To know how to invest, first it is necessary to understand the basics of investment. To learn an investment art is more like to study a new language. A fundamental thing any successful investor needs to do is to allow his earnings to run on for a long time. Before consideration of some advance theories and practical investment, there is a need to understand the fundamental concepts and terms of investment. Money Investing is a complex thing; moreover, people often feel themselves confused due to sufficient knowledge and poor experience in this field. In this article, we will try to make main basic investment theories clear. Moreover, people should thoroughly study the investment concepts before their attempt to understand the mechanism of investment.
Risk and Return
Risk and return are the most fundamental concepts of investment. Risk and return are directly proportional data. It means, taking a high risk, investors will receive a high return and the vice versa. There is an example for comparison. Some people use to dive in the water knowing nothing about its depth. Others prefer first to measure water depth, to calculate its indicators, and then to find out about diving safety. This example proves extremely high benefits for investors to predict a possible investing risk and to imagine its future effect.
In some books on the investing theme, they consider a risk as “a chance to the actual rate of Return on Investment can differ from expected”. In other books, the risk refers to “probability of negative outcome on your investment.” Thus, people use a risk concept to calculate the level of uncertainty. To take a low risk means to expect low return, and the vice versa. The investors stay always in a search for a right solution that will help them to achieve the best high return with the best low risk. This is an ideal situation, hard-to-finding in the current uncertain economic environment. As discussed, high risks lead investors to high returns, whereas low risk normally leads them to low returns. The rate of return on investment mainly depends on the level of risk associated with investment. It is easy graphically to explain the relation between risk and return as the figure below illustrates.
Often people misunderstand the risk concept because of assuming that the high-risk level leads the high-return rate in any case. A high risk actually means only a possibility to provide an investor a high return, but there are no guaranties. Analogically, low-risk taking does not always lead to low return-earnings, because it is just a possibility to get low returns. Another concept necessary to understand is a risk-free rate. The risk-free rate is the rate of return on investment, achieved by investors through taking no risk. As an example, it could be a rate of return on United States Government Bond. If the U.S. Government provided an 8% return on its bond investment, the risk-free rate would be 8%. Afterwards, the question arises: “Does investor aim to earn more than 8%?” The more he aims to benefit from the investment, the higher risk involved. Taking into account an acceptable scope of investing risk, the investor can accept a reasonable decision about his interest in the investment process. Benefits from investments can extremely vary investor to investor. There are a number of factors, affecting investors’ decisions, for example, an objective, personal situation, income level, etc.
Financial Investment Diversification
Diversification is one of vital investment basics. It is important to understand this concept to get to know why investors diversify their portfolio. Most investors cannot resist the short-term economic fluctuations, increasing as well as decreasing earnings from investments. To avoid a negative effect from economy uncertainty, investors need to diversify their investments. Diversification means managing and minimizing the risk by investing money in different sectors. As a complex concept, diversification needs its explanation through the example below.
There are two companies in a coastal area. One company sells sunscreen creams, and the other one sells umbrellas. As you can find out, the economic situation both of them depends on a season. If there were a rainy season, the umbrella company would operate with higher financial result. It is because of increase in demand for umbrellas. However, in sunny weather, the umbrella company most likely would have nothing to earn. In this situation, we have to invest a part of your investment in both the companies so that we are able to survive in both seasons.”
Diversifying investments Investors should abide by two main rules described below.
It is necessary to invest money in different sectors allocating savings to stocks, cash, bonds, and in real estate. To avoid industry related risks, it is better to invest in different industrial sectors.
It is necessary to invest money in companies with a variable risk. Before that, investor should choose an entity with different risk levels; moreover, blue chip shares should be not always preferred.
Diversification helps to achieve the long-term goals and makes us able to stand in short-term fluctuations. Diversifying their investment portfolios investors only minimizes the risk; however, there is no guarantee of high earnings. There is always a certain amount of risk involved no matter how much investor diversifies his investment.
Often investors wonder how many items they should use to achieve an optimum level of diversification. Experts suggest that 20 different stocks added in the portfolio are the most reasonable decision to avoid all individual risks attached with investment. Diversification means to buy the shares of the companies, variable in a size and type of industry.
Dollar Cost Averaging
The most difficult task while understanding the investment basics is picking the tops and bottoms of the stock market. Every investor aims to buy the stock at the lowest level and sell at record high level. Dollar cost averaging is a concept of buying shares for a particular amount regardless of their price. If an investor wants to buy the stocks of XYZ Company for $500 every week, we will buy the shares regardless of their price. If the price is higher, it is rather reasonable to buy fewer shares, and vice versa. The cost of the shares will be average out in the end. This technique helps to reduce the level of risk involved by purchasing shares at different prices.
Asset allocation is primarily decision about where to invest money. People, which want to invest their savings for a longer term, should invest in stocks. However, if people wish to invest for a short or medium term they should put their money in securities of different sectors and industries. Asset allocation is a technique that provides a balance in your investment and helps to diversify investments in a safe way. In asset management, it is actually necessary to divide the investment between cash, bonds, real estate, and stocks. Each of these investing directions provides its own level of risks and returns; therefore, the behavior of each sector is mainly different.
The asset allocation concept has a relation to an age of a person. Investing their money, the older people prefer to take lower risk. It is because of their savings, which in retirement generally come from the only source of income. To preserve their assets, it is safer for retirees to invest money in more conservative manner.
Another important aspect of asset allocation is to choose proper portfolio items for investment. The question arises: “How much money should we put on stocks and other securities such as bonds, securities?” Older and retired persons need more to invest in the items in which less risk is involved such as bonds and securities.
Random Walk Theory
In 1973, Burton Malkiel first developed Random Walk Theory. The book titled “A Random Walk Down Wall Street” is now considered a classic investment theory. This theory states that the previous performance of any company in the stock market cannot be used to predict with precision its future performance. In 1953, this theory was first examined by Maurice Kendall stated that the fluctuations of stock prices were independent of each other.
Random Walk Theory says that the stock market always takes a random walk. People are able precisely to predict almost nothing about stock changes in the future. The chances of going the stock prices both upward and downward are equal. The followers of this theory assume a possibility to achieve high returns due to the correct calculations. Burton Malkiel stated that all types of analysis worked out to predict volatility of stock prices in the future make investors just waste their time. Malkiel supposed that only the long-term shareholding allows achieving high returns on your investment.
There are many followers of the Random Walk Theory. The others consider Investment a complex science, and they cannot invest their money based on a book written 40 years back. Today, investment basics changed as compare to 1973; moreover, nowadays people have a great access to the market news and ways to exchange views.
Hypothesis of Efficient Market
In 1960s, Eugene Fama first developed the idea of Efficient Market Hypothesis This theory states that it is not possible to beat the market as prices reflect all information. Disputed theory creates many controversies. Followers of this theory suggest futility of all types of technical and fundamental analysis.
In Efficient Market Hypothesis, investor can buy and sell shares anytime he wants. The return on investment mainly depends on a chance rather than investor’s skills. According this theory, if the stock market is efficient, the prices always go up. That is why it is useless to look for low-price shares.
Technical analysts always resist this theory due to their assumption that there is no logic in that old theory of investment. There are many arguments against the Efficient Market Hypothesis. As an instance, people invest their money because of the expectations, based on analysis of the company’s past performance and logical assumption about future prices.
The Optimal Portfolio concept is based on Modern Portfolio Theory. Harry Markowitz first introduced this concept. He stated that different portfolios provide different levels of risks as well as return. The investors should accept a right decision about how much high risk they can manage. Then, on a base of that decision, they diversify their portfolios. The figure below explains what the optimal portfolio means.
If we look at the figure, we can see the optimal portfolio is always in the middle of the curve. Going up the straight line, portfolio reaches higher risk involved. Investors also have to think how volatile portfolio he should choose. Certainly, volatile investment is the one that provides investors with high returns; however, at the same time, risk involved is also higher.
Capital Asset Pricing Model
In 1952, Harry Markowitz developed Capital Asset Pricing Model, known also as a model for risky securities pricing. Some others have overhauled this concept during 60s. The model reflects the relation between risk and return. Its main idea manifests that expected return on security is equal to a sum of the security’s risk-free rate and a risk premium. If the result is lower than the required return, then it is not reasonable to invest in that option. The formula below describes Capital Asset Pricing Model.
In formula above, the result largely depends on the Beta value of the security. Stock’s beta measures the sensitivity of a stock relative to the overall market or an index. The trend is that the higher Beta’s value the higher expected market return. The sensitivity of stock usually is compared to the S&P 500 Index. However, this is just a theory, and there is no guarantee that this theory gives us 100% results in a practice case.
This article is aimed to help people to understand the basic concepts of investment and give readers some ideas about how the investment theories work.
CEMEX is one of the largest building materials suppliers and cement producers in the world. The company produces, distributes and sells cement, mix-concrete, aggregates, and related building materials in more than 50 countries in all over the world. CEMEX has a rich history of improving the well-being of those it serves through its efforts to pursue innovative industry solutions and efficiency advances and to promote a sustainable future. CEMEX is recovering from the global economic recession and the loss that the company had in the last couple of years. The year 2011 compared with the year 2010, the company had a good impact.
CEMEX is one of the largest building materials suppliers and cement producers in the world. The company produces, distributes and sells cement, mix-concrete, aggregates, and related building materials in more than 50 countries in all over the world. CEMEX has a rich history of improving the wellbeing of those it serves through its efforts to pursue innovative industry solutions and efficiency advances and to promote a sustainable future.
The aim of this paper is to evaluate the performance of CEMEX through a critical analysis of the financial statements of the last two years, the analysis of five aspects of performance evaluation which are profitability, efficiency, short and long term Solvency and market based ratios. In this analysis will include the information of the company CEMEX, and the analysis of the financial information.
CEMEX is one of the largest cement companies in the world, was founded in Mexico in 1906, the company is based in Monterrey, Nuevo Leon, Mexico and has operations throughout the world with production facilities in 50 countries in North America, Caribbean, South America, Europe, Asia and Africa (Cemex, 2012).
CEMEX had an annual cement production of production capability of 82 million tons. One third of the sales come from Mexico operations, one quarter comes from the plants in USA, 15% from Spain operations and other small percentages from the other plants in the world (Cemex, 2012). The main competitors of CEMEX are Holcim, Lafarge and Heidelberg Cement. CEMEX is constantly evolving to become more flexible in their operations, more creative in the commercial offerings, more sustainable in the use of the resources, more innovative in their global business and more efficient in their capital allocation.
Interpretation of accounts: ratio analysis
In this analysis we review the financial statements (Balance Sheet, Cash flow and income statement) of the company CEMEX. These to evaluate the performance of the company in the different aspects.
Profitability ratios. An expectation on making more income from sales of the good or service than they spend performing the services or making the goods.
Efficiency ratios. A level of performance that describes a process that uses the lowest amount of inputs to create the greatest amount of outputs.
Short-term solvency ratios. Measure a company’s ability to pay its current bills and operating costs – obligations coming due in the next fiscal year.
Long-term solvency ratios. Measure a company’s ability to meet it’s long term obligations, such as it long term debts (bank loans) and to survive over a long period of time.
Market indicators. These ratios relate the current market price of the company’s stock to earnings or dividends (Reimers, JL, 2008).
Analysis of financial statements
The year 2011 was an important year for CEMEX, after the global economic recession the company is facing a difficult situation with some of the markets, nevertheless CEMEX launched an accurate transformation designed to make the company more efficient, more agile and more customer focused. The changes made in the company, designed to position the company for a future of beneficial growth, are already showing results. The results of the ratios of the 2011 financial statements are the next ones:
Gross profit margin
Net profit margin
Return on assets
Return on equity
Table 4.1 Profitability ratios
Table 4.2 Liquidity ratios
Table 4.3 Efficiency ratios
Debt to equity
Total debt/total equity
Total debt / total capital
Table 4.4 Solvency ratios
After the global economic recession CEMEX is facing difficult situations, in table 4.1 the gross profit shows that the company has 28.5% in 2011, compared with 2010 is almost the same; in the table 4.1 shows the gross margin in 2010 was 28%, there was an increase of 0.5%. In the table 4.1 shows that the company had a loss in the net profit, the ROA and the ROE in the last two years but an increase on the operating margin compared with the year 2010, in year 2010 was 2.5% and the year 2011 increase to 6.3%. That means that the company is profitable, there were some difficult situations the last couple of years nevertheless the company is making a profit.
With the information of the financial statements we can determine that the company is facing some problems with the ability of paying current bills and operating costs, in the table 4.2 the current ratio of the year 2011 is 1.04 on the year 2010 was 0.98, there was an increase this year, although the ideal ratio is 2:1, this year the current and quick ratio were below the ideal ratio. In the table 4.2 the quick ratio in 2011 was 0.73 and in the year 2010 was 0.71, the ideal for the quick ratio is 1:1. Table 4.5 shows that the company has a debt to total capital of 55.59%.
The table 4.3 shows that the company is turning over the inventory 11 times in the year 2011, the year 2010 the turning over of the inventory was 12 times in a year. The average is 12 times. The assets turnover in the year 2011 is of 34%, this value is the same than the year 2010, and this means that the company is efficient.
The market indicators for CEMEX for the year 2011 are book value per share is 17.54 and the tangible book value per share is 2.94. The earning per share in 2011 is -11.13, that means that there were losses; the earnings per share excluding extraordinary items dropped 13.71% (Financial Times, 2012).
Comparing CEMEX in the last 4 years there was a significant deterioration on the operating margin and the EBITDA margin, from the year 2008 to the year 2011 year. Now the company is increasing the operating margin, this year have an improvement compared to year 2010, this deterioration was in the time of the global economic recession.
Conclusion and recommendations
CEMEX is recovering from the global economic recession and the loss that the company had in the last couple of years. The year 2011 compared with the year 2010, the company had a good impact on the operating margin and the gross profit margin it increases a 6.3% on operating margin. That means that the company is profitable but has some losses in the return on Assets and the return on equity, on the solvency part the current ratio and quick ratio are below the ideal, the company needs to keep an eye on the solvency of the company, the company has a little improvement on the efficiency on the inventory turnover, nevertheless the company has a debt of 55.59%. The company is doing better than last year and has some projects to increase the sales, improve operation, be more creative in the commercial offerings, more sustainable in the use of the resources, more innovative in their global business and more efficient in their capital allocation, the recommendations are to keep those projects and further expand them.
There is no doubt that any investor would ideally choose a portfolio which would give him high returns and put him through low risk. However, the investment world and its choices are not that simple and easy. Many times, the choices have to be made under difficult circumstances. But there are quite a few portfolio management tools and theories that can come to the rescue of the investor in making his choices. In this paper we will be discussing about one of prominent theories in this aspect. We would also try why many investors do not invest according to the theory. The portfolio management theory that is being discussed in this paper is the modern portfolio theory.
Modern Portfolio Theory was first introduced to the financial world by future Nobel laureate, Harry Markowitz through his research paper in 1952. In 1959 Markowitz also wrote a book, Portfolio Selection, based on the same. He used mathematics to explain the relationship of risk to return as it relates to asset allocation. It was agreed that in cases where high returns were expected, the risk factor associated with it was also very high. However, he proved that asset classes acted differently during a market cycle. The paper also discussed how an investor can construct an investment portfolio based on his risk tolerance levels and expectation for returns (Omisore and Yusuf et al. 2012, pp. 19-28).
To put it in simpler words, stocks are generally associated with high risk and high returns. And hence if an investor buys more stocks, he might be exposing himself to too much risk. On the other hand, bonds are known for moderate returns and lower risk. Hence, according to modern portfolio theory, if an investor opts for a combination of stocks and bonds, his chances of getting a reasonable return while handling a relatively lower level of risk, increases. In short this theory for portfolio management encourages asset diversification.
However, recent studies have shown that most of times the investor does not take his investment decisions as per modern portfolio theory. This observation is made on the basis that though the benefits of diversification have increased in the recent years, considering the mean–variance portfolio theory, it is surprising to see that the level of diversification in investor portfolios has not increased accordingly. While the level of diversification exceeds much more than 300 stocks, the actual number of stocks that the investor holds remains just 3-4 (Statman 2004, pp. 44-52).
Management of Risk and Return
Many critics of modern portfolio theory would point out that this method of choosing the right investment path has ignored the part played by analysis of market and its trends. And this is also one of the key reasons that the investors cite to avoid much diversification of their assets. They believe that risk can be managed with the help of right knowledge and trading skills. This makes many to invest in high risk assets with the hope of getting more returns. They remain under the impression that in case a bear a market happens they will be quick to realize it and would sell off their high risk assets at a reasonable price. At times they also choose other alternatives to reduce the risk factor such as delegation of authority or decision delay, making them feel that they have taken a well calculated risk. And amidst all these they miss out on the diversification of their assets as they consider having solid information about a few firms better than opting for diversification (Werner F.M. De Bondt 1998, pp. 831-844).
Though investors and traders try to put in practice a variety of rules and techniques, to keep their emotions at bay and let their reasons speak while making investment decisions, most of the time trading happens out of impulse. They end up buying or selling their assets without prior planning or by listening to some random suggestions made by an acquaintance (Werner F.M. De Bondt 1998, pp. 831-844).
It is also interesting to see how investors decide upon buying shares in a bull market and selling them off in a bear market. In some of the cases even the experts, who are known for taking decision in the most rational way, based upon accurate models, at times find themselves going after the crowd mentality.
Misunderstanding Modern Portfolio Theory
One another reason for many investors for not choosing the modern portfolio theory way of investing is that they confuse it with ‘buy and hold’ strategy which is done with the intention of reaping good returns in the long run. However, this is not the case with the modern portfolio theory. Though it may resemble with the ‘buy and hold’ manner of investing, as an investor who opts for modern portfolio theory will remain fully invested, it is misleading to say that the assets will remain unmanaged. As mentioned earlier, a rebalancing of holdings is always needed in accordance to mean–variance portfolio theory. This would mean that the total assets need to rebalance either quarterly or annually to keep them in line with their original portfolio percentages (Hudson Wealth Management LLC 2013).
It is understood that the basic fact of investing is that the investors are rewarded for taking high risks. However, not all risk is rewarded. Further, in the current economic scenario, there are not many who can really afford to take a hit. In cases for investors who hold on to a high number of high risk and highly rewarding assets are also at a greater of risk of facing a financial crisis. Hence, it is better to go with a disciplined modern portfolio theory approach of diversification which has been theoretically and practically proven for the last 60 years and have proven the ability to maximize the returns and minimize risks.
Omisore, I., Yusuf, M. and Christopher, N. 2012. The modern portfolio theory as an investment decision tool. Journal of Accounting and Taxation, 4 (2), pp. 19-28.
Statman, M. 2004. The Diversification Puzzle. Financial Analysts Journal, 60 (4), pp. 44-52.
Werner F.M. De Bondt. 1998. A Portrait of the Individual Investor. European Economic Review, 42 pp. 831-844.
Hudson Wealth Management LLC. 2013. What Is Modern Portfolio Theory and is it Still Effective?
In an address to MIT graduates, Carly Fiorina, the legendary HP leader has been quoted as saying, “….the most magical, tangible and ultimately the most important ingredient in the transformed landscape is people” (Fiorina, 2000).
The pervasive question in strategic management on why some organizations are more successfully than many others is answered by their varying management of human capital (Hitt et al 2001). According to the resource-based view of organizations, organizations vary in their performances because of their varying resources and associated capabilities. Resources can be tangible and intangible. The intangible resources and capabilities are difficult to replicate and are socially complex and can be built or changed only in the long run (Hitt et al 2001). Thus, the competitive advantages produced from intangible resources are very unique, rare and difficult to replicate. The intangibility of human resource management is removed with an approach called human capital management which urges the organization to view its human resources as a financially quantifiable function – to analyze impact of people on contribution to shareholder value, to demonstrate value of HRM with ROI calculations and provide direction for future HRM practices (Angela & Armstrong, 2007).
Human capital theory views human resources and its skills as an asset of an organization and that the organization must strive to grow and safeguard this asset (Lepak & Snell, 1999). Human capital is a term applied to the approach of considering people as assets for the organization, putting people on the right side of the balance sheet, in a lighter vein. The human capital approach puts the HR function at a more quantifiable level thus rendering it strategically relevant. The approach enables the organization to orient and align its human resources to effectively meet organizational objectives (Lepak & Snell, 1999).
The scope of human capital management covers reporting the human capital of an organization. Such reporting enables stakeholders to develop another performance metric to evaluate the organization. The human value of an organization points to the potential it possesses for future performance, the strength of its internal processes and the sustainability of the business model.
The Implications of Human Capital Management
Human knowledge can be classified into articulable knowledge which can be codified and passed on easily and tacit knowledge which is based on organizational routines and social in context (Lane & Lubatkin, 1998). Tacit knowledge is unique and cannot be replicated and gained on the job and are unique in every organization for a particular role (Lepak & Snell, 1999). Hence there is a need to classify and segregate knowledge into core and peripheral assets.
The value of human capital is dependent on its potential to contribute to the organization’s core competencies and thus to achieve organizational objectives. The core assets contribute most and hence need significant continuous internal development and nurturing. As organizations move to more advanced technologies, the role of knowledge workers increases and hence the need to effectively manage core assets is more important (Lepak & Snell, 1999). Human capital is not owned by organizations, but merely secured through relationships (Angela & Armstrong 2007, p9) and hence the need to manage the same and ensure that the asset stays within the organization.
The pressures on efficiency and costs drive organizations to make or buy labor. This make or buy decision is based on the importance of a particular skill. Core assets cannot be outsourced and an organization that does this is under peril of losing its competitive advantage (Porter, 1985). Developing peripheral assets within the organization leads to higher overhead and transactional costs. Thus, these peripheral assets can be externalized or acquired from other parties for whom this is the core asset.
The implication of human capital management is that there is a positive correlation between leveraging human capital and organizational performance. The value of human capital is defined as the ratio of strategic benefits to customers derived from skills related to the costs incurred (Lepak & Snell, 1999). Human capital management forms the bridge between HR practices and strategic business performance. This argument places human capital management as a value creating activity for the organization. Thus, human capital is always measured in relation to the value it creates for the customer.
Investment in Human Capital – Theoretical Analysis
An employee gains knowledge on-the-job, by schooling and through other sources. The fact that an employee gains in experience and knowledge and thus becomes more skilled leads to the development of innate knowledge which is very important in the understanding of the uniqueness of a particular individual. What he gains through formal education is the foundation on which his social behaviors and personality are rooted within the organizational context. The other sources include access to information, inquisitiveness and developing skills out of the scope of the role (Becker, 1962). Hence, the education or the prior preparedness of the employee to be based within the organizational context in social behaviors and attitudes is very important to how effectively he is able to contribute to the organizational goals and objectives.
Human capital management focuses on the following HR processes (Angela & Armstrong, 2007 & Lepak & Snell, 1999):
Resourcing strategies – the process of acquiring human capital, and managing them effectively to utilize them to achieve the organizational objectives. These strategies define the forecasting of skills required and the measures to acquire such skills through internal development or external acquisition – the make or buy decision. The make-or-buy decision also implies that the organization can outsource some of its competences to be effective, thus bearing significant ramifications for organizational effectiveness.
Reward strategies – the fact that individuals expect return on their own investment in organizations – in skills and efforts spent on the job. Human capital theory encourages skill and performance base reward fabrication and to compensate an individual by fixing his market worth because the individual owns his own human capital. the fixing of the market worth of an individual is similar to accounting for the value of a physical asset, only that in human capital the value of an individual is in the skills and competencies of the individual.
Retention strategies – the contribution by individuals to the organization make the organization find ways to retain this human capital either by increasing its valuation or by forming strategic alliances with its human capital for long term relationship. Thus, the role of promotions and awards play a part in ensuring that organizations are able to protect their human capital from leaving and thus aiding competitors. This multi-faceted approach to retention aids in reducing attrition and loss of human capital.
Development strategies – organizations always try to develop their human capital – the core competencies of individuals. Core skills need to be developed internally and thus organizations go for training and knowledge acquisition for their employees. This increases the market worth of the employee by making him more skillful, and thus reiterates the importance of retention and reward strategies. The buying of core competencies results in the erosion of human capital in the organization, leading to loss of competency in many core business areas.
Valuation of Human Capital
The concept of human capital also means that the human capital has to be measured in financial terms and thus the significance and implications of the process be known. The economic value of people in the organization has to be accounted for through human asset accounting – for measurement, enumeration and analysis. Measurement and analysis help the human resources function to work at a more strategic level. It also provides investors and other stake holders with a better feedback on the working and sustainability of the business. There are three types of human resource accounting models (Bontis et al, 1999):
Cost models, which consider the historical, acquisition and retaining costs of an individual or an asset
Human resource model which also goes into non-monetary behavioral attributes
Monetary models which account for discounted estimates of estimated future earnings
Human capital accounting models attempt to calculate contributions made by human assets by capitalizing expenditures in retaining the asset – salaries. Instead of putting total wage bill in the expenditure side in an income statement, a discounted cash flow of wages is classified as an asset in the balance sheet (Bontis et al, 1999). This requires a number of assumptions on the HR practice’s estimation. The average increase in wage per year and the tenure of expected employment are estimated for the workforce and all these cash flows for many years are discounted back to year one. The remaining figure is represented as the human capital value for the organization.
The assumptions made in the model explained above necessitate planning and predicting workforce strength and composition for many years ahead. Often, this proves very difficult to do accurately. Assumptions about tenure of employees, wage rises and turnover rates are not determinable accurately. Hence, all these models suffer from uncertainty and inconsistency (Bontis et al, 1999). Also, the practice of treating humans as assets is debated to be morally unacceptable as here it is assumed that the organization owns individuals.
HRA data can be utilized for three purposes (Bontis et al, 1999):
To report human capital in audited financial statements for external stake holders
Feedback on achieving strategic goals internally
Developing future plans and strategy by assessing the uniqueness of the human capital prevalent in the organization
Only one of the purposes stated above needs auditing authentication – financial reporting. The other purposes are to help the organization assess and plan and strategize for itself the direction it has to take in evaluating its own human capital, its uniqueness and planning for additions or reductions or acquisitions of human capital. Hence, the focus of human capital management is in aiding in organizational effectiveness and thus to deliver more value to stakeholders. The lack of orientation towards human capital in financial statements is because of the fact that the field is constantly evolving and human capital management is still considered only a sustainability issues and not a purely financial issue.
Human Capital in Banking
The Service Organization Perspective
In service organizations human capital represents a significant portion of organizational value. In a service business, the service offered to customers is readily perishable, consumed immediately and irreversible (Kotler, 2002). When a product goes wrong or malfunctions, the company can satisfy a customer by replacing the product or just by a repair, but in service, the problem created cannot usually be reversed or rectified. The experience the customer gets when accessing the services is all the more important to ensure that the customer is satisfied. This goes a long way in achieving organizational goals. When a customer is accessing a service in a bank, he is effectively touching its employees. The role of employees in ensuring a great service experience for the customer is highly critical.
The above argument implies that the quality of service delivered can vary according to human capabilities – both the server and the served. The participation of the employee and the customer in a service rendering process is equally important. The role of the customer also plays a part in ensuring that the process goes effectively. Hence, customer management through interaction with employees forms the basis of customer satisfaction. Service delivery is just one aspect of the business. But intellectual capital is a very important part of a bank, as it works primarily on accumulated knowledge and experience. Relationships are another important reason why human capital is very important. Some information is codified and present at the push of a button, but much more is tacit knowledge within employees which need careful nurturing and planning. The tacit knowledge is more social..
Professionals gain knowledge through education (articulable) and on the job (tacit). Service professionals receive extensive education and training prior to entering the profession. The quality of the knowledge they acquire varies as per the quality of the scholars and teachers they have access to. Universities and schools are ranked and evaluated by the quality of teacher’s it employs. Individuals from the best schools and universities are said to possess the highest level of knowledge in their field and membership to elite social circles (D’Aveni & Kesner, 1993). Consequently, such professionals get the highest salaries, because of the knowledge and their social networks.
After completing their formal education, professionals enter organizations in trainee roles or apprenticeships. In these roles they acquire tacit knowledge, by observing and doing things in the organizational context (Szulanski, 1996). They bring in articulable knowledge from outside and develop tacit knowledge within the firm. The tacit knowledge thus developed during employment is a very important human capital component of the organization. Such firm-specific knowledge is unique cannot be replicated. This is truer in service organizations, where people are the first interface for customers and also for the bank.
Human Capital Management in Banking Industry
The broad nature of the discussions above indicate three well definable parts of human capital management – the implications of human capital management, how it is measured and how it is managed to create positive outcomes (Sherwin, 1983). As technology evolves, global expansion has become a reality, paving the way for fast growth, leading to significant challenges in human resource management. There is also an increased demand for more information from external stakeholders on human capital and its implications on organizational performance (Bontis et al, 1999). These challenges coupled together call for focus on human capital management in banks, with global footprint, widely dispersed service delivery networks and great diversity.
There are several levels of understanding human capital in the context of banks depending on the sophistication and detailing of the metrics and subsequent managing required (Whitaker & Wilson, 2007).
Impact of Existing Processes
The impact of the existing people management processes, mechanisms and systems forms the first level of understanding. The understanding required for this is that the organization must understand the people levers or capabilities that are critical to the business performance. Once these are understood, then metrics are developed to assess how well these capabilities are developed. This understanding helps the bank to understand present effectiveness of its processes and its people.
The next level of focus is the impact the organization’s people strategy has on business performance and quantifying the same. An example of a strategic people initiative is engagement. An organization can measure employee engagement through organization-wide surveys and playing it back to understand its correlation to business performance – key metrics like transactions per teller, profit margins and employee attrition (Bartel, 2004). This is possible only with the commitment of the top management of the bank and their understanding of such measurements and metrics. Thus, the dimension of managing human capital has to woven into organizational strategy and form the basis of evaluating business leaders.
After measurement discussed in the points above, it is important that the bank or the organization translates this into action to improve on its standing with those parameters and benchmarks. Improving processes to enable people to contribute more to the business is important. Else human capital management will be stuck at number of days of training per employee (Lepak & Snell, 1999). The bank must measure the highest employee engagement levels of managers across the organization and try to find attributes and qualities which lead to such high engagement levels and try to replicate this to other managers whose employees are not measuring up so high in engagement scores, taking the example of employee engagement in point 2 further. Thus, human capital management is much more than a measurement tool. It is a management style wherein the probability of achieving the organizational goals is improved.
Drivers of Human Capital Management – Banking
There are many human resource practices within the organization and these are organized into drivers which necessitate human capital approach. Human capital drivers for an industry can be divided into five categories with each driver having human capital practices associated with it (Massi & McMurrer, 2007):
The role of leadership in any organization is important. In the financial sector, where the implications of a business failure are destructive socially, the importance of leadership practices is doubled. The most important consistent factors are open and effective communication, rational decision making and systems thinking. Unless these characteristics are displayed, there will be no coordination and direction for a bank, especially a large multinational bank.
Employee engagement starts with a good job design and ends with evaluation. The intermediate processes are workload and job stability. In the banking scenario, employees handle significant amounts of money, hence errors are bound to be costly. The evaluation of organization-wide data on employee engagement is a pre-requisite in any bank or financial services firm. Employee engagement scores must be actively used in assessing leaders and thus form a synergy between good leadership and engaged employees. This stops attrition.
Access to Knowledge
Organizations must have the information and its enablers within the reach of its employees. Also the data available from across the organization must be able to be consolidated and analyzed to create understanding and hence value to the firm. This is true with banks, where business locations are spread out, even across continents. Also, various divisions could be operating on different solution platforms, necessitating high level commitment o data integration and subsequent knowledge creation. Hence, access and availability of data is very critical to success.
Effective training and well defined work processes, the right working environment and fair recruitment and reward practices ensure that individuals have a satisfying career experience with the firm and also for the firm to be able to retain its human assets. The process of evaluating this driver leads to make-or-buy decisions and reversing such decisions too. This is not just about cost savings through cutting jobs, but also about creating vital jobs to ensure effectiveness.
The organization must encourage innovations and promote systems thinking and a learning attitude among the workforce. This develops tacit knowledge and ensures that employees are well tuned to changes in their environment. This is true with financial institutions because of the fact that changes are frequent in this field and business is spread out globally. The ability of the firm to learn from within its processes creates cost saving opportunities and also work force optimization opportunities.
Human Capital Measurement in Banks – Implementation
In the Balance Score Card, the final quadrant, People, is the most difficult to quantify and report for many organizations. The information available to fill this quadrant is available as fragmented and un-integral data from across the globe for a bank. This is because the global organization implements different managerial systems which are incompatible to each other or use legacy systems. Even though data is available in most organizations and people know where the data is, they will not be able to compile this quickly, analyze and use it for decision making. Hence, the first and most significant driver for successful implementation of the human capital approach in banking is the availability of data. Unless contiguous data is available at the push of a button, there is bound to resistance in the system to utilize data which is available in various forms and formats.
Data is available for organizations from across the globe, across functions and divisions in business. Thus, integration of processes and the systems that run and create this data has to be accomplished and compatible with each other. Without integration, the intention will not translate to accurate measurements. Thus, an organization needs a single people management system and single global HR management system. This makes data available for strategic planning and analysis at a macro level. Thus, to implement a human capital management program within the organization, significant investments may be needed to create common platforms to enable people to utilize data more effectively and integrate the various divisions of the bank.
Banks are a people centered business, with people forming the core of the services offered and people being consumers of the services offered. Thus, the evaluation of the impact of people and their roles in ensuring customer satisfaction and to drive business performance is important (Bontis et al, 1999). Such a tool is the Human Capital Scorecard (HCS). The HCS enables an organization to (Whitaker & Wilson, 2007):
Plan sourcing to meet growth aspirations
Identify and analyze key human resource issues
Informed business decisions by risk evaluation and priorities
Monitor progress of strategic initiatives
The HCS has been successfully implemented by Standard Chartered Bank, throughout its global operations and various businesses (Whitaker & Wilson, 2007). The scorecard has measures inbuilt into it which help analyzing the effectiveness of human resources processes in helping business performance. Standard Chartered has automated its HCS enabling it to take out the scorecard for every division for every country in a matter of seconds. This is possible because of data homogeneity.
The use of advanced systems to compute and analyze global human resources data is applied in many banks with thousands of employees. Without such integration of systems and automation of the process of evaluating and compiling data, human capital can never be assessed and used as a basis for strategic plans and further evaluate performance. There are several software companies which cater to the need of banks in their human capital management initiatives. Such companies utilize data from other managerial systems such as ERP and CRM systems to compile and present data for human resource analysis (ACCA, 2009). Usually, the data required for implementing human capital management is available within the organization (Whitaker & Wilson, 2007), but the forms and content of such data will be radically different, arising out of legacy systems prevalent in different countries and divisions. This could lead to significant investments in managerial software and systems to ensure that data is available in the form it is wanted quickly.
Human Capital Management Solutions
Human capital management is available as customized software solutions for banks and other organizations. Such solutions specialize in extracting data from legacy ERP systems of the bank and integrate and present them in ways suitable to the particular bank. Their primary function is turn data into intelligence for the organization. This intelligence or relevant reports are alone are not enough, but the will to utilize this intelligence is more important.
We will now explore the case of human capital management solution implemented in two prominent and large banks:
Case 1: BNL –Gruppo BNP Paribas
BNL is one of the top Italian Banks raking in the top 60 among European banks. It is owned by BNP Paribas, a global financial institution which employs over 170000 people. BNL has approximately 16000 employees (SAS, 2010). This gives an indication of the complexities and the enormity of the human resource management function.
The objectives of a program implementation have to clear before embarking on the process. The bank wanted to implement a human capital management system with the following objectives:
Using HR employee and line manager times effectively
Identifying areas where it gets maximum return n investment in human capital
Spending human resources budget in effective ways to align individual and organizational development needs
The solution was implemented in multiple stages, with the first stage being understanding of and evaluating existing human resource practices:
Analyzing historical staffing and retention costs, estimating redundancies
Effectively design career paths and skill maps
Simplifying budgeting and reporting
Analyze compensation components and simulating for synergies and cost-savings
Having analyzed the existing business processes, the bank then went on to creating intelligence. The solution’s second stage saw BNL adding more features and capabilities to the SAS solution:
Efficiency studies – time and cost study
Role and position analysis
Performance analysis through scorecard models
The key challenge to the implementation lay in the extraction of vital information from the bank’s SAP R/3 ERP module and utilizing it in this solution. This involved significant complexities in configuring the solution for BNL. This is a major problem faced by organizations when implementing organization wide business solutions.
The successful implementation of the SAS Human Capital Management solution the bank has been able to generate return on investment because of the solution implementation. Also the solution put valuable information in the hands of human resource managers and line managers, thus reducing dependence on central planning but not reducing the quality of decisions made. This leads to significant time and cost rationalizations for the organization (ACCA, 2009).
Case 2: Standard Chartered Bank
Standard Chartered is a banking powerhouse head quartered in the UK. It employs over 60000 people in 1500 branches spanning 56 countries across Europe, Asia and Africa. The company has a high growth strategy and has doubled headcount and revenue post 2005 (Whitaker & Wilson, 2007). The organization manages human resources at a global level and places considerable importance on human resource management and is one of the pioneers in human capital management in banking.
Standard Chartered approach towards human capital management is guided by three principles (Whitaker & Wilson, 2007):
Focus on the right talent at all levels for all roles and enabling human resources function to identify and retain high performing individuals
Help individual employees utilize their strengths effectively and manage their limitations
Develop exceptional managers and leaders who will help the bank achieve its human resources potential
Manage and assess strategic human resource initiatives like diversity development
True to the classical implementation process of human capital management (Pfeffer, 1995), the bank at the first level analyzes the effectiveness of its people processes; understand the levers and drivers which contribute most to the core capabilities of the division or the organization (Lepak & Snell, 1999). The analysis happens on multiple metrics. The progress of high value individuals, their retention compared to the general population, talent management processes, succession planning for key roles are some of the processes that are measured to ensure that the various HR practices of the organization are being effective in their improvement of these key metrics.
The next level of understanding comes from the “so-what” angle. The inferences captured from the first level are taken to the level of understanding on how to make them better. The key drivers of human capital management and associated human resource practices are analyzed and taken to a new level of understanding. For example, leadership practices in the organization are assessed through various tools and practices across the various functional domains. Gallup scores from subordinates are also used. Then the efficacy of leaders is studied and exceptional leaders are unearthed through such an analysis. Standard Chartered does not stop with this but goes on to the level of understanding winning traits and characteristics of its most effective leaders and trying to replicate them across the organization.
The above discussion is a vital reminder that human capital management is more about action that access to information and understanding functional efficiency and processes. The action part is not brought out by any software or enterprise solution. The top management has to understand the essence of human capital management and utilize the data to further the achievement of organizational goals (Hitt et al, 2001). Unless this is done, the actionable elements of the concept will remain undone and human capital management will remain on paper and will not help the organization or its stakeholders in any way (Bassie & Mcmurrer, 2007).
To transform information to action, Standard Chartered uses a Human Capital Scorecard. This is an adaptation of the Balanced Scorecard and gives the top management the insights they need to make decisions regarding human capital. Data from across the globe is consolidated through a single global data warehouse and a Human Capital Scorecard is generated for every country and for every division to enable its leaders to make effective interpretations of the human issues in their sphere of action. The scorecard provides leaders with tools to effectively analyze trends and identify issues with the human capital and also to measure progress of previously started human resource initiatives. Thus, the leader is able to meet the human resource goals for his division or country and is also able to ensure that he is in line with the organizational goals and the specific goals set for his division.
The scorecard is generated annually, quarterly and in every month and the bank has automated the process to be able to generate country reports in 40 seconds. The reasoning of the bank for the high level of automation is to reduce the time spent on human resource planning thus making business leaders more efficient and also to ultimately make this tool available with its line managers, so that the dependence on headquarters will go down to make effective decisions. This saves significant costs for the organization.
To utilize the scorecard further, the bank sets a strategic planning agenda every year to evaluate and plan for human resource management annually. For example, in 2006, the scorecard highlighted the trend of attrition in the first year of joining by new employees. This led to increased focus on the induction process for joiners. The results of this action will be assessed periodically again through the scorecard. This process has brought increased rigor into the understanding, planning and action parts of the human resource function and involved other functional areas into effective human capital management.
The Importance of Human Capital Reporting to Stakeholders
There are other successful cases of human capital solutions implementations in the banking sector. For example, the Banca Carige, one of the oldest banks in Italy implemented an SAS Human Capital Management Solution to increase visibility and to make better HR decisions (SAS, 2010). The plethora of human capital management solutions available in the market indicates a high level of competency and popularity of the approach to banks.
The significant stakeholders for a bank are its shareholders, the Government, the society at large and the bank and its employees. For all these stakeholders, the primary concern with respect to the working of the bank is the need to have access to transparent, well-defined and quantifiable measure of the human resource strategy and the performance of its human resources to understand how the bank’s intangible elements are related to the bank’s worth and the efficacy of its decision making (ACCA, 2007). This creates the relevance of human capital reporting, with human capital becoming a metric of organizational performance and business sustainability. The employees of the bank are also important stakeholders. By defining its human capital strategy, the bank can focus on how to develop this capital for organizational growth. For example, Standard Chartered’s human capital goals for 2007 included the following points, affecting its employees (ACCA, 2007):
Embed sustainable lending training in core risk management training.
Review our approach to climate risk, including raising levels of awareness amongst appropriate staff on how to assess climate risk.
Upgrade the social, ethical and environmental (SEE) e-learning. Get external stakeholders’ input.
The market has started demanding significant data on human capital management as a sustainability issue and this has resulted in ranking in the US on human capital reporting. The fact that human capital reporting is deemed a sustainability requirement makes it imperative on organizations to go in for reporting. The Dow Jones Sustainability Index features human capital reporting as criteria in rating organizations (Sustainability Index, 2008). Association of Chartered Certified Accountants (ACCA) 2007 ranking rated Wells Fargo in the top 5 among Fortune 100 companies in human capital reporting (Creelman, 2007). The importance of human capital reporting is gaining statutory importance with many countries making it mandatory for organizations. In Denmark it is a statutory requirement in management reports, while in Austria, it is mandatory in all universities (Eubusiness, 2006).
In the small entrepreneurship context, human capital reporting creates investment opportunities for banks by showing them enterprises with great promise (Eubusiness, 2006). The downside of why most SMEs do not report human capital is lack of awareness in how to report human capital and lack of clear guidelines. Thus, banks could significantly benefit from companies and SMEs reporting human and intellectual capital in their annual and management reports. So the gaining of popularity by human capital measurement and reporting can aid banks both internally and externally.
Financial institutions have created human capital strategy papers for specific periods, which strategize the human capital approach and link it with its strategy and organizational objectives (FHFA, 2009). By doing so, banks are able to create an environment where human resources function is treated as a profit center and as one which yields business benefits which are tangible and measurable.
Human Capital Reporting – In Practice
In many countries, human capital reporting, or for the matter, any form of extended reporting is optional. When human capital reporting is viewed from the CSR perspective alone, it creates a number of reporting formats, which result in incomparable reporting structures which are not of use for observing industry trends and the value of the philosophy. Hence, there is a growing demand among intellectuals for a consistent reporting structure or pattern which will enable the further development of knowledge based on understanding these reports (Cuganesan, 2007). The genuine interest taken by some leading banks have created a need for other banks to adopt human capital reporting.
Standard Chartered Bank has been a leader in human capital management and reporting. It is one of the first organizations, along with Royal Bank of Scotland to measure and report human capital. It recognizes that human capital is intangible and hence difficult to quantify as directly related to cost and financial implications, as the variables are too complex to decipher and harness. Hence, it uses proxies which are tied to performance, like cost of training, cost of increasing workforce, etc. to arrive at relationships between factors in human capital which it deems to be important and its actual performance, at a national and an international level. It reports these proxy relationships as individual metrics, indices and ratios, which indicate a certain level of competency or worth for the bank (Bentley, 2007). Royal Bank of Scotland also reports similar indices and ratios to quantify its human capital to its stakeholders. Though various standards have been adopted by various nations, the reporting is still not mandatory, meaning that organizations need not report, even if they do they can do it in their own ways.
Banks are service providers to retail customers and business. They are faced with a number of challenges – high competition, geographical business spread, high headcount and significant emphasis on people and service quality. People deliver quality here, and not machines or computers. Hence, the way banks and financial institutions manage their people is very important and in fact the most important factor in success.
Human capital management which emphasizes the role of employees in an organization as its assets is best suited and is very important for banks in today’s complexities in financial services. The rapid advancement in technologies have enabled banks to serve customers far away and also allowed banks and customers access to each other from far apart. Thus, the role of intangibles is more important than tangible advantages. Thus, a person could be using phone banking more frequently than a bank teller. Significant levels of automation have taken place and it would seem as if the whole banking process would be automated and there would be no people working in banks.
But human beings create this technology, knowledge and manage it. Hence, the underlying factor for success is always going to be the human edge, the edge of the employee. The worth of an employee is far more than the salary he gets paid, he is worth the knowledge he possesses. Unless this knowledge is quantified and billed accordingly, the organization cannot realize its full value and hence is bound to discount in unwarrantedly. This is more so in banking, where business relationships hold the key to retaining and acquiring customers.
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The criteria to record and recognize the inventory is also explained as instructed under International Accounting Standard 2. Inventory is separated from the Non-Current Assets like plant and equipment which are held for sale at maturity and a further categorization of inventory is given in two forms like By-Products and Main products. The item which is normally sold out by the companies through ordinary course of its activities are termed as Inventory. Generally three forms of inventory are founded in any manufacturing companies which are Finished Products, Raw Material and Work-In-Process. All three inventories have different cost classifications and nature and should be measure on separate basis. There are four cost formulas to measure the inventory and are generally practiced in the US. Four formulas are LIFO, FIFO, Weighted Average Method and Specific Identification. This also explains the concept at which the reporting cost of the inventory is provided and Inventory should be reported at lower of Cost or Net Realizable Value (NRV). Cost is the value at which the inventory is purchased including purchase cost, carriage inwards and other taxes paid on the purchase whereas the Net Realizable Value id the amount at which the inventory can be sold out in the market less any expected expenses to complete the sale process.
International Accounting Standard 2 is one of the Accounting Standards issued by the Accounting Standard Committee to record and measure the financial items pertaining financial features. International Accounting Standard 2 encompasses the recording and measurement of Inventory. Inventory is defined in the International Accounting Standard 2 as “Assets which are held for sale in the ordinary course of activity by the company and it comprises Finished Products, Raw Materials and Work-in-Process. Inventories are the goods manufactured by the company in order to obtain the economic benefits from the sale to the customers. The main objective of the issuance of this standard is to separate the Non-Current Assets of the company from the inventory which is a Current Asset. Prior to the interpretation of International Accounting Standard 2, most of the companies have faced problems in the identification and recognition of the inventory and commonly the estimation and recording of the cost of inventory was a key concern for them. International Accounting Standard 2 has led the management to maintain and report the inventory at the reasonable and appropriate value. International Accounting Standard 2 defines the items of Inventory along with the methods to record the inventory. The methods which are being interpreted under International Accounting Standard 2 are FIFO, AVCO and LIFO. First in First Out (FIFO) is the method which explains that the oldest inventory should be sold out first and then the next one whereas the Weighted Average Cost Method (AVCO) means the inventory should be recorded by calculating the average cost of available inventory and then multiply this with the number of units in stock. Last in First Out (LIFO) is a method which is not being used currently because of some drawbacks attached to it as it promotes the system to sale the most recent purchases to be sold out prior to sale the old inventory. This Standard provides detail of each and every feature associated to the inventory and how to deal with that.
Due to the misappropriation of inventory there was a need to guide the companies as to record the inventories properly. This is why the International Accounting Standard 2 was issued and interpreted in a detailed way. If the company is involved in the sale and purchase of something then it is likely to hold inventory which can be in the form of Raw Materials, Finished goods and Work-in-process. Theoretically everything which is held for sale is termed as inventory but the question rises that either the plant and machinery held for sale are also termed as inventory then the answer would be ‘No’. Everything which is sold out through ordinary course of business is termed as sales and purchases eventually known as inventory. So the Non-Current Assets are not classified as Inventory under IAS 2. There are further 3 techniques are issued under this standard to record the inventory and inventory handling. First in First out (FIFO) is a method which tends to sale the oldest unit of inventory first and it makes sense as it would reduce the threat of inventory obsolescence. Weighted Average Cost Method (AVCO) is method which uses an average cost for all the units of inventory and records the inventory on this basis so there is no separation of recent and old purchases. Last in First out (LIFO) method promotes the sale of most recent purchases and there are more chances of obsolescence of inventory. Apart from these techniques the cost recognition criteria is also listed in this standard. As per International Accounting Standard 2, inventory should be recognized at lower of Cost or Net Realizable Value (NRV). Net Realizable Value is the value at which the inventory can be sold in the market or simple the market value. Theoretically this is the fair value concept and more appropriate to record the assets as it would lead to a fair appropriation of the assets of the company and no chance of being misled.
International Accounting Standard 2 defines the criteria to record inventory “Inventory should be recorded at lower of Cost or Net Realizable value (NRV). Cost is the amount at which the Inventory is being purchased initially and whereas the NRV is the amount at which inventory can be sold out. Net Realizable Value is the amount of cost less any expenses required to make inventory into a saleable state. Though there are some problems in the recognition of inventory because there are three types of inventories in a company which are subject to value at the most appropriate amount before recognition. Finished goods are required to be valued so that it can be recorded at lower of NRV or Cost as they do not require any further assessment criteria but Work-in-Process requires some extra work to make an appropriate valuation of inventory. There is a need to consider that how much material has been incurred to the product till that date and how many labor hours has been spent on the product. There is also a further calculation of overheads cost as to how much overheads should be allocated to the Work-in-process units as they are not yet completed so there is a need to calculate the amount of overheads. Generally the overheads are absorbed by the companies by using labor hours but mostly companies also use the machine hours as the absorption base. So this can ease the calculation of overheads allocation just simply cost of labor per hour multiply by the number of labor hours or machine hours incurred to the product. Generally the wastage costs, idle labor hours, storage costs and other costs like these are also included in the product cost. In most of the production processed two type of products are produced in a single process and are named as Main product and By-Product. By-products are the products which are produced unintentionally as these are not the ordinary items of the company for sale purposes but these should also be recorded as inventory because the economic benefits are expected to flow to entity from the sale of these products and the cost of such products can be measured at the joint process phase of production.
After the recognition of per unit cost, there are some formulas for the inventory valuation generally practiced in the US. LIFO, FIFO, Weighted Average Method and Specific Identification. Under IFRS and US GAAP all these formulas are same but the practice of some formulas are limited across the world due to the drawbacks attached to them and these methods are LIFO and Specific Identification. Main drawbacks to LIFO are much more in general as it promotes the threat of Inventory obsolescence and more risk in the incorrect valuation of the inventory. Due to this reason LIFO is discouraged across the world and now Weighted Average Method and FIFO are used extensively. In the past most of companies used the LIFO as their tax shields to reduce the profits and other manipulations but after the consideration of such issues the application of LIFO is now restricted and now limited to some states only.
There are some costs which cannot be the part of inventory in any case and they should be reported as an expense to the income statement. Most common examples of these costs are:
Abnormal Wastage of material
Abnormal Idle hours of Labor
Abnormal overheads due to the Abnormal Idle Hours
Reduction in the Net Realizable value of the inventory
There are some handling costs which are not important for the product but incurred and these should not be measured in the inventory cost as well
Admin expenses and other costs associated to admin department
This research provided a complete detail of the International Accounting Standard 2. The complete criteria and detail of the inventory recognition and measurement criteria is explained in this assignment. The measurement of the inventory is based on the management’s perception but with the introduction of this standard, all the criteria and relevant aspects have cleared. Management is guided thoroughly on the measurement of inventory and the recognition of the inventory instruments as to remove the ambiguity between the inventory and other assets of the company. Management has four different formulas to record the cost of the inventory and the most practical and generally accepted formulas are the FIFO and weighted average method. Management should use the cost formula among both of these as these are the recommended and practically accepted under IFRS and US GAAP. There would not be any problem in the inventory measurement if these rules are followed. Management is required to differentiate the By-products and Main products as both of these have different characteristics and benefits and need to be separately identified. The relevant cost should be ascertained to the inventory whilst the other should be charged to the expenses like abnormal wastage and labor cost etc.