Modern entrepreneur and entrepreneurship : theory, process and practice

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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


(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


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


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


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


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


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


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.


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 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


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


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.


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


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


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


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) = Rransaction, 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.

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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

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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

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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

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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

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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

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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

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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.

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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

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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

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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

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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

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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.

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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

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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.

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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

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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.


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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.

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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


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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

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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


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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.

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I


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


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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

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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

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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

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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

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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


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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

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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


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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.

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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


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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

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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.


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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


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


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

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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

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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

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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

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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

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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?

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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

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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

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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.

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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

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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.)

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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;

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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

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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.

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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 '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:.. 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


(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


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


(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


(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


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


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

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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

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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

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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

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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.

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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

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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.

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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.

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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.

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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.

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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.

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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.

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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

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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-

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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.

***

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