Assume there are 10 members willing to form a chit fund group and contribute Rs. 10,000 per month toward the chit fund pool (known as ‘chit value’ or ‘pot’). The tenure of the chit group will be equal to the number of members in the group; this means that the chit group has a tenure of 10 months.
The ‘chit value’ or ‘pot’ amounts to Rs. 10,000 x 10 members, i.e., Rs. 1 Lakh.
An auction is held each month where members can bid for prize money.
How the auction works:
Subscribers bid for a discount on the chit value. The subscriber bidding for the highest discount on the chit value wins the prize money, and this discount offered by the winning member is also called as the auction discount. Prize money = Chit Value minus auction discount.
Therefore, from the above considered chit group, if a member bids for 30% discount on the chit value, and that discount happens to be the highest, such a member is identified as the prized subscriber and takes the prize money.
Depending on the chit fund company, 5 or 7% of the chit value is reserved for the foreman’s commission. Let’s consider that in our case, the foreman’s commission is 5% of the chit value, i.e., Rs. 5000 (5% of Rs. 1 Lakh)
30% of chit value (Rs. 1 Lakh) = Rs. 30,000.
Rs. 30,000 is treated as the auction discount.
Hence, Prize Money is Rs. 1 Lakh - Rs. 30,000 = Rs. 70,000/- (this prize money serves as the borrowing instrument for the winning member/prized subscriber).
This prize money is awarded to the winning bidder (also known as the prized subscriber)
In the next step, the amount equivalent to the foreman’s commission is deducted from the auction discount, i.e., Rs. 30,000 - Rs. 5000. The remainder discount after such deduction is Rs. 25,000/-.
This remainder discount is divided equally among all the members as the dividend (also known as chit dividend), i.e., chit dividend amounts to Rs. 25,000/10 = Rs. 2,500.
The chit dividend works as the monthly savings for all the subscribers, and in the next month’s chit instalment, they will pay Rs. 2,500 less from the Rs. 10,000 monthly chit installment decided at the commencement of the chit fund group.
This chit cycle, i.e., monthly contributions, the process of auctions, awarding the prize money, and distributing the chit dividend, continues until all the members have won an auction.