to the provisions of imports & export control regulations. Foreign Exchange Regulations Act exports can be effected by post. Trade samples of value not exceeding Rs. 50 can be sent by post without any formal approval; samples of value more than Rs. 50 and up to Rs. 270 can be sent on production of a certificate from an authorized dealer in foreign exchange to the effect that there is no involvement of foreign exchange. Samples whose value exceed Rs. 270 can be sent on grant of waiver of exchange formalities by the Reserve Bank of India, Parcels containing trade samples or trade goods meant for permissible destination can be booked at any post office in India. Parcels for trade samples should be accompanied by (a) customs declaration form in quadruplicate one copy having been pasted on the parcels for goods of which value does not exceed Rs. 50; (b) dispatch note; (c) certificate from any authorized dealer in foreign exchange to the effect that the articles are being supplied free of charge and that no transaction in foreign exchange is involved and the documents to accompany parcels of trade goods are (a) PP form in triplicate with copy duly countersigned by bank; (b) export license if applicable; (c) Form D in quadruplicate for goods entitled to customs, drawback; (d) AR form in duplicate for goods entitled to excess rebate; and (e) VP leOD form in triplicate. Shipping by Air: Air exportation is increasingly used for export of certain types of goods which are perishable, seasonal, or high in cost but low in bulk, shipping by air is advantageous in many ways. Firstly, lesser packing charges are involved as there would be less handling of goods in transit. Secondly, there is likely to be less risk of pilferage and damage. Lastly, shipping by air ensures faster delivery of goods

Export Trade

415

which in turn leads to quicker payments resulting in lower stock and quicker turnover. Where the goods are exported by air, the proof of shipment is known as Air Consignment Note and is :.n lieu of bill of lading which is obtained in case of export by sea.

Shipping by Sea: Shipping by sea is one of the most traditional forms of exporting goods to overseas markets. First step for shipping the goods by sea is to make necessary transportation arrangements for movement of goods from the place of its manufacture to the port and from the port to the port of delivery. At this stage, the exporter is advised to avail the facility or concessional reduced rates of freight. Once the goods have reached the port, the exporter has to arrange for off loading of goods from the wagons, storing them until the steamer is ready to take the cargo and arrange for their actual loading into steamer. Actual loading of cargo is done either through port commissioner's shed Vessels called 'Jetty' or in the 'Mid stream called Over side Loading. In the former case goods are loaded in the shed vessel. They are rent to the Port Commissioner's Jetty from where they are loaded and .taken care of the men of the port commissioner. An exporter has to pay the following charges to the Port Commissioner before the goods are sent to the shed, (i) Shipping charges; (ii) Unloading charges; (iii) River dues; (iv) Fixed toll; (v) Rents, if any; (vi) Renewal charges; if any; (vii) Shunting charges. In the case of Over side Loading, the cargo has to be taken by boards for loading. In such case the exporter has direct touch with the ship without the Port Commissioner's formalities and therefore, has not to bear loading and unloading charges. However, he has to pay (i) :River dues; (ii) Surcharge; (iii) Fixed toll; and {iv) Rent. He has aJso to pay boat charges quantum of which depends on the amount of cargo and the rate fixed between hire and fhe boatman.

On payment of landing charges, the exporter gets a smail slip called land,ing slip. The goods are sent to the Port Commissioner's Shed, the exporter will have to use either a lorry of a caFt. Therefore,

416

Export Trade

he has to prepare an export cart/lorry ticket giving the name of the ship, shed number, shipper mark, on packages, quantity and description. The exporter has also to send along with the lorry ticket a form called Dock Challan giving the details about the 'consignee's name and address, vessel's napte, port of destination, exporter's name, marks and number of packages as shown in the shipping bill, gross weight, in metric tonnes, port charges payable and other details as may be required. In case the loading is done in mid stream the Boat Note containing the details stated above should be prepared. The dock challan has to be presented in the Ports commissioner's collection office where the clerk calculates and checks the Port Commissioner's shipping charges to be deposited with the cash clerk. Thereafter, documents are checked end registered by the Gats Wardener and entry of Cargo into dock permitted. The dock challan and cart ticket are accepted by the export shad writer who registers the dock challan for sending it to Customs Preventive Officer for endorsement and mean while issues unloading slip form lorry after checking its condition. The Super Cargo arranges for unloading cargo from lorry. The Customs Preventive Officer examines and checks the contents, weight etc. of the goods and if in order allows shipment and the Dock Challan is finally signed by the Customs Division at Officer and released by the Port Commissioner Writer in shed, I\hen the supper cargo takes over the control of the cargo for shipmentThe cargo is thereafter loaded in the ship and mates receipt written up and after being signed by the Vessel's Chief Officer delivered to the Port Commissioner or the shipper direct In case of over side shipment. The mate receipt is submitted to the steamer agent along with typed bill of lading comprising requisite number of negotiable and not negotiable copies for calculation of ocean freight based on the measurement, weight of the consignment. After the freight Is paid, the bill of lading duly signed and stamped are returned to the shipper or his agent where the freight is payable at destination, an endorsement to that effect is made by the steamer agent on the face of the bill of lading itself. All the negotiable copies

417

Export Trade

of the bill of lading are called a full set". The full set of clean or board bill of lading Is distinct from claused bill of lading which bears adverse endorsement like 'one case damaged' packed in old gunny bags' should be presented to the Bank along with other shipping documents for negotiation. H

Marine Insurance: In order to shield the cargo from various hazards of fire, storm, collusion, theft, leakage, explosions, spoilage etc., necessary arrangements should be made for insurance of cargo. For getting the cargo insured the shipper should contact insurance underwriter and fill full particulars in Declaration Form supplied by the company. Particulars requires to be filled in, interalia; include following: (a) name of the party, which effects insurance or on whose behalf insurance is effected. (b) whether payment on account of claim is desired in any foreign currency;

(c) name of the steamer and voyage; (d) whether strike, riots and civil commotion risks to be included; (e) description of goods and their packing details; (f) details of risk to be covered i.e., whether it iifree of particular average or with particular average, cOlllPrehensive or all risks and inland transit.

Customs Clearance: Before the goods are loaded on board the ship, they are examined by the customs authorities who are required to see that the goods sent out are permissible for export and all the relevant formalities have been gone through and the law of the land has been complied with. The Shipping Bill along with the following document has to be presented to the customs authorities: (a) Commercial invoice. (b) Packing list along with packing specifications.

Export Trade

418

(c) Contract with the overseas buyer. (d) Copy of letter of credit, if any. (e) G.R.-l Ports. (f) Certificate of quality or grading, if required.

Shipping bill is prepared by the exporter. There are three forms of the shipping bill available with the customs authorities. One is for goods on yellow paper known as dutiable shipping bill on which there is export duty and other is for goods on white paper known as free shipping bill on which there is no export duty. Third is green paper known as draw back shipping bill for claiming customs draw back against goods exported. Shipping bill contains particulars of the goods exported and other particulars such as name of the vessel, master or agent, flag, port at which goods are to be discharged, country and final destination, exporter and his address. There are also details about the package and the goods such as numbers and description of the goods, quantity details about each case, f.o.b. price, real value as defined in the Customs Act, 1962, total number of packages, their total weight and value etc. The shipping bill has also columns on right hand side for Port Commissioner Stamp and for Customs House Stamp. The Port Commissioner stamp is affixed as soon as the receipt for lading charges is shown to officials will put his stamp when the Appraiser has satisfied himself about the f.o.b. and the real value of the goods. He would also satisfy himself that the floods are accompanied by the license or endorsement, if acquired. In case of export, where there is no export duty to be paid or to be claimed back, pink colour shipping bill should be used where the goods are exported by air. Where the goods are to be exported by sea white colour-shipping bill is prescribed for the goods and yellow colour-shipping bill for dutiable goods. Green colour shipping bills are to be used in case of drawback shipping bills irrespective whether the shipment is by air or sea. Where the goods are shipped under drawback, an endorsement has to be made whether the shipment is being made under schedule 1 or schedule II and whether any drawback rate under schedule II

Export Trade

419

has already been fixed or the export is made under provision for drawback. The Customs authorities scrutinise the shipping bills along with requisite documents and if, prima facie, satisfied passes the shipping bill for export subject to the physical examination being done by the dock or air transit staff of the customs for which the shipping bill passed by the export department has to be presented to the cargo supervisor of the steamship company of the shed manager who is the port official at the shed of the ship for permission to bring in the cargo for export. For physical examination of the cargo, the shipping bill after having been passed by the Appraising Department of the Customs should be presented to the preventive officer in charge of the shed or section for 'let ships' remark. It is only after the shipping bill is endorsed with the 'let ship' remark, that the goods can be taken on board the ship by Cargo Supervisor of the ship, who makes necessary arrangements for loading the goods on the ship by the port trust labour and makes receipt issued by the Chief Officer of the ship acknowledging that the goods have been received by him on board the ship to be ultimately delivered by the port trusts, the exporter or his agent after satisfying that they have received their dues* The exporter or his agent should then present the mate's receipt along with freight payment certificate and the freight amount unless the freight is payable at the destination to the steamer agent for issue of negotiable and non-negotiable copies of bills of landing. Where the goods are exported under drawback of duty, the goods should be first presented for examination and Identification to the dock staff of customs. Thereafter the shipping bill being presented to the export department of Customs for possession and allowing shipment. Clearance of Excisable Goods: The excisable goods can be exported outside India either under claim for rebate of excise duty or in bond. The difference between the two procedures is that In the case of former, the duty is first paid and refund is claimed after exportation, and in the later case, the

420

Export Trade

goods are allowed to be exported without payment of duty, on execution of a bond with sufficient surety, security in the prescribed bond, and under such conditions as the collector of Central Excise approves, for a sum at least equivalent to the duty chargeable to the goods in question. All manufacturer exporters, and merchant exporters exporting excisable goods under bond should maintain a Running Bond Account in the prescribed form. Exporters while maintaining the Running Bond Account should also make entries in respect of clearance from the factories situated in other collectorates. While opening the Running Bond Account, the exporters will start their account by entering therein all consignment which have been cleared from the factory or the place of manufacture for export and for which export has been not so far taken place. After these entries are made the current clearance for export should be entered in the order of clearance.

I

For removal of excisable goods, the exporter should submit the original copy of gate pass (GP-l in case of removal of goods under claim for rebate and GP-2 in case of removal under bond) along with five copies of AR-4A form to the Range Superintendent of Central Excise. The Range Superintendent after verifying the fact that the duty has been paid, certifies the fact of payment of duty on all the copies and returns the original and duplicate copies to the exporter. Triplicate copy of the form is sent to the Maritime Collector for Central Excise at the port of shipment quadruplicate to the Chief Accounts Officer and triplicate retained for record. However, if the exporter desires that the goods should be inspected at the factory and package sealed, he should apply in Form AR-4 (in quadruplicate). At the time of presentation of the AR-4/ AR-4A to the Range Superintendent/ Inspector for Clearance .of excisable goods, the exporter will present his Running Bond Account for the verification of the entries by Range Staff. This requirement should be followed in case of goods cleared from factories in Bombay Central Excise Collectorate. The value to be filled in AR-4/ AR-4A Forms is the assessable value of goods approved by the excise authorities for similar / same goods for home consumption Hence, it is different from the Lo.b. value to be shown in the invoice/shipping bill.

Export Trade

421

The original and duplicate copies of AR-4/ 4A form are than presented by the exporter to the customs at the port of shipment along with other shipping documents. The Customs House after necessary scrutiny and appraisement of value and assessment of duty, it any, grant permission to export and stamp shipping bill number on the forms. These forms along-with Gate Pass and consignment are presented to the Dock Examiner/Appraiser of Customs who conducts physical examination and identifies the packaged with marks and numbers given in Form AR-4/ AR-4A. These forms and other documents are then presented to Preventive Officer, who certifies the fact of shipment with references to Mate Receipt on the original and duplicate copies of AR 4/ 4A forms. The original copy is forwarded to the Preventive Department of Customs and duplicate copy is handed over to the exporter's agent. The Preventive Department after registering particulars of the forms in register forwards the original copy to the Martime Collectors, who collect the AR-4/ AK-4A received from Preventive Department with the triplicate copy received earlier from the Range Superintendent and enters necessary particulars in refund register. He also allows provisional credit in the running bond account for the amount of the duty for the goods certified to have been exported and communicate the amount of such provisional credit to the exporter and Range Superintendent. The export should then make an application in form C in triplicate (original copy duly signed on a revenue stamp of 20 paise) to the Maritime Collector of Central Excise at the port of shipment accompanied by the following documents. (a) Duplicate copy of the AR-4/ AR-4A form bearing the certificate of shipment of the Customs Preventive Officer. In this connection, exporter should complete the following certificate at the bank of the form. "I hereby certify that the goods have not been relented or intended to be relanded at any port in India". (b) Non-negotiable copy of the bill of lading giving details of

the Central Excise numbers of the consignment. (c) Original copy of the Gate Pass.

422

Export Trade

If the claim is found in order and a rebate Is held to be admissible, the Assistant Collector of Central Excise accords his sanction and signs the refund order on all the three copies of the application. The duplicate copy of the AR-4/ AR-4A and original and duplicate copy of the application form bearing the refund order are sent to Chief Accounts Officer for arranging payment to the exporter, who is intimated by the Chief Accounts Officer to collect the cheque of that the amount Is credited to his account.

Exchange Control Formalities:

Whenever goods are sent outside the country, there is an obligation on part of the exporter to satisfy the Reserve Bank of India that he has received payment from the overseas buyer. The government does not allow any exporter to export for no consideration. And if he does not get the money from the overseas buyer, he subjects himself to prosecution for violating the foreign exchange regulations. Exchange control applies to all exporters irrespective of whether the items exported are in the restricted category of trade or not. Exchange control requires all the exporters. (a) to make a declaration on the prescribed form to the Collector of Customs that foreign exchange representing the full export value of goods has been or will be disposed of in a manner and within the period specified by the Reserve Bank; (b) to negotiate all shipping documents, including those

relating to sales on consignment basis, through the authorized dealers; and (c) to receive payment by an approved method. The declaration is not required in the case of trade samples supplied free of payment, personal effects of travellers, transshipment of cargo, goods exported under orders of Government authorities and parcels dispatched by post or air freight provided the contents of the parcel are less than Rs. 50 in value and the export does not involve any transaction in foreign exchange. Every person, firm or company engaged in export business in India should obtain a code number from the Reserve Bank.

Export Trade

423

Applications for this purpose should be made by the Head/ Principal Office of the exporters in the prescribed form CNX in duplicate to the Reserve Bank of India within whose jurisdiction (See Appendix VII) the Head/Principal Office of the applicant is situated. The Reserve Bank returns to the exporter the duplicate of the form with the branches in India should invariably cite the code number so allotted by the Reserve Bank in G.R.I./E.P./P.P./V.P./ G.O.D. forms used for declaration of exports. Exporters have to make a declaration on the appropriate exchange control form (completed in duplicate or triplicate as the case may be) the original copy of which has to be submitted to the Customs authorities at the time of shipment. The particulars to be furnished in the form comprise the invoice value of shipment, the type of goods, the method by and the currency in which payment is to be received and the name of the authorized dealer through which documents are to be negotiated. The prescribed forms of declaration are as follows. Form G.R.I. :

Form G.R.l. is for general use for declaring exports to all countries (other than Pakistan and Afghanistan) to which the exchange control procedure applies and where payment is to be received by one of the prescribed methods in a permitted currency. This form is to be completed in triplicate. All the three copies of G.R.I./EP forms, duly supported by the relevant documents, should be submitted to the Customs at the time of shipment by sea or air. The Customs authorities will, after necessary scrutiny, retain the originals of those forms for transmission to the Reserve Bank and return the duplicate and triplicate copies duly authenticated to the concerned exporters for submission to the Reserve Bank through an authorized dealer.

The authorized dealer, after verifying the particulars given in the form forwards the second copy of the G.R. form to the Reserve Bank of India. On the other hand, the Customs authorities, after passing the Shipping Bill, will sent the original G.R. Form to the Exchange Control Department of the Reserve Bank of India.

424

Export Trade

Similarly, the authorized dealer after realisation of payment will make endorsement on the third copy of the G.R.I, and forward it to Exchange Control Department of the Reserve Bank of India. The Exchange Control Department will verify the original G.R. form and if satisfied will close the concerned file. Occasionally, the exporters draw clean bills on foreign parties covering shipments to be made later. In all such cases the G.R. forms have to be completed twice, first, when the bills are drawn and again, when the shipments are effected. At the first stage, the exporters are required to complete the first and second copies of the G.R. forms which are to be sent to the Reserve Bank by the authorized dealer after negotiation with a note to the effect that shipment is being made at a later date. The third copy of the form duly certified is to be sent to the Reserve Bank after realisation of payment against the bills. When the shipment is actually effected, a fresh set of G.R. forms is to be completed by the exporter, the first copy of which is to be submitted to the Customs, along with the relative Shipping Bill, the remaining copies are to be sent to the Reserve Bank through the authorized dealer who negotiated the original clean bill. In cases where exporters follow the practice of drawing bills of only a percentage of the invoice value, the balance being payable after arrival of the goods at destination, they are required to give an undertaking to the negotiating bank that the balance of proceeds will be surrendered within the prescribed time limit from the date of shipment and endorsement to this effect is to be made on the second copy of the G.R. form by the authorized dealer concerned before forwarding it to the Reserve Bank. The third copy is to be submitted by him to the Reserve Bank only after full payment has been received.

FormG.R.3: This form is to be filled in by exporters who under special arrangements entered into with the Reserve Bank are permitted to retain the proceeds of their exports (excluding those to Pakistan) with their agents or branches abroad (excepting those in Pakistan) for financing their imports from those countries into India or to make other types of approved payment there.

Export Trade

425

This form is also to be completed in triplicate. The first copy is for submission to the Customs authorities at the time of shipment. The second and third copies are to be dealt with by the exporter in accordance with the advice of Reserve Bank.

FormE.P.: This form, is for declaring shipments to Pakistan and Afghanistan only and is similar in nature to form G.R.I.

FormE.P.I: This form similar to form G. R. 3, is for the use of exporters to Afghanistan who have been authorized by the Reserve Bank to retain the proceeds of their exports to that country and to utilize them to finance their imports from Afghanistan or for other purposes.

FormP.P.: Exports to all countries by parcel posts, except when on "value payable" or "cash on delivery" basis, should be declared on P.P. forms. The procedure in respect of declaration on P.P. forms is similar to that for G.R. and E.P. form except that the authorized dealer has to countersign the original copy of the P.P. forms (after satisfying himself that the parcel has been valued and sealed by the Customs authorities where it contains jewellery or precious stones) before it is presented to the postal authorities. In cases where exporters are unable to get the P.P. form countersigned by the authorized dealers, owing to reasons such as absence of banking facilities in the country of destination of parcels, the Reserve Bank will, on application, countersign the P.P. forms, provided satisfactory guarantee is furnished by the applicants for the realisation of the proceeds. Export of goods by postal packet or airfreight of less than Rs. 50 in value can be made without a declaration as to the realisation of proceeds. Form V.P./C.O.D. :

Exports to all countries by parcel post under arrangement to realise the proceeds through postal channels "value payable" or "cash on delivery" basis should be declared on V.P./C.O.D. forms.

426

Export Trade

Exporters of films have to declare on G.R.I/E.P./P.P. forms only where films are exported on outright sale basis. When exports of films are on a rental basis, they should obtain a waiver of the G.R.I/ B.P./P.P. form from the Bank. Moreover, exports on a consignment basis have to be declared on G.R. or E.P. form as the case may be. The procedure for completing the declaration forms is the same as for exports against firms sale contract except that the third copy of the form should be accompanied by account of sales. Further, when a portion of a s~ipment already filed with the Customs is short-shipped, the exporter has to give notice of the short-shipment to the Customs authorities on the prescribed forms in duplicate. After verifying that the goods were actually shortshipped, the Customs authorities will forward to the Reserve Bank the duplicate copy of the notice duly certified as correct. Time Limit for Realisation of Exchange Proceeds: The period prescribed for the realisation of foreign exchange proceeds of export is six months, except in the case of exports to Pakistan and Afghanistan for which the period is three months. As a rule, exporters are required to adhere strictly to the prescribed time limit for the delivery of export proceeds to the authorized dealer. Where the proceeds are not received within the time specified, the authorized dealer has to take up the matter with exporter and ask him to deliver the proceeds within 21 days. If the exporter fails to do so, the matter is reported to the Reserve-Bank stating the reasons for delay. The exporter has to apply to the Reserve Bank for the extension of time limit for delivery of the export proceeds in case where be has not been able to realise the proceeds for reasons beyond his control. The Bank may grant an extension of time if the circumstances appear to warrant it. In cases where the Bank does not consider it necessary to grant extension, it may instruct the person entitled to sell the goods, arrange for their sale and obtain payment in an approved manner. Alternatively, the Bank may order that the goods be assigned to Government of India or to a person specified on its "behalf. Failure

Export Trade

427

to comply with any general or special directions given by the Reserve Bank will render the exporter liable to penalties prescribed in the· Foreign Exchange Regulation Act, 1973. Exports under Deferred Credit Arrangement: As regards exports under deferred credit arrangements where the exporter is eligible to obtain export credit from an authorized bank under the export credit refinances scheme for a period of over six months and up to five years, restrictions regarding the time limit as stated above may be relaxed by the Bank and extended up to a maximum period of five years from the date of shipment depending on the type of goods exported. For this purpose, an exporter is required to submit to the Bank, through his banker, an application in the prescribed form in triplicate asking Reserve for the extension. Gift Parcels: Gift parcels as well as other exports which do not involve any transaction in foreign exchange are permitted, without compliance withG.R./E.P./P.P.form procedure provided the exports are made by parcel post or air freight and the authorized dealer is satisfied that the contents of the parcel are less than Rs. 270 in value. In all other cases, prior permission of the Bank is necessary for sending gift parcels. In December 1973 the Reserve Bank of India introduced Buyers' Credit Scheme under which the Bank in participation with the eligible Banks in India grants credits directly to foreign buyers in connection with export of capital goods from India. The Scheme is intended to enable Indian exporters (including export houses) in the private and public sectors to export capital goods. The exporters obligation is to fulfil the commercial terms of the contract and once this is done, they are paid for their exports out of the credits on a non-recourse basis. While no maximum limit for such credits is stipulated, applications are normally considered only in respect of high value contracts viz. those of the value of Rs. 1 crore and above. The buyer is required to have a stake in transaction by way of advance / down payment. In July 1975, the Reserve Bank announced a simplified procedure for exports on deferred payment basis, including post-

428

Export Trade

facto exchange control clearance by the (R.B.I.) and insurance cover by the Export Credit and Cuarantee Corporation. The new procedure, which grants a general permission to exporters, will apply only to cases where (1) the value does not exceed Rs. 50 lakhs; (2) the credit period does not exceed five years for specified types of goods; and (3) finance from the Industrial Development Bank of India (1.0.B.I.) is not required. The general permission enables exporters to make offers abroad and to enter into negotiations for export of goods or submit tenders provided certain minimum conditions laid down in this regard are satisfied. The permission also enables exporters to enter into contracts provided the contract terms conform to the minimum conditions. The RBI has also granted general permission for issuing bid bonds and performance guarantees. Applications are, however, required to be made to the R.B.!, for post-facto exchange control clearance, and to the E.CC.C for insurance cover, within 15 days after the signing of the contract. The procedure in respect of cases not covered by the general permission has been streamlined by making the IDBI the focal point for grant of approvals. Under the revised procedure, the exporters before they make offers or submit tenders, should submit applications in a composite form to the IDBI through their bankers. The applications will be processed by a working group consisting of the IDBI, RBI and ECCC :E;xporters and their bankers will be associated with the discussions wherever necessary and package clearance for the offer or bid will be granted by the IDBI. Once such clearance is given, the exporters can enter into contracts in the event they succeed in their bids, subject only to the provision that they will furnish copies of the contracts together with complete information in the prescribed form to the IDBI, RBI and ECCC for post-facto approval and grant of financial assistance. Approved Methods of ~ayment : The methods by which payment for exports to various countries may be received are set out as below:

429

Export Trade Description of territories (a) Convertible Account Countries (i) Austria BelgiumLuxembourg Canada Denmark (including Faroe Islands)

Prescribed methods of payment (a) Payment in the currency of any territory in this sub-group.

French France Area (France and its non- metropolitan Area) Italy Japan Netherlands Monetary Area (Netherlands and its nonmeteropolitan Area) Norway Sweden Switzerland and Liechtenstein The United State of America and any territory under the soverighty of the U.S.A. West Germany. (b) Bilateral Account Countries Bulgaria Czechoslovakia German Democratic Republic (East Germany) Hungary Northy Korea Poland Rumania U.S.S.R. Yugoslavia

(b) Payment in sterling from an external account as defined in the U.K. Exchange Control Regulations.

(c) Sterling Area Countries (Scheduled Territories) (See paragraph 2, Section II) of Exchange Control Manual, (Sixth Edition) 1971

(c)

(a)

Payment in sterling or any sterling area currency other than Indian rupee from the account of a resident in any country in this group other than India. (c) Payment in rupees from the account of a bank in any country in this group other than India

Special Arrangements: (ii) Notwithstanding the general directions given above regarding the methods of payment special arrangements in respect

430

Export Trade

of exports of certain specified goods to Afghanistan. Sudan and U.A.R. as well as those financed under the credits extended by the Government of India to foreign Governments, as set out below, should be followed: (a) Afghanistan: Under the -terms of Indo-Afghan Trade Agreement, which Is renewed from time to time, the value of exports of certain specified goods to Afghanistan is set off against the value of goods imported from that country under the supervision of the Reserve Bank and the Import Trade Control authorities. Payments for such exports may also be received. (1) In any convertible currency, provided a letter of credit has been opened in favour of the exporter; or (2) in purpose from the account of a bank in Afghanistan. (b) Sudan: Payment for exports of specified goods under the Indo-Sudan Trade Agreement should be received from the special account maintained in sterling by the State Bank of India Bombay, with the Bank of Sudan. (c) U.A.R.: Payment for exports of specified goods under the

Indo-U.A.R. Trade Agreement should be received from the nonconvertible rupee account styled "Special Account - U.A.R." maintained by the Central Bank of Egypt, Cairo, with the State Bank of India, Bombay. (d) Government Credits : Exports of some goods are also arranged under lines of credit offered by the Government of India to Government of certain foreign countries. Payment for exports financed under such GovernmenHo-Government credits should be received strictly in accordance with the procedure advised to authorized dealers in this regard by the Reserve Bank. Prior Approval: (iii) Financing of exports in a manner other than the methods stated above requires the permission of the Reserve Bank. While referring applications to the Reserve Bank in terms of this subparagraph, the reasons why financing is not being done in one of the approved methods should be explained where possible. In cases where foreign currency payment is proposed to be received against

Export Trade

431

exports to a Bilateral Account country, it should be indicated whether such pay Inent has been voluntarily offered by the overseas importer. As far as possible, suitable documentary evidence in original should be forwarded with the application. Getting Paid in Export Trade: Means of getting paid in export trade include (i) letter of credit, and (ii) bill of exchange which may be payable either on sight or after expiry of a period stipulated in the bill itself. A brief discussion of these modes is given below. A letter of credit is an instrument issued by a bank on behalf of and for the account of the buyer of the goods whereby the bank undertakes that the bill of exchange of the seller, drawn on the buyer, or on the issuing bank or on another bank designa ted in the instrument, will be duly honoured by acceptance or payment as the case may be provided the exporter complies with the terms and conditions of contract as indicated in the letter of credit. Thus, by means of a letter of credit, promise to pay made by the importer is substituted by the promise to pay made by his bank. Various types of letter of credit are dealt with separately. The second method of getting payment is by means of documentary bill of exchange, also called "Draft", drawn on the importer by the exporter. When the drawer, i.e., exporter expects the drawee, i.e., the importer to make payment immediately the draft is presented to him, this draft is called a "Sight Draft" or in said to be "drawn at first sight" or "on demand" or" on presentation". When the draft is drawn, for payment at any later date than presentation it is called a "usance draft or usance bill" or "terra draft". In the case of sight draft, the exporter through his bank in India, sends draft and other shipping documents to the importer's bank. The importer's bank notifies the importer to this effect and hands over shipping documents to him.only when the latter has paid for the draft. That is why this form of payment is also called" documents against Payment". In the case of usance draft, the exporter draws a draft on the buyer stipulating the period after expiry of which the latter must

432

Export Trade

pay the amount of the draft. The draft along with other shipping documents is sent to the importer's bank which hands over shipping documents to the importer only when the draft has been accepted by the importer. When a draft has been accepted, the bank abroad notifies the exporter that his draft has been accepted. The bank also notifies the date of acceptance. On realisation of the money after expiry of period stipulated in the draft itself, the foreign bank, which holds the draft as an agent of the exporter, remits the proceeds to the exporter after deducting its own charges. The exporter can also "avail himself of the facility of discounting usance draft with his bank. This form of receiving payment is called "Documents against Acceptance". Eliminating Exchange Risk: Whenever an exporter has drawn a bill of exchange especially a usance bill of exchange under which he has to receive payment in foreign currency at some future date, he runs a risk that the value of that foreign currency in terms of the domestic currency might decline by the tine he actually receives the remittance in question. The best thing for the exporter to avoid such risk will be to agree to a certain rate with his bank which would make the payment in rupees after converting remittance received from abroad in foreign currency into rupee according to the rate agreed upon.

***