SCM Volume 2

SCM
CONCEPT AND
PRACTICE
Updated with Jan’19 Edition of ICAI Mat
and Dec’18 Edition of ICMAI Mat
For CA-CMA – Final

Volume 2
Block C and D
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Study Materials List
CA Final New CA Final Old CMA Final

1. SCM Concept and Practice Vol. 1 and 2 ✓ ✓ ✓
2. Work Book ✓ ✓ ✓
3. Divya Jadi Booti ✓
4. Case Studies and Theories ✓
5. QT and Theories ✓ ✓
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Concept & Practice
Contents
CA Final-SCM CMA Final
Chapter Page No
New Old SCM SPM
CA Final New Syllabus ✓ ✓
CA Final Old Syllabus ✓ ✓
The Three Tier Preparation Model ✓ ✓ ✓ ✓
How to Make Notes ✓ ✓ ✓ ✓
The Day before CA Final Costing Exam ✓
The Exam Hall Strategy ✓ ✓ ✓ ✓
How to Study Theories ✓ ✓ ✓ ✓
How to Approach a Question ✓ ✓ ✓ ✓
Skillwise weightage in CA Final New ✓
Syllabus
VOLUME 1
1. ✓ ✓ ✓
Traditional vs Strategic Cost Management
19 – 23
A 2.3. Relevant Costing
24 – 55 ✓
✓
✓
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Divisional Transfer Pricing
56 – 101
4. CVP Analysis 102 – 119 ✓ ✓ ✓
5. Make or Buy Decisions 120 – 132 ✓ ✓ ✓
6. Key Factors 133 – 147 ✓ ✓ ✓
B 7.
8.
Sub Contracting
Theory of Constraints
148 – 159
160 – 168
✓
✓
✓
✓
✓
✓
9. Linear Programming 169 – 179 ✓ ✓ ✓
10. Other Areas of Decision Making & Service 180 – 196 ✓ ✓ ✓
Sector
VOLUME 2
11. Total Quality Management and Innovation 197 – 223 ✓ ✓ ✓ ✓
12. Just in Time and Lean System 224 – 246 ✓ ✓ ✓
13. Activity Based Costing 247 – 258 ✓ ✓ ✓ ✓
14. Strategic Analysis of Operating Income 259 – 269 ✓ ✓ ✓ ✓
C 15.
16.
Target Costing
Pricing Strategies
270 – 281
282 – 311
✓
✓
✓
✓
✓
✓
✓
✓
17. Learning Curve Theory 312 – 323 ✓ ✓ ✓
18. Life Cycle Costing 324 – 337 ✓ ✓ ✓
19. Supply Chain Management 338 – 359 ✓ ✓ ✓
20. Standard Costing 360 – 397 ✓ ✓ ✓
D 21.
22.
Performance Evaluation
Budgeting and Budgetary Control
398 – 419
420 – 432
✓
✓
✓
✓
✓
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Concept & Practice
Scoring Priorities for this subject
1. Concepts/Understanding
2. Application / Sums Solving

3. Presentation
4. Accuracy
5. Speed
d |SCM
Concept & Practice
Total Quality Management
Chapter 11
1. TOTAL QUALITY MANAGEMENT

2. SIX SIGMA QUALITY
A. Numerical Concept of Six Sigma
B. The Value of the Defect Percentage Under Various
Sigma Levels
C. Limitations of Six Sigma
D. Lean Six Sigma
3. DMAIC
4. DMADV
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A. Similarities between DMADV and DMAIC
B. Differences between DMAIC and DMADV
5. BUSINESS PROCESS REENGINEERING
A. The four key components of BPR
B. Principles of BPR
C. Main Stages of BPR
6. PROCESS INNOVATION
7. DEMING’S 14 POINTS METHODOLOGY:
8. PDCA CYCLE OF MR. DEMING
9. FOUR P’S OF QUALITY CONTROL
10. SIX C’S OF QUALITY CONTROL
11. EIGHT DIMENSIONS OF QUALITY
12. QUALITY CONTROL COSTS - BY JOSEPH JURAN AND
PHILIP CROSBY
A. Costs associated with delivering Quality are:
B. Optimal COQ
C. Steps of Application of PAF Model
D. The Iceberg Model
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Concept & Practice| 197
1. TOTAL QUALITY MANAGEMENT

CIMA defines ‘Total Quality Management’ as “Integrated and comprehensive system
of planning and controlling all business functions so that products or services are
produced which meet or exceed customer expectations. TQM is a philosophy of busi-
ness behaviour, embracing principles such as employee involvement, continuous
improvement at all levels and customer focus, as well as being a collection of relat-
ed techniques aimed at improving quality such as full documentation of activities,
clear goal-setting and performance measurement from the customer perspective.”
2. SIX SIGMA QUALITY

Six Sigma refers to the philosophy and methods which the companies such as Motorola
and General Electric had used to eliminate defects in their products and processes.
Six Sigma is a business management strategy, originally developed by Motorola, USA in
1986, that is widely used in many sectors of industry. The core of Six Sigma was “born”
at Motorola in the 1970s out of senior executive Art Sundry’s criticism of Motorola’s bad
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quality. As a result of this criticism, the company discovered a connection between increases
in quality and decreases in costs of production. At that time, the prevailing view was that
quality costs extra money. In fact, it reduced total costs by driving down the costs for repair
or control. Six Sigma was heavily inspired by the quality improvement methodologies of
the six preceding decades, such as quality control, Total Quality Management (TQM), and
Zero Defects. Originally, it referred to the ability of manufacturing processes to produce
a very high proportion of output within specification. Processes that operate with “six
sigma quality” over the short term are assumed to produce long-term defect levels below
3.4 defects per million opportunities (DPMO). Six Sigma’s implicit goal is to improve all
processes to that level of quality or better.
Six Sigma is a registered service mark and trademark of Motorola Inc. As of 2006 Motorola
reported over US$17 billion in savings from Six Sigma.
Representation of Six Sigma Process through Normal Distribution
defects defects
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Concept & Practice
A. NUMERICAL CONCEPT OF SIX SIGMA

‘Sigma’ is a statistical term that measures how far a process deviates from perfection.
The higher the sigma number, the closer the process is to perfection.
The values of Defect Percentage
Six Sigma is 3.4 defects per million opportunities or getting things right 99.99966% of
the time. It is possible to develop ways of reducing defects by measuring the level of
defects in a process and discovering the causes.
B. THE VALUE OF THE DEFECT PERCENTAGE UNDER VARIOUS SIGMA

LEVELS
Sigma Defects per Million Percentage Percentage
Quality/ Profitability
Level Opportunities (DPMO) Defective (%) Yield (%)
1σ 6,91,462 69 31Loss
2σ 3,08,538 31 69Non-Competitive
3σ 66,807 6.7 93.3Average Industries
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4σ 6,210 0.62 99.38Above Average
5σ 233 0.023 99.977Below Maximum
Productivity
6σ 3.4 0.0034 99.99966 Near Perfection
The second last column (in above table) indicates the percentage of values that lie
within the control limits. The more popular measure, the number of defects per million
opportunities, is indicated in second column.
It may not be possible to achieve ‘perfect Six Sigma’ but relevant benefits can be
achieved from a rise from one Sigma Level to another.
C. LIMITATIONS OF SIX SIGMA

• Six Sigma focuses on quality only.
• Six Sigma does not work well with intangible results.
• Substantial infrastructure investment is required.
• Six Sigma is complicated for some tasks.
• Not all products need to meet Six Sigma standards.
• Six Sigma focuses on specific type of process only.
• There are lot to real time barriers which needs to be resolved while translating the
theoretical concepts into practical applications.
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D. LEAN SIX SIGMA

Lean Six Sigma is the combination of Lean and Six Sigma which help to achieve
greater results that had not been achieved if Lean or Six Sigma would have been
used individually. It increases the speed and effectiveness of any process within any
organization. By using lean Six Sigma, organisations will be able to Maximize Profits,
Build Better Teams, Minimize Costs, and Satisfy Customers.
3. DMAIC
While Six sigma methods include many of the statistical tools that were employed in
other quality movements, here they are employed in a systematic project oriented fashion
through the define(D), measure(M), analyze(A), improve(I) and control(C) cycle. This
cycle was developed by General Electric.
The focus of methodology, however, is understanding and achieving what the customer
wants, since that is seen as the key to profitability of a production process. In fact, to get
across this point, some use of the DMAIC as an acronym for “Dumb Managers Always
Ignore Customers”.
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This method is very robust. It is used to improve existing business process. To produce
dramatic improvement in business process, many entities have used it successfully. It has
five phases:
DMAIC is used under the following circumstances:
• A product or process exists.
• The project is part of ongoing continuous improvement process.
• Only a single process needs to be altered.
• Competitor’s actions are stable.
• Customer’s behaviour is unchanging.
• Technology is stable.
4. DMADV
The application of these methods is aimed at creating a high-quality product keeping in
mind customer requirements at every stage of the product. It is an improvement system
which is used to develop new processes or products at Six Sigma quality levels. Phases are
described in diagram:
Define the project goals and customer deliverables.
Measure and determine customer needs and specifications.
Analyze the process options to meet the customer needs.
Design (detailed) the process to meet customer needs.
Verify the design performance and ability to meet customer needs.
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Concept & Practice
DMDAV is used under the following circumstances:

• A product or process is not in existence
• Existing process has been optimised using either DMAIC or some other process.
• Project have strategic importance.
• Multiple process need to be altered.
• Competitor’s performance is changing.
• Customer’s behaviour is changing.
• Technology is growing.
A. SIMILARITIES BETWEEN DMADV AND DMAIC

• Both of these six sigma methodologies are based on defects per million
opportunities (DPMO).
• Both DMADV and DMAIC use the same kind of six sigma quality management
tools.
• Customer’s needs are the basic parameter for both six sigma methodologies.
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Both DMADV and DMAIC are fundamental six sigma methodologies for improving
quality of product/process. Broadly, DMAIC deals with improving some existing
process to make it align with customer’s needs while DMADV deals with new design
or redesign.
B. DIFFERENCES BETWEEN DMAIC AND DMADV

DMAIC DMADV
Review the existing processes and fixes
Emphases on the design of the product
problem(s) and processes.
More reactive process. Proactive process.
Increase the capability. Increase the capacity.
Rupee benefits quantified rather quickly.
Rupee benefits more difficult to quantify
and tend to be much more long term.
Examples of DMAIC problem-solving Examples of procedures that the DMADV
methods: development method is designed to
• Reduce the cycle time to process a address:
patent. • Add a new service
• Reduce the number of errors in sales • Create a real-time system.
list. • Create a multiple-source lead track-
• Improve search time for critical infor- ing system
mation.
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5. BUSINESS PROCESS REENGINEERING

In 1989, Michael Hammer, an ex-MIT computer professor turned consultant, published an
article in the Harvard Business Review titled, “Reengineering Work: Don’t Automate,
Obliterate”. Although several major companies had been experimenting with
reengineering principles prior to that time, Hammer generally is credited with first using
the term “reengineering”. Hammer defines Business Process Reengineering (BPR) (or simply
reengineering) as “the fundamental rethinking and radical redesign of business processes
to achieve dramatic improvements in critical contemporary measures of performance,
such as cost, quality, service, and speed.”
A. THE FOUR KEY COMPONENTS OF BPR

Business Process
Reengineering
Fundamental Radical Dramatic End to End

Rethinking Redesign Improvements Business Process
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• Fundamental rethinking of business processes requires management to

challenge the very basic assumptions under which it operates and to ask such
rudimentary questions as “Why do we do what we do?” and “Why do we do it the
way we do it?”
• Radical redesign relies on a fresh-start, clean-slate approach to examining
an organization’s business processes. This approach focuses on answers to the
question, “If we were a brandnew business, how would we operate our company?”
The goal is to reinvent what is done and how it is done rather than to tinker with
the present system by making marginal, incremental, superficial improvements
to what’s already being done.
• Achieving dramatic improvements in performance measurements is related to
the preceding two elements. The fundamental rethinking and radical redesign
of business processes are aimed toward making quantum leaps in performance,
however measured. BPR is not about improvement in quality, speed, and the
like that is on the order of 10%. Improvement of that order of magnitude often
can be accomplished with marginal, incremental changes to existing processes.
Reengineering, on the other hand, has much loftier objectives. For example, the
reengineering of Ford’s procurement process reduced the number of persons
employed in the process by 75%.
• Reengineering focuses on end-to-end business processes rather than on the
individual activities that comprise the processes. Michael Hammer contends that
the fragmented business processes and bureaucratic, hierarchical organization
structures evident in most businesses today have their origins in the Industrial
Revolution, when specialization of labour and economies of scale were the
promised keys to success. He argues that managers lose sight of their real
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objectives when processes are segmented into individual tasks, each task is
assigned to a specialist, and elaborate mechanisms are established to track and
control the performance of those tasks. Instead, BPR takes a holistic view of a
business process as comprising a string of activities that cuts across traditional
departmental or functional lines. BPR is concerned with the results of the process
(i.e., with those activities that add value to the process). This crossfunctional focus
has been used for many years by manufacturing companies. Reengineering
would apply that view to all business processes.
For example, consider the activities such as receiving a customer’s order, checking
the customer’s credit, verifying inventory availability, accepting the order, picking
the goods in the warehouse, and shipping the goods to the customer, as discrete
activities. Reengineering would change our emphasis by breaking down the walls
among the separate functions and departments. Instead of order taking, picking,
shipping, and so forth, the entire process of “order fulfilment” would be examined and
would concentrate on those activities that add value for the customer. The customer
is not concerned with the individual tasks that an organisation undertakes to fill an
order nor is the customer concerned with how the company organizes itself to carry
out those jobs. The customer is concerned only with getting the right goods, in the
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proper quantities, in satisfactory condition, and at the agreed-upon time and price.
B. PRINCIPLES OF BPR
The principles of successful BPR are as follows:
1. Organize around outcomes
2. Have those who need the results of a process perform the process
3. Integrate the processing of information into the work process that produces the
information
4. Treat geographically dispersed resources as though they were centralized
5. Line parallel activities instead of integrating their results
6. Put the decision point where the work is performed, and build controls into the
process
7. Capture information once and at the source
Organize around outcomes, not tasks
This principle argues that an organisation should have one person perform all the
steps in a process; design the job around an objective or outcome rather than a single
task. For example, at an electronics company a “customer service representative”
takes a customer order, translates the order into internal codes for the ordered items’
components, requisitions, receives, and assembles the item, and delivers and installs
the item. As a result, one person is responsible for getting the item to the customer
and for answering customer questions during the process. Notice that while this
eliminates many handoffs, numerous errors, delays, and misunderstandings, it also
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eliminates the traditional segregation of duties that organisations normally associate

with the order fulfilment process.
Have those who need the results of a process perform the process
Departments in organizations are organized around specialized functions performed
for customers for the output of other units. In some situations, reengineering can
provide “customers” with more timely service and reduce the overhead needed
to coordinate the activities of these units by having customers provide their own
service. For example, in exchange for the promise of more timely repairs, an electronic
equipment manufacturer asked its large customers to perform some of their own
routine repairs and to carry the spare parts inventory required for their own machines.
Now, customers make some repairs themselves using spare parts stored on site. The
field service representatives, who had been making all repairs, answer customer calls
and guide customers through a repair process using a diagnosis support system (an
expert system). A computerized inventory management system monitors the spare
parts inventories. Field service representatives are dispatched only for complex
problems. The electronics manufacturer achieved better customer service and lower
inventory carrying costs.
Integrate the processing of information into the work process that produces the
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information
At Ford Motor Company, the receiving department and the receiving system -
produced and processed information about the goods received instead of sending
it to accounts payable. The receiving system compared the goods received with the
order and took appropriate action (send the goods back or create a payable). Notice
again, the relaxing of segregation of duties. Management must evaluate and accept
the risks associated with the increased opportunity for unauthorized or inaccurate
transaction.
Treat geographically dispersed resources as though they were centralized
Decentralized resources typically provide better service to their customers at the
expense of creating redundant operations and lost economies of scale. At Hewlett-
Packard (HP), a major computer and peripherals manufacturer, 50 decentralized
purchasing factions provided excellent responsiveness and service to the plants, but
prevented HP from benefiting from quantity discounts. After reengineering, HP has a
centralized purchasing function that creates and maintains a centralized database of
vendors with whom they have negotiated contracts. Decentralized units can access
the database to execute their own purchase orders.
Line parallel activities instead of integrating their results
If parallel activities have been created, use communications networks, shared
databases, and teleconferencing to coordinate activities that must eventually come
together. For example, in the loan application process, decisions by one function that
will affect the loan decision must be immediately communicated to other functions.
Put the decision point where the work is performed, and build controls into the process
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Concept & Practice
Organisations often distinguish those who do the work from those who monitor and
make decisions about the work. This is done under the assumption that those who do
the work do not have the time, inclination, knowledge, or responsibility for monitoring
and controlling what they do. Organisations can reduce non value-added management
and flatten the organization structure if the organisations use information technology
to capture and store data, and expert systems to supply knowledge, to enable people
to make their own decisions. This changes the role of manager from controller and
supervisor to supporter and facilitator. And, as organisations flatten, they can eliminate
the middle managers who had been summarizing and reporting information to upper
management. To compensate, executives must be directly lined to databases using
executive information systems.
Capture information once and at the source
Collected and store data in online data-bases for all who need them. This principle
is facilitated by information technology, such as telecommunications, networking,
client/server architecture, EDI, image processing, relational database system, bare
coding, intelligent workflow software.
C. MAIN STAGES OF BPR

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• Process Identification Each task performed being re -engineered is broken
down into a series of processes.
• Process Rationalisation Processes which are non value adding, to be discarded.
• Process Redesign Remaining processes are redesigned.
• Process Reassembly Re-engineered processes are implemented in the most
efficient manner.
6. PROCESS INNOVATION
Process Innovation means the implementation of a new or significantly improved
production or delivery method (including significant changes in techniques, equipment
and/ or software). Changes, improvements, increase on product or service capability
done by addition in manufacturing or logical system, ceasing to use a process, simple
capital replacement or extension, changes resulting purely from changes in factor prices,
customization, regular seasonal and other cyclical changes, trading of new or significantly
improved products are not considered innovations.
The process of innovating new solutions could fall into one of these areas:
• Production: This is related to processes, equipment and technology to enhance
manufacturing or production processes. This includes computer software.
• Delivery: Delivery process innovations involve tools, techniques and software
solutions to help in supply chain and delivery systems. This includes barcodes, tracking
systems or shipping software.
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• Support Services: Innovations in processes aren’t limited to simply production or

delivery, but also areas including purchasing, maintenance and accounting.
7. DEMING’S 14 POINTS METHODOLOGY:

1. Create constancy of purpose for improving products and services.
2. Adopt the new philosophy.
3. Cease dependence on inspection to achieve quality.
4. End the practice of awarding business on price alone; instead, minimize total cost by
working with a single supplier.
5. Improve constantly and forever every process for planning, production and service.
6. Institute training on the job.
7. Adopt and institute leadership.
8. Drive out fear.
9. Break down barriers between staff areas.
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10. Eliminate slogans, exhortations and targets for the workforce.

11. Eliminate numerical quotas for the workforce and numerical goals for management.
12. Remove barriers that rob people of pride of workmanship, and eliminate the annual
rating or merit system.
13. Institute a vigorous program of education and self-improvement for everyone.
14. Put everybody in the company to work accomplishing the transformation.
8. PDCA CYCLE OF MR. DEMING

It is a detailed version of DMAIC cycle above consisting of four steps – Plan (P), Do (D),
Check (C) and Act (A).
ACT PLAN
DEMING
Circle
CHECK DO
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9. FOUR P’S OF QUALITY CONTROL

People, Process, Problem, Preparation
10. SIX C’S OF QUALITY CONTROL

• Commitment: If a TQM culture is to be developed, so that quality improvement
becomes a normal part of everyone’s job, a clear commitment, from the top must be
provided. Without this all else fails. It is not sufficient to delegate ‘quality’ issues to a
single person since this will not provide an environment for changing attitudes and
breaking down the barriers to quality improvement. Such expectations must be made
clear, together with the support and training necessary to their achievement.
• Culture: Training lies at the centre of effecting a change in culture and attitudes.
Management accountants, too often associate ‘creativity’ with ‘creative accounting’
and associated negative perceptions. This must be changed to encourage individual
contributions and to make ‘quality’ a normal part of everyone’s job.
• Continuous Improvement: Recognition that TQM is a ‘process’ not a ‘programme’
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necessitates that we are committed in the long term to the never-ending search for
ways to do the job better. There will always be room for improvement, however small.
• Co-operation: The application of Total Employee Involvement (TEI) principles is
paramount. The on-the-job experience of all employees must be fully utilised and their
involvement and cooperation sought in the development of improvement strategies
and associated performance measures.
• Customer Focus: The needs of the customer are the major driving thrust; not just the
external customer (in receipt of the final product or service) but the internal customer’s
(colleagues who receive and supply goods, services or information). Perfect service
with zero defects in all that is acceptable at either internal or external levels. Too
frequently, in practice, TQM implementations focus entirely on the external customer
to the exclusion of internal relationships; they will not survive in the short term
unless they foster the mutual respect necessary to preserve morale and employee
participation.
• Control: Documentation, procedures and awareness of current best practice are
essential if TQM implementation is to function appropriately. The need for control
mechanisms is frequently overlooked, in practice, in the euphoria of customer service
and employee empowerment. Unless procedures are in place improvements cannot
be monitored and measured nor deficiencies corrected.
11. EIGHT DIMENSIONS OF QUALITY

1. Performance: Performance refers to a product’s primary operating characteristics.
This dimension of quality involves measurable attributes; brands can usually be
ranked objectively on individual aspects of performance.
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2. Features: Features are additional characteristics that enhance the appeal of the
product or service to the user.
3. Reliability: Reliability is the likelihood that a product will not fail within a specific time
period. This is a key element for users who need the product to work without fail.
4. Conformance: Conformance is the precision with which the product or service meets
the specified standards.
5. Durability: Durability measures the length of a product’s life. When the product
can be repaired, estimating durability is more complicated. The item will be used until
it is no longer economical to operate it. This happens when the repair rate and the
associated costs increase significantly.
6. Serviceability: Serviceability is the speed with which the product can be put into
service when it breaks down, as well as the competence and the behavior of the
serviceperson.
7. Aesthetics: Aesthetics is the subjective dimension indicating the kind of response a
user has to a product. It represents the individual’s personal preference.
8. Perceived Quality: Perceived Quality is the quality attributed to a good or service
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based on indirect measures.
12. QUALITY CONTROL COSTS - BY JOSEPH JURAN AND PHILIP

CROSBY
A. COSTS ASSOCIATED WITH DELIVERING QUALITY ARE:
Cost of Quality
Cost of Poor Quality Cost of Good Quality

or or
Price of Non Conformance Price of Conformance
or or
Cost of Failure of Control Cost of Control
Internal Failure External Failure Appraisal Prevention

Cost Cost Cost Cost
(a) Appraisal Costs: - These are connected with measuring conformity with
requirements and include –
1. Cost of incoming inspections (note that if suppliers adopt a total quality
approach, this cost can be eliminated)
2. Cost of set up inspections
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3. Cost of acquiring and operating the process control and measuring

equipment.
(b) Prevention Costs: - These are the costs of ensuring that defects do not occur in
the first place. These may be –
1. Routine preventive repairs and maintenance to equipment
2. Quality training for operatives to improve skills and efficiency. Training
employees works provided the employee also understand and accept the
benefits of such training. Training can occur both inside and outside the
workplace. Internal training may include the ideas of team working and
quality discussion groups, which are known as QUALITY CIRCLES.
3. Building of quality into the design and manufacturing process. When a
product is designed, its specification should consider factors that will
minimise future rectification costs. Production methods should be as simple
as possible and use the skills and resource existing within the sphere of
knowledge of the organisation and its employees.
(c) Internal Failure Costs:- These costs are:
1. Costs of scrap
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2. Reworking costs
3. Manufacturing and process engineering required to correct the failed
process.
It is contended that, in many companies, the costs of internal failure are so great
that a total quality programme can be financed entirely from the savings that are
made from it – hence the expression ‘quality is free’.
(d) External Failure Costs:- These costs are:
1. Marketing costs associated with failed products and loss of customer
goodwill.
2. Manufacturing or process engineering costs relating to failed products
externally.
3. Compensation or replacement for units returned by customers.
4. Repair costs (after sales)
5. Travel costs to visit sites with faulty products
B. OPTIMAL COQ
It is generally accepted that an increased expenditure in prevention and appraisal is
likely to result in a substantial reduction in failure costs. Because of the trade off, there
may be an optimum operating level in which the combined costs are at a minimum.
Hence it is further argued that striving for zero defects through a program of continuous
improvements is not good for the economic interest of the company.
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Total Costs
Cost of
Non-conformance
Cost of
conformance
0 1 2 3 4 % defects
C. STEPS OF APPLICATION OF PAF MODEL

The prevention, appraisal, and failure (PAF) model is the most widely accepted method
for measuring and classifying quality costs. Follow this five-step process.
1. Gather some basic information about the number of failures in the system
2. Apply some assumptions to that data in order to quantify the data
3. Chart the data based on the four elements listed above and study it
4. Allocate resources to combat the weak-spots.
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5. Do this study on a regular basis and evaluate your performance
D. THE ICEBERG MODEL

Many of the costs of quality are hidden and thus making it difficult to identify by formal
measurement systems. The iceberg model is very often used to illustrate this matter:
Waste
Customer
Rejects Returns Inspection
Costs
Rework Testing Costs Recalls
Excessive Overtime Excessive Field Incorrectly

Service Expenses Late Completed Sales Order
Pricing or Paperwork
Billing Errors
Planning Delays Unused Capacity
Excessive Excess Inventory
Employee Development Complaint
Fluctuation Cost of Failed Handling
Product
Time with
Dissatised Customer
Excessive IT
System Costs
Only a minority of the costs of poor and good quality is obvious – appear above the
surface of the water. The reduction of cost under water has a huge scope. If we identify
and improve these costs, the costs of doing business will significantly reduce.
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1
Quality products can be determined by using a few of the dimensions of quality. Identify the
following under the appropriate dimension:
(i) Consistency of performance over time.
(ii) Primary product characteristics.
(iii) Exterior finish of a product
(iv) Useful life of a product.
Solution
Quality of Products with Appropriate Dimension
Sl. Quality of Products (Examples) Dimension
(i) Consistency of performance over time Reliability
(ii) Primary product characteristics Performance
(iii) Exterior finish of a product Aesthetics
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(iv) Useful like of a product Durability
Reference What’s New

Eight Dimensions of Quality
2
Classify the following items under the appropriate category of quality costs viz. Prevention cost,
appraisal cost, internal failure cost and external failure cost:
(a) Rework
(b) Disposal of scrap
(c) Warranty repairs
(d) Revenue loss
(e) Repairs to manufacturing equipment
(f) Discount on defective sale
(g) Raw material inspection
(h) Finished product inspection
(i) Establishment of quality circles
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(j) Packaging inspection

(k) Quality Consultant Cost
(l) Re-purchase of components to create replacement
(m) Customer survey for feed back on quality
(n) Employee time spend on reviewing and assessing the quality of output.
(o) Testing of material of special nature from outside laboratory.

Quality Control Cost
3
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TQM ltd. implemented a quality improvement programme and had the following results:
2010 2011
(` in ‘000) (` in ‘000)
Sales 6,000 6,000
Scrap 600 300
Rework 500 400
Production inspection 200 240
Product warranty 300 150
Quality training 75 150
Material inspection 80 60
You are required to:
(a) Classify the quality costs as prevention, appraisal, internal failure and external failure and
express each class as a percentage of sales.
(b) Compute the amount of increase in profits due to quality improvement.

Quality Control Cost
212 |SCM
Concept & Practice
4
The following is the information regarding turnover and quality cost of the company:
(i) Sales revenue – ` 10,000,000. Net income – ` 10,00,000
(ii) During the year, customers returned 30,000 units needing repair. Repair cost averages ` 7
per unit.
(iii) Six inspectors are employed, each earning an annual salary of ` 25,000. These six inspec-
tors are involved only with final inspection (Product acceptance).
(iv) Total scrap is 30000 units. All scrap is quality related. The cost of scrap is about ` 15 per unit.
(v) Each year, approximately 150000 units are rejected in final inspection. Of these units, 80
percent can be recovered through rework. The cost of rework is ` 3 per unit.
(vi) A customer cancelled an order that would have increased the profits by ` 2,50,000. The
customer’s reason for cancellation was poor product performance. The accounting and
marketing departments agree that the company loses at least this much during the year
for the same reason.
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(vii) The company employs five full time employees in its complaint department, Each earns `
20,000 a year.
(viii) The company gave sales allowances totalling ` 1,30,000 due to substandard products be-
ing sent to the customer.
(ix) The company requires all new employees to take in three hour Quality – Training pro-
gramme. The estimated cost for the programme is ` 80,000
(x) Inspection of the final product requires testing equipment. The annual cost of operating
and manufacturing this equipment is ` 1,20,000
Required:
Prepare a simple quality cost report classifying costs by rational category.

Quality Control Cost Report
CMA Final Dec’18
SCM
5
Carlon Ltd makes and sells a single product, the unit specification are as follows:
Direct Materials X 8 sq mt at ` 40 per square metre

Machine time 0.6 Running hours
Machine cost per gross hour ` 400
Selling price ` 1,000
Carlon ltd requires to fulfil orders for 5,000 product units per period. There are no stocks of
product units at the beginning or end of the period under review. The stock level of Material X
remains unchanged throughout the period.
Carlon ltd is planning to implement a Quality Management Programme (QMP). The following
additional information regarding costs and revenues are given as of now and after implemen-
tation of Quality Management Programme.
Before the implementation of QMP After the implementation

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5% of incoming material from suppliers scrapped due to poor Reduced to 3%

receipt and storage organisation.
4% of material X input to the machine process is wasted due Reduced to 2.5%
to processing problems.
Inspection and Storage of Material X costs ` 1 per sq mt. No change in the unit rate
Purchased
Inspection during the production cycle, calibration checks on Reduction of 40% of the
inspection equipment, vendor rating and other checks cost ` existing cost
2,50,000 per period.
Production quantity is increased to allow for the downgrading Reduction to 7.5%
of 12.5% of the production units at the final inspection stage.
Downgraded units are sold as ‘seconds’ at a discount of 30% of
the standard selling price.
Production quantity is increased to allow for return from cus- Reduction to 2.5%
tomers (these are replaced free of charge) due to specification
failure and account for 5% of units actually delivered to cus-
tomers.
Product liability and other claims by customers is estimated at Reduction to 1%
3 % of sales revenue from standard product sale.
Machine idle time is 20% of gross machine hours used (i.e. Reduction to 12.5%
Running hours = 80% of Gross Hours)
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Concept & Practice
Sundry costs of administration, selling and distribution total – Reduction by 10% of the
` 6,00,000 per period. existing
Prevention programme costs ` 2,00,000 Increase to ` 6,00,000
The QMP will have a reduction in Machine run time required per product unit to 0.5 hour.
Required:
1. Prepare summaries showing the calculation of (i) Total production unit (pre – inspection).
(ii) Purchase of Materials X (square metres), (iii) Gross Machine Hours. In each case, the fig-
ures are required for the situation both before and after the implementation of the QMP so
that orders for 5,000 product units can be fulfilled.
2. Prepare Profit and Loss Account for Carlon Ltd for the period showing the profit earned
both before and after the implementation of the Total Quality Programme.

Comparative Profitability before and after
TQM
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6
The budget estimates of a company using sophisticated high speed machines based on a
normal working of 50,000 machine hours are as under:
` in lakhs
Sales (1,00,000 units) 100
Raw materials 20
Direct wages 20
Factory overheads – Variable 10
Fixed 10
Selling and distribution overheads – Variable 5
Fixed 5
Administrative overhead – Fixed 10
Total costs 80
Profit 20
Since the demand for the company product is high the possibilities of increasing the production
are explored by the budget committee. The Technical Director stated that maintenance has not
been given due importance in the budget and that if preventive maintenance is introduced, the
breakdown repair costs and the hours lost due to breakdown can be reduced and consequently
production can be increased.
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In support of this, he presented the following data, showing how injection of more and more
funds on preventive maintenance will bring down the break – down repair costs and reduce or
eliminate stoppages due to breakdown: -
Proposed expenditure on Expenditure estimated to be
Machine hours saved
preventive maintenance (`) incurred on breakdown (`)
19,200 1,92,000 Nil
38,400 1,53,600 800
76,800 1,15,200 1,600
1,53,600 76,800 2,400
3,07,200 57,600 3,200
6,14,400 - 4,000
Using the differential cost and contribution concept, advise the management upto what level
breakdown hours can be reduced to increase production and maximise profits of the company
consistent with minimum costs.
Incremental analysis of Preventive Mainte-
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nance Cost
7
A company manufactures a single product, which requires two components. The company
purchases one of the components from two suppliers: X Ltd and Y Ltd. The price quoted by X
Ltd. is ` 180 per hundred units of the component and it is found that on an average 3 % of the
total receipt from this supplier is defective. The corresponding quotation from Y ltd is ` 174 per
hundred units, but the defective would go up to 5%. If the defectives are not detected, they are
utilised in production causing a damage of ` 180 per 100 units of the components.
The company intends to introduce a system of inspection for the components on receipt. The
inspection cost is estimated at ` 24 per 100 units of the component. Such an inspection will be
able to detect only 90% of the defective components received. No payment will be made for
components found to be defective in inspection.
(a) Advise whether inspection at the point of receipt is justified?
(b) Which of the two suppliers should be asked to supply? Assume total requirement is 10,000
units of the component.
216 |SCM
Concept & Practice

Implementation of Inspection Program
8
A company has a normal manufacturing capacity of 1,50,000 units of a product per annum. The
actual costs based on this output achieved during the last year were as under:
`
Direct material 36
Direct labour 20
Variable overheads 20
Fixed overheads 20
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The budget for the next year envisages the following increases:
Direct materials 33 1/3 %

Direct labour 10 %
Variable overheads 5%
Fixed overheads 15 %
In view of the substantial increase in material costs, the company explored the possibilities of
using a substitute material. The company has been able to identify a cheaper source of direct
materials which will cost ` 40 per unit of output.
The tests reveal that the use of cheaper direct material as above will make the following impact
on the costs:
(i) The direct labour cost will increase by ` 1 per unit of output.
(ii) It will lead to 5% rejection in output.
(iii) It will result in a final quality testing programme evaluating an additional fixed cost of `
4,00,000.
The selling prices are estimated as under for different levels of sales volume for the next year:
Selling price per unit (`) 128 136 144 152 160 168 176
Demand (‘000 units) 190 170 150 140 125 110 95
Required:
(i) Advise whether the company should use the regular direct materials or cheaper direct
materials to maximise its profitability by producing the normal volume of output.
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(ii) Considering the range of selling prices estimated at different volumes of output, deter-
mine the selling price which will maximise the profit if (A) regular direct materials are used
and (B) Cheaper direct materials are used.
(iii) Calculate for the price selected by you in (ii) above, the amount of additional fixed cost at
which the company will be indifferent in choice of direct materials.
(iv) Find Indifference point of the additional quality cost if selling price is ` 160 per unit

Comparative Study of using regular and
cheaper substitute material
9
A Ltd. produces and markets a range of consumer durable appliances. It ensures after sales
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service through X ltd. The big appliances are serviced at customer’s residence while small appli-
ances are serviced at workshop of X ltd.
The material supplied to X ltd is charged at cost + 10 %. X ltd charges customers at 25 % over
the above price. For labour, the company receives 10 % of the rate fixed for work done under
the after sales service agreement and 15 % of the rate fixed in case jobs not covered under the
agreement from X Ltd. 60 % by value of the total work undertaken by X Ltd was for big appli-
ances and rest accounted for small appliances during the previous year.
The company decides to carry out all or some of the work itself and has chosen one area in the
first instance. During the previous year the company earned a profit of ` 2,16,000 as detailed
below from X Ltd. for the area chosen:
Particulars Materials (`) Labour (`)
Under after sales service agreement 60,000 1,00,000
For jobs not covered under the agreement 20,000 36,000
The company forecasts same value of work in that area for the ensuing period.
The following three options are under consideration of the management:
(1) To set up a local service centre to provide service for small appliances only. The existing
system is to continue for big appliances.
(2) To set up a local services centre to provide service for big appliances only. The existing
system is to continue for small appliances.
(3) To set up a local service centre to provide service to all appliances. The existing system
then stands withdrawn.
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Concept & Practice
The relevant costs for carrying out jobs under the above options are as under:
Particulars (` ‘000) Option 1 Option 2 Option 3

Heat, rent, light, etc 125 50 150
Management costs 108 83 150
Service staff costs 230 440 750
Transport costs 25 220 230
You are required to find out the most profitable option.

Evaluation of After sale service implemen-
tation
10
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A company makes a single product which sells at ` 800 per unit and whose variable cost of
production is ` 500 per unit. Production and sales are 1,000 units per month. Production is
running to full capacity and there is market enough to absorb an additional 20% of output each
month.
The company has two options:
Option 1: Inspect finished goods at ` 10,000 per month. 4% of production is detected as defec-
tives and scrapped at no value. There will be no warranty replacement, since every defect is
detected. A small spare part which wears out due to defective material is required to be replaced
at ` 2,000 per spare for every 20 units of scrap generated. This repair cost is not included in the
manufacturing cost mentioned above.
Option 2: Shift the finished goods inspection at no extra cost to raw material inspection, (since
defective raw materials are entitled to free replacement by the supplier), take up the machine
set up tuning and machine inspection at an additional cost of ` 8,000 per month, so that scrap
of finished goods is completely eliminated. However, delivery of uninspected finished products
may result in 1 % of the quantity sold to be replaced under free warranty due to minor variation
in dimensions, which does not result in the wearing out of the spare as stated in Option 1.
(i) Using monthly figures relevant for decision making, advise which option is more beneficial
to the company from a financial perspective.
(ii) Identify the quality costs that can be classified as
a. Appraisal costs and
b. External failure costs.
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Incremental analysis of Quality Control
Cost
11
Burdoy Ltd has a dedicated set of production facilities for component X. A just in time system is
in place such that no stocks of materials, work in progress or finished goods are held.
At the beginning of period 1, the planned information relating to the production of component
X through the dedicated facilities is as follows:
(i) Each unit of component X has input materials: 3 units of material A at ` 18 per unit and 2
units of material B at ` 9 per unit.
(ii) Variable cost per unit of component X (excluding materials) is ` 15 per unit worked on.
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(iii) Fixed costs of the dedicated facilities for the period is ` 1,62,000.
(iv) It is anticipated that 10 % of the units of X worked on in the process will be defective and
will be scrapped.
It is estimated that customers will require replacement (free of charge) of faulty units of
component X at the rate of 2 % of the quantity invoiced to them in fulfilment of orders.
Burdoy Ltd is pursuing a total quality management philosophy. Consequently all losses
will be treated as abnormal in recognition of a zero defect policy and will be valued at
variable cost of production.
Actual statistics for each period 1 to 3 for component X are shown in Appendix below. No
changes have occurred from the planned price levels from materials, variable overhead or
fixed overhead costs.
Required:
(a) Prepare an analysis of the relevant figures provided in Appendix to show that the period 1
actual results were achieved at the planned level in respect of (i) quantities and losses and
(ii) unit cost levels for material and variable costs.
(b) Use your analysis from (a) in order to calculate the value of the planned level of each of
internal and external failure costs for period 1.
(c) Actual free replacements of components to customers were 170 units and 40 units in peri-
ods 2 and 3 respectively. Other data relating to period 2 and 3 is shown in Appendix.
Burdoy Ltd authorized additional expenditure during period 2 and 3 as follows:
Period 2: Equipment accuracy checks of ` 10,000 and staff training of ` 5,000.
220 |SCM
Concept & Practice
Period 3: Equipment accuracy checks of ` 10,000 plus ` 5,000 of inspection costs, also staff
training costs of ` 3,000 on extra planned maintenance of equipment.
Required:
i. Prepare an analysis for each of periods 2 and 3 which reconciles the number of
components invoiced to customers with those worked on in the production process.
The analysis should show the change from the planned quantity of process losses and
changes from the planned quantity of replacement of faulty components in customer
hands. (All relevant working notes should be shown).
ii. Prepare a cost analysis for each of periods 2 and 3 which shows actual internal failure
costs, external failure costs, appraisal costs and prevention costs.
iii. Prepare a report, which explains the meaning and inter relationship of figures in
Appendix and in analysis (a), (b) and (c) (i)/ (ii). The report should also give examples
of each cost type and comment on their use in the monitoring and progressing of the
TQM policy being pursued by Burdoy Ltd.
Appendix
Actual statistics for Component X
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Period 1 Period 2 Period 3
Invoiced to customers (units) 5,400 5,500 5,450
Worked on in process (units) 6,120 6,200 5,780
Total cost:
Material A and B (`) 4,40,640 4,46,400 4,16,160
Variable costs of production (excluding material costs) (`) 91,800 93,000 86,700
Fixed Costs (`) 1,62,000 1,77,000 1,85,000

Comparative Profitability before and after
TQM
Answer
(a) (i)
Components worked on in the process (units) 6,120
Less: Planned defective units (10% of 6,120) 612
Replacements to customers (2 % of 5,400) 108
Components invoiced to customers 5,400
The actual details are matching exactly with the planned level of defects and replace-
ments.
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(ii) Planned component cost = (3 × ` 18 for material A) + (2 × ` 9 for material B) + ` 15

variable cost = ` 87
Comparing with data in the appendix:
Materials = ` 4,40,640 / 6,120 = ` 72
Variable overhead = ` 91,800/ 6,120 = ` 15
The actual details are matching exactly with the planned level of cost per unit.
(b) Internal failure cost = ` 53,244 (612 units × ` 87)
External failure cost = ` 9,396 (108 units × ` 87)
(c) (i)
Period 2 Period 3
Particulars
Actual Planned Diff. Actual Planned Diff.
Worked on in process 6,200 6,200 5,780 5,780
Less: Defects 530 620 90 290 578 288
Components Delivered 5,670 – 5,490 –
Less: Free Replacements
(60) 69 170 110 40 109
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Components Invoiced 5,500 5,500 5,450 5,450

(ii)
Particulars Period 2 Period 3
Internal Failure costs – Defects 46,110 (530 x 87) 25,350 (290 x 87)
External failure cost – Warranty 14,790 (170 x 87) 3,480 (40 x 87)
Appraisal costs – Equipment accuracy 10,000 15,000
checks
Prevention costs – Staff training 5,000 8,000
(iii) The following points should be included in the report:
1. Insufficient detail is provided in the statistics shown in the appendix thus resulting in
the need for an improvement in reporting.
2. The information presented in (c) (i) indicates that free replacement to customers were
60 greater than planned in period 2 but approximately 70 less than planned in period
3. In contrast, the in process defects were 90 less than planned (approximately 15 %)
in period 2 and 288 less than plan (approximately 50 %) in period 3.
3. Internal failure costs show a downward trend from periods 1-3 with a substantial
decline in period 3. External failure costs increased in period 2 but declined significantly
in period 3.
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Concept & Practice
4. The cost savings arising in period 2 and 3 are as follows:

Particulars Period 2 (`) Period 3 (`)
Increase/ Decrease from previous
period:
Internal failure costs -7,134 (53,244 – 46,110) -20,880 (46,110 – 25,230)
External failure costs + 5,394 (9,396 – 14,790) -11,310 (14,790 – 3.480)
Total Decrease -1.740 -32,190
The above savings should be compared against the investment of ` 10,000 appraisal costs
and ` 5,000 prevention costs for period 2 and ` 15,000 appraisal cost and ` 8,000 prevention
cost in period 3. It can be seen that the costs exceed the savings in period 2 but the savings
exceeded the costs in period 3. There has also been an increase in the external failure costs
from period 1 to period 2. Investigations should be made relating to the likely time lag
from incurring prevention or appraisal costs and their subsequent benefits.
5. The impact on customer goodwill from the reduction in replacements should also be ex-
amined.
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Just in Time and Lean System
Chapter 12
1. LEAN SYSTEM
2. JUST-IN-TIME (JIT) – THE PULL SYSTEM

A. “Process that vastly reduces the amount of raw materials
inventory and improves the quality of received parts”
B. “Process in which a company reduces the amount of
work-in-process, while also shrinking the number of
products that can be produced before defects are identi-
fied and fixed, thereby reducing scrap costs”
C. “Processes in which company alters in supporting
accounting system”
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D. Main features of JIT production system:

E. Essential Pre-requisites of a JIT system
F. Performance Measurements in JIT
3. KAIZEN COSTING
A. Kaizen Costing Principles
B. Kaizen Costing vs Standard Costing
4. TOTAL PRODUCTIVE MAINTENANCE (TPM)

A. How TPM can be introduced in the organization?
B. Eight pillars of TPM with 5 S strategy as foundation.
C. Performance Measurement in TPM - Overall Equipment
Effectiveness
D. Connection Between TQM and TPM
5. ACCOUNTING FOR PULL SYSTEM – BACK FLUSH

COSTING
A. Problems with back-flushing
B. Two variants of Back Flush Costing
6. TIME ANALYSIS UNDER JIT
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Concept & Practice
1. LEAN SYSTEM
Lean System is an organized method for waste minimization without sacrificing productivity
within a manufacturing system. Lean implementation emphasizes the importance of
optimizing work flow through strategic operational procedures while minimizing waste
and being adaptable.
Waste is any step or action in a process that is not required to complete a process successfully
(called “Non-Value Adding”). When Waste is removed, only the steps that are required
(called “Value-Adding”) to deliver a satisfactory product or service to the customer remain
in the process.
There are generally 7 type of wastes:
1. Overproduction: Producing ahead of demand.
2. Inventory: Having more inventory than is minimally required at any point in the
process, including end-product.
3. Waiting: Waiting includes products waiting on the next production step.
4. Motion: People or equipment moving or walking more than is required to perform
the process.
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5. Transportation: Moving products that is not actually required to perform the process.
6. Rework from defects: Non-right first time.
7. Over Processing: Unnecessary work elements (non-value added activities).
Many large manufacturing companies like General Motors and Toyota are into lean
manufacturing. Lean manufacturing involves a shift in traditional thinking, from batch and
queue to product-aligned pull production. Instead of producing a lot of parts, the focus is
on different types of operations conducted adjacent to each other in a continuous flow.
Some of the techniques are:
(a) Just-in-Time (JIT)
(b) Kaizen Costing
(c) 5 S
(d) Total Productive Maintenance (TPM)
(e) Cellular Manufacturing/ One-Piece Flow Production Systems
(f) Six Sigma (SS)
Most of these applications are based on following principles:
• Perfect first-time quality
• Waste minimization
• Continuous improvement
• Flexibility
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The characteristics of lean manufacturing:

• Zero waiting time
• Zero inventory
• Pull processing
• Continuous flow of production
• Continuous finding ways of reducing process time.
2. JUST-IN-TIME (JIT) – THE PULL SYSTEM

A just in time approach is a collection of ideas that streamline a company’s production
process activities to such an extent that wastage of all kinds viz., of time, material, and
labour is systematically driven out of the process. JIT has a decisive, positive impact on
product costs.
CIMA defines:
“Just-in-time (JIT): System whose objective is to produce or to procure products or
components as they are required by a customer or for use, rather than for stock. just-
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in-time system Pull system, which responds to demand, in contrast to a push system,
in which stocks act as buffers between the different elements of the system such as
purchasing, production and sales”.
“Just-in-time production: Production system which is driven by demand for finished
products, whereby each component on a production line is produced only when needed
for the next stage”.
“Just-in-time purchasing: Purchasing system in which material purchases are contract-
ed so that the receipt and usage of material, to the maximum extent possible, coincide”.
A complete JIT system begins with production, includes deliveries to a company’s

production facilities, continues through the manufacturing plant, and even includes the
types of transactions processed by the accounting system.
A. “PROCESS THAT VASTLY REDUCES THE AMOUNT OF RAW MATE-

RIALS INVENTORY AND IMPROVES THE QUALITY OF RECEIVED
PARTS”
• To begin with, a company must ensure that it receives products/spare parts/
materials from its suppliers on the exact date and at the exact time when they
are needed. For this reason the purchasing staff must investigate and evaluate
every supplier, eliminate those which could not keep up with the delivery dates.
• In addition, deliveries should be sent straight to the production floor for immediate
use in manufactured products, so that there is no time to inspect incoming parts
for defects.
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Concept & Practice
• Instead, the engineering staff must visit supplier sites and examine their processes,
not only to see if they can reliably ship high-quality parts but also to provide them
with engineering assistance to bring them up to a higher standard of product.
• As soon as suppliers certify for their delivery and quality, the concern must
install a system, which may be as simplistic as a fax machine or as advanced as
an electronic data interchange system or linked computer systems, that tells
suppliers exactly how much of which parts are to be sent to the company.
• Drivers then bring small deliveries of product to the company, possibly going to
the extreme of dropping them off at the specific machines that will use them first.
B. “PROCESS IN WHICH A COMPANY REDUCES THE AMOUNT OF

WORK-IN-PROCESS, WHILE ALSO SHRINKING THE NUMBER OF
PRODUCTS THAT CAN BE PRODUCED BEFORE DEFECTS ARE IDEN-
TIFIED AND FIXED, THEREBY REDUCING SCRAP COSTS”
• Next, we shorten the setup times for concern’s machinery. In most of the
factories equipment is changed over to new configurations as rarely as possible
because the conversion is both lengthy and expensive. When setups take a long
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time, company management authorises long production runs, which spreads the
cost of the setup over far more units, thereby reducing the setup cost on a per-
unit basis. However, with this approach too many products are frequently made
at one time, resulting in product obsolescence, inventory carrying costs, and
many defective products (because problems may not be discovered until a large
number of items have already been completed). ‘But under JIT system a different
approach to the setup issue is followed which focuses on making a video tape
of a typical set up, instead of reducing the length of equipments setups and
thereby eliminating the need for long production runs to reduce per unit costs. A
team of industrial engineers and machine users examines this tape, spotting and
gradually eliminating steps that contribute to a lengthy setup’ . It is not unusual,
after a number of iterations, to achieve setup times of minutes or seconds when
the previous setup times were well into hours.
• It is not sufficient to reduce machine setup times because there are still problems
with machines not being coordinated properly so that there is a smooth,
streamlined flow of parts from machine to machine. In most of the companies
there is such a large difference between the operating speeds of different
machines that work-in-process inventory builds up in front of the slowest ones.
Not only does this create an excessive quantity of work-in-process inventory, but
defective parts produced by an upstream machine may not be discovered until
the next downstream machine operator works his way through a pile of work-in-
process and finds them. By the time this happens the upstream machine may have
created more defective parts, all of which must now be destroyed or reworked.
There are two ways to resolve both problems.
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(a) The first involves a “kanban card,” which is a notification card that a
downstream machine sends to each machine that feeds it parts, authorizing
the production of just enough components to fulfill the production
requirements being authorized in turn by the next machine further
downstream. This is also known as a “pull” system, since kanbans are initiated
at the end of the production process, pulling work authorizations through the
production system. With this approach, there is no way for work-in-process
inventory to build up in the production system, since it can be created only
with a kanban authorization.
(b) The second way to reduce excessive work-in-process inventory and
defective parts, is to, group machines into working cells. A working cell is
a small cluster of machines which can be run by a single machine operator.
This individual machine operator takes each output part from machine to
machine within the cell; and thus there is no way for work-in-process to
build up between machines. Also, this operator can immediately identify
defective output which otherwise is difficult for each machine of the cell. This
configuration has the additional benefit of lower maintenance costs since the
smaller machines used in a machine cell are generally much simpler than the
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large, automated machinery they replace. Also, because the new machines
are so small, it is much easier to reconfigure the production facility when
it is necessary to produce different products, avoiding the large expense of
carefully repositioning and aligning equipment.
Both kanbans and machine cells should be used together—they are not mutually
exclusive. By doing so a company can achieve extremely low product defect rates,
as well as vanishingly small investments in work-in-process inventory.
• Before the preceding steps are completed, it becomes apparent that a major
change must also be made in the work force. The traditional approach is to have
one employee maintaining one machine, which is so monotonous that workers
quickly lapse into apathy and develop a complete disregard for the quality of their
work. Now, with full responsibility for a number of machines, as well as product
quality, workers become much more interested in what they are doing. To enhance
this situation the human resource development department of organisation must
prepare and organise training classes to teach to employees how to operate
a multitude of different machines, perform limited maintenance on the
machines without having to call in the maintenance staff, spot product errors,
understand how the entire system flows, and when to halt the production
process to fix problems. In short, the workforce must be completely retrained
and focused on a wide range of activities. This usually results in a reconfiguration
of the compensation system as well, because the focus of attention shifts away
from performance based to high production volumes and in the direction of
performance based to high product quality.
• A major result of having an empowered workforce is that employees are allowed
to stop their machines when they see a problem, and either fix it on the spot or
immediately call in a repair team. In either case the result is immediate resolution
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Concept & Practice
of the bulk of performance problems. This one step has a profound impact
on much of the manufacturing variance analysis. Historically, management
accountants compile all kinds of variance information at the end of each month,
investigate problems in detail, and then present a formal problem analysis report
to management a few weeks after the end of the month. However, because the
production staff resolved the underlying issues within a few minutes of their
occurence, the variance report becomes a complete waste of time. Management
no longer cares what happened a month in the past because it is presently dealing
with current problems that will not appear on management accountant reports
for weeks to come. In short, the quick response capabilities of a JIT system allows
the management accountant to omit a large amount of the variance reporting
that was previously an important central job function.
C. “PROCESSES IN WHICH COMPANY ALTERS IN SUPPORTING AC-

COUNTING SYSTEM”
• Finally, the massive changes caused by a JIT system also requires several
alterations in the supporting accounting systems. Because of the large number
of daily supplier shipments, the accounting staff faces the prospect of going
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through a large pile of accounts payable paperwork. To make the problem worse
there is no receiving paperwork, because the suppliers deliver parts directly
to the production operation, so there is no way to determine if deliveries have
been made. To avoid the first problem, accountants can switch to making a
single consolidated monthly payment to each supplier. The second problem
requires a more advanced solution. To prove that a supplier has delivered the part
quantities which it claims it has, the accounting system that can determine the
amount of finished products created during the period and then multiply these
quantities by the parts listed on the bill of materials for each product, obtaining
a total quantity for each part used. The accountants then pay suppliers based
on this theoretical production quantity, which is also adjusted for scrap during
the production process (otherwise suppliers—unfairly—will not be paid for their
parts that are scrapped during the company’s production process). This approach
also means that there is no need for suppliers to send invoices, since the
company relies solely on its internal production records to complete payments.
Clearly, the changes imposed by a JIT system are profound and can greatly improve
company operations when installed and operated correctly. They can also have a
profound effect on product costs.
So, JIT system aims at:
• Meeting customer demand in a timely manner
• Providing high quality products and
• Providing products at the lowest possible total cost.
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D. MAIN FEATURES OF JIT PRODUCTION SYSTEM:

• Organise production in manufacturing cells, a grouping of all the different types
of equipment used to make a given product. Materials move from one machine
to another where various operations are performed in sequence. Material –
handling cost are reduced.
• Hire and retain workers who are multi-skilled so that they are capable of performing
a variety of operations, including repairs and maintenance tasks. Thus, labour idle
time gets reduced.
• Apply TQM to eliminate defects. As, there are tight link stages in the production
line, and minimum inventories at each stage, defect arising in one stage can
hamper the other stages. JIT creates urgency for eliminating defects as quickly
as possible.
• Place emphasis on reducing set-up time which makes production in smaller
batches economical and reducing inventory levels. Thus, company can respond
to customer demand faster.
• Carefully selected suppliers capable of delivering high quality materials in a
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timely manner directly at the shop – floor, reducing the material receipt time.
E. ESSENTIAL PRE-REQUISITES OF A JIT SYSTEM

• Low variety of goods
• Vendor reliability
• Good communication
• Demand stability
• TQM
• Defect free materials
• Preventive maintenance
F. PERFORMANCE MEASUREMENTS IN JIT

(a) Small machines, small investment, lesser need to justify
(b) Rewarding employees on quality or improvements
(c) Eliminating labour efficiency variance altogether
(d) High inventory turnover ratio (Toyota achieved 70 times)
(e) Concern for Customer Complaints
(f ) Reduction of scrap
(g) Keeping track of cost of quality
(h) Customer Service – On time delivery, shipping full orders and no returns
(i) Ideas generated by employees
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Concept & Practice
3. KAIZEN COSTING
Lean manufacturing is founded on the idea of kaizen, or continual improvement. Continuous
improvement is the continual examination and improvement of existing processes and is
very different from approaches such as business process re-engineering (BPR), which seeks
to make radical one-off changes to improve an organization’s operations and processes.
This philosophy implies that small, incremental changes routinely applied and sustained
over a long period result in significant improvements.
The kaizen strategy aims to involve workers from multiple functions and levels in the
organization in working together to address a problem or improve a particular process.
Some of the activities in the kaizen costing methodology include the elimination of waste
in the production, assembly, and distribution processes, as well as the elimination of work
steps in any of these areas. Though these points are also covered in the value engineering
phase of target costing, the initial value engineering may not uncover all possible cost
savings.
Thus, kaizen costing is really designed to repeat many of the value engineering steps for
as long as a product is produced, constantly refining the process and thereby stripping out
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extra costs.
The cost reductions resulting from kaizen costing are much smaller than those achieved
with value engineering but are still worth the effort since competitive pressures are likely
to force down the price of a product over time, and any possible cost savings allow a
company to still attain its targeted profit margins while continuing to reduce cost.
A. KAIZEN COSTING PRINCIPLES

• The system seeks gradual improvements in the existing situation, at an acceptable
cost.
• It encourages collective decision making and application of knowledge.
• There are no limits to the level of improvements that can be implemented.
• Kaizen involves setting standards and then continually improving these standards
to achieve long-term sustainable improvements.
• The focus is on eliminating waste, improving systems, and improving productivity.
• Involves all employees and all areas of the business.
B. KAIZEN COSTING VS STANDARD COSTING

Kaizen Costing Standard Costing
1. Focus on Cost reduction 1. Focus on cost control
2. Sets small standards and reduce continuously 2. Sets long term stable standards
3. Employee participation in setting standards 3. No employee participation
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4. TOTAL PRODUCTIVE MAINTENANCE (TPM)

Total Productive Maintenance (TPM) is a system of maintaining and improving the integrity
of production and quality systems. This is done through the machines, equipment,
processes, and employees that add to the value in Business Organisation. This concept
was first introduced by M/s Nippon Denso Co. Ltd. of Japan, a supplier of M/s Toyota Motor
Company.
TPM helps in keeping all equipment in top working condition so as to avoid breakdowns
and delays in manufacturing processes.
A. HOW TPM CAN BE INTRODUCED IN THE ORGANIZATION?

The introduction of TPM follows four main phases:
• Preparation Stage: Establish a suitable environment and conducting programme
awareness.
• Introduction Stage: Initialization of TPM, information to suppliers, customers,
and other stakeholders.
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• Implementation Stage: This is done with the help of eight activities referred as
eight pillars of TPM.
• Institutionalizing stage: This is the stage of getting TPM awards.
B. EIGHT PILLARS OF TPM WITH 5 S STRATEGY AS FOUNDATION.

Foundation & Pillars About Techniques
Foundation: 5S TPM starts with 5S. It deals with Seiri (sort), Seiton (set
organizing a workplace which in order) Seiso, (shine),
helps to recognize the uncover Seiketsu (standardize),
problems. Shitsuke, (sustain).
P-1: Autonomous Operation of equipment without Cleaning, Lubricating,
Maintenance breakdown and eliminating the Visual Inspection, Tight-
defects at source through active ening of Loosened Bolts
employee participation. etc.
P-2: Focussed This pillar is about the minor Kaizen Register, Kaizen
Improvement improvements made on continu- Summary Sheet,
(Kaizen) ous basis. This pillar aims to reduce Why-Why Analysis,
losses in the workplace that affect Summary of Losses.
efficiencies.
232 |SCM
Concept & Practice
P-3: Planned This is proper maintenance system Preventive Maintenance,

Maintenance adopted for improvement in relia- Breakdown Maintenance,
bility and maintainability of equip- Corrective Maintenance,
ment. It aims to have zero break- and Maintenance Preven-
down and optimum maintenance tion.
cost.
P-4: Early Manage- This focuses on shortening the Engineering and Re-engi-
ment time required for product and neering Processes.
equipment development.
P-5: Quality Main- This is towards achieving custom- Root Cause Analysis,
tenance er satisfaction through delivery of Customer Data Analysis.
highest quality product.
P-6: Education & It aims to improve knowledge/skills Training Calendar, Policies
Training and enhance morale of employees. for Education and Train-
ing, On-site Training etc.
P-7: Office TPM This refers to application of TPM Analyzing processes
techniques in administration to and procedure towards
improve productivity and efficien- increased Office Automa-
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cy in the functions with elimination.
tion of losses.
P-8: Safety, Health, Above all the safety of worker is Drama, Safety Slogans,
and Environment utmost importance. It aims to have Quizzes, Posters Making
zero accidents and zero health to create awareness relat-
damages. ed to safety.
C. PERFORMANCE MEASUREMENT IN TPM - OVERALL EQUIPMENT

EFFECTIVENESS
The most important approach to the measurement of TPM performance is known
as Overall Equipment Effectiveness (OEE) measure. The calculation of OEE measure
requires the identification of “six big losses”
1. Equipment Failure/ Breakdown
2. Set-up/ Adjustments
3. Idling and Minor Stoppages
4. Reduced Speed
5. Reduced Yield and
6. Quality Defects and Rework
The first two losses refer to time losses and are used to calculate the availability of
equipment. The third and fourth losses are speed losses that determine performance
efficiency of equipment. The last two losses are regarded as quality losses.
Performance × Availability × Quality = OEE %
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OEE may be applied to any individual assets or to a process. It is unlikely that any
manufacturing process can run at 100% OEE. According to Dal et al (2000), Nakajima
(1998) suggested that ideal values for the OEE component measures are:
Availability > 90%
Performance > 95%
Quality > 99%
Accordingly, OEE at World Class Performance would be approximately 85%. Kotze
(1993) contradicted, that an OEE figure greater than 50% is more realistic and therefore
more useful as an acceptable target.
D. CONNECTION BETWEEN TQM AND TPM

The connection between TQM and TPM are summarized below:
• TQM and TPM make company more competitive by reducing costs, improving
customer satisfactions and slashing lead times.
• Involvement of the workers into all phases of TQM and TPM is necessary.
• Both processes need fundamental training and education of participants.
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• TPM and TQM take long time to notice sustained tangible benefits.
• Commitment from top managements are necessary for success of the
implementation.
5. ACCOUNTING FOR PULL SYSTEM – BACK FLUSH COSTING

Back-flushing requires no data entry of any kind until a finished product is completed. At
that time the total amount finished is entered into the computer system, which multiplies
it by all the components listed in the bill of materials for each item produced. This yields
a lengthy list of components that should have been used in the production process and
which are subtracted from the beginning inventory balance to arrive at the amount of
inventory that should now be left on hand.
Given the large transaction volumes associated with JIT, this is an ideal solution to the
problem.
A. PROBLEMS WITH BACK-FLUSHING

• Production reporting: The total production figure entered into the system must
be absolutely correct, or else the wrong component types and quantities will be
subtracted from stock. This is a particular problem when there is high turnover or
a low level of training to the production staff that records this information, which
leads to errors.
• Scrap reporting: All abnormal scrap must be diligently tracked and recorded;
otherwise these materials will fall outside the black-flushing system and will not
234 |SCM
Concept & Practice
be charged to inventory. Since scrap can occur anywhere in a production process,

a lack of attention by any of the production staff can result in an inaccurate
inventory. Once again, high production turnover or a low level of employee
training increases this problem.
• Lot tracing: Lot tracing is impossible under the back-flushing system. It is
required when a manufacturer need to keep records of which production lots
were used to create a product in case all the items in a lot must be recalled. Only
a picking system can adequately record this information. Some computer system
allows picking and back-flushing system to coexist, so that pick transactions for
lot tracing purpose can still be entered in the computer. Lot tracing may then
still be possible if the right software is available; however, this feature is generally
present only on high-end systems.
• Inventory accuracy: The inventory balance may be too high at all times because
the backflushing transaction that relieves inventory usually does so only once
a day, during which time other inventory is sent to the production process; this
makes it difficult to maintain an accurate set of inventory records in the warehouse.
Of all the issues noted here, the worst is a situation where the production staff is
clearly incapable of providing sufficiently accurate scrap or production reporting for
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the back-flushing system. If there is an easily traceable cause, such as less capable
workers on a particular shift, moving a few reliable employees into these positions can
provide immediate relief from the problem.
It may even be possible to have an experienced shift supervisor to collect this
information. However, where this is not possible for whatever reason, computer
system users experience back-flushing garbage in, garbage out (GIGO)—entering
inaccurate information rapidly eliminates any degree of accuracy in the inventory
records, requiring many physical inventory counts to correct the problem.
Consequently, the success of a back-flushing system is directly related to a company’s
willingness to invest in a well-paid, experienced well-educated production staff that
undergoes little turnover.
B. TWO VARIANTS OF BACK FLUSH COSTING

Variant 1 :
This is the less radical variant.
There are two inventory accounts - raw materials and finished goods, i.e. No WIP
account. There are two trigger points:
1. Purchase of raw materials - Dr Materials account Cr Creditors
2. The cost of labour and other manufacturing expenses - are debited to a conversion
cost account and credited to cash or creditors. The conversion cost account can
be thought of as a suspense account where amounts are placed temporarily.
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3. On completion of units - Dr Finished goods account with the standard cost of

goods produced Cr Materials account with the standard cost of materials Cr
Conversion cost account with the standard cost of conversion.
4. Goods Sold is recorded
5. Variance in Conversion Cost is accounted in Conversion Cost Account
Variant 2
This is more radical.
No records are kept of work-in-progress raw materials, so if this method is to be used,
stocks of both raw materials and work-in-progress must be negligible. Also assumed
that all costs are equal to standard cost. It has only one trigger point.
1. As before, the cost of labour and other manufacturing expenses are initially
debited to a conversion cost account and credited to cash or creditors.
2. Entries into the finished goods inventory account are made only when goods are
completed, and the journal entries will be: Dr Finished goods account with the
standard cost of goods produced Cr Creditors with the standard cost of material
used in goods produced Cr Conversion cost account with the standard cost of
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conversion.
6. TIME ANALYSIS UNDER JIT

In many Western organizations in the past it took several months to make a product from
start to finish, despite the fact that if worked on continuously it could be made in say,
two days. The difference in time is largely due to non value adding time like set up time,
movement time, waiting time and inspection time. It is apparent that value is only added
to the product during the actual processing time. These have been estimated to represent
as little as 10% of the total manufacturing lead time in many companies and thus up to
90% of production time adds costs and no value.
The objective of JIT is to organize the production system in such a way that the manufacturing
lead time becomes equal to process time.
Manufacturing Lead time = Setup time + Movement Time + Process Time + Waiting
Time + Inspection Time.
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Concept & Practice
1
ABC Ltd. is planning to introduce Kaizen Costing approach in its manufacturing plant. State
whether and why the following are Valid or Not in respect of Kaizen Costing.
(i) VP (Finance) is of the view that company has to make a huge initial investment to bring a
large scale modification in production process.
(ii) Head (Personnel) has made a point that introduction of Kaizen Costing does not eliminate
the training requirement of employees.
(iii) General Manager (Manufacturing) firmly believes that only shop floor employees and
workers’ involvement is prerequisite of Kaizen Costing approach.
(iv) Manager (Operations) has concerns about creation of confusion among employees and
workers regarding their roles and degradation in quality of production.
Answer
(i) Invalid: Kaizen Costing is the system of cost reduction procedures which involves making
small and continuous improvements to the production processes rather than innovations
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or large-scale investment.
(ii) Valid: The training of employees is very much a long-term and ongoing process in the
Kaizen costing approach. Training enhances the abilities of employees.
(iii) Invalid: Kaizen costing approach involves everyone from top management level to the
shop floor employees. Every employee’s active participation is a must requirement.
(iv) Invalid: Though the aim of Kaizen Costing is to reduce the cost but at the same time it
also aims to maintain the quality. Kaizen costing also aims to bring the clarity in roles and
responsibilities for all employees.

Kaizen
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2
Gold Coast Company Ltd. manufactures spare parts. It works in two shifts of 8 hours for 6 days
in a week. Lunch break is 45 mins and other miscellaneous breaks add up to 25 minutes. The
following details are collected for the last 4 weeks by the TPM team for one of their important
equipment
Hours for Planned Preventive Maintenance 15 minutes per shift

For Breakdown Maintenance 6 hours total
Set up Changes 15 hours total
Power Failure 4 hours total
Standard Cycle Time per piece 3 minutes
No of Parts Produced per shift 120
Parts Accepted per shift 115
Required
CALCULATE ‘OEE’.
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Overall Equipment Effectiveness
Answer
Note 1: Calculation of Shifts
Days per week …(A) 6

Shifts per week …(B) 2
Total Working Shifts per week …(C = A × B) 12
Total Weeks …(D) 4
Total Shifts …(E = C × D) 48
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Concept & Practice
3
Give Back flush Costing Journal Entries in respect of the following transaction –
i. Raw material purchased ` 3,20,000

ii. Materials placed into production
iii. Actual Direct Labour Cost ` 50,000
iv. Actual Overhead Cost ` 4,50,000
v. Conversion Cost Applied ` 4,70,000
vi. All units were completed and sold
vii. Variance is recognized

Accounting under Back Flush
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4
Napier Company uses a backflush costing system with three trigger points:
(a) Purchase of Direct Materials
(b) Completion of Good Finished Units of Product
(c) Sales of Finished Goods
You are provided with the following information for July 2016.
Direct Materials Purchased `2,64,000 Conversion Costs Allocated `1,20,000

Direct Materials Used `2,55,000 Costs Transferred to Finished Goods `3,75,000
Conversion Costs Incurred `1,26,600 Cost of Goods Sold `3,57,000
Required
(i) Prepare journal entries for July (without disposing of under allocated/ over allocated con-
version costs).
(ii) Under an ideal JIT production system, how would the amounts in your journal entries
change from the journal entries in requirement (i)?
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Accounting under Back Flush
RTP
5
Queenstown Furniture (QF) manufactures high-quality wooden doors within the forests of
Queenstown since 1952. Management is having emphasize on creativity, engineering, inno-
vation and experience to provide customers with the door they desire, whether it is a stand-
ard design or a one-of-a-kind custom door. The following information pertains to operations
during April:
Processing time 9.0 hrs.* Waiting time 6.0 hrs.*

Inspection time 1.5 hr.* Movement time 7.5 hrs.*
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Units per batch 60 units

(*) average time per batch
Required
Compute the following operational measures:
(i) Average non-value-added time per batch
(ii) Average value added time per batch
(iii) Manufacturing cycle efficiency
(iv) Manufacturing cycle time

Time analysis under JIT
RTP
6
Kumar Enterprises has decided to adopt JIT policy for materials. The following effects of JIT are
identified:
• To implement JIT, the company has to modify its production and material receipt facili-
ties at a capital cost of ` 6,00,000. The new facilities will require a cash operating cost of `
48,000 p.a.
240 |SCM
Concept & Practice
• Raw material stock holding will be reduced from ` 28,00,000 to ` 8,00,000.

• The company can earn 15 % on its long term investments.
• The company can avoid rental expenditure on storage facilities amounting to ` 30,000 p.a.
Property taxes and insurance amounting to ` 12,000 will be saved due to JIT programme.
• Presently there are 7 workers in the stores department at a salary of ` 3,000 each per month.
After implementing JIT scheme, only 2 workers will be required in this department. Of the
balance 5 workers, 3 will be transferred to other departments, while 2 workers’ employ-
ment will be terminated.
• Due to receipt of smaller lots of raw materials, there will be some disruption of production.
The costs of stock – out will be ` 3,40,000 in the first year only. This Stock – out costs can be
brought down from the second year onwards.
Determine the financial impact of the JIT policy. Is it advisable for the company to implement
the JIT policy.

JIT Purchase System
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Answer
Cost Benefit Analysis of JIT Policy:
COSTS `
Interest on capital for modifying production facilities (` 6,00,000 x 15%) 90,000
Operating Costs of new production facilities 48,000
Stock – out Costs (first year only)
Total 3,40,000
4,78,000
BENEFITS `
Interest on investments for released funds
( ` 28,00,000 – ` 8,00,000 )x 15% 3,00,000
Savings in salary of 2 workers terminated
(` 3,000 x 12 months x 2) 72,000
Savings in Rental Expenditure 30,000
Savings In Property Tax and Insurance 12,000
Net Loss due to JIT policy ( first year) 64,000
Total 4,78,000
Therefore, JIT Policy should not be implemented in first year
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7
X Video Company sells package of blank video tapes to its customer. It purchases video tapes
from Y Tape Company @ ` 140 a packet. Y Tape Company pays all freight to X Video Compa-
ny. No incoming inspection is necessary because Y Tape Company has a superb reputation
for delivery of quality merchandise. Annual demand of X Video Company is 13,000 packages.
X Video Co. requires 15% annual return on investment. The purchase order lead time is two
weeks. The purchase order is passed through Internet and it costs ` 2 per order. The relevant
insurance, material handling etc ` 3.10 per package per year. X Video Company has to decide
whether or not to shift to JIT purchasing. Y Tape Company agrees to deliver 100 packages of
video tapes 130 times per year (5 times every two weeks) instead of existing delivery system of
1,000 packages 13 times a year with additional amount of ` 0.02 per package. X Video Co. incurs
no stock out under its current purchasing policy. It is estimated X Video Co. incurs stock out cost
on 50 video tape packages under a JIT purchasing policy. In the event of a stock out, X Video Co.
has to rush order tape packages which costs ` 4 per package.
Comment whether X Video Company should implement JIT purchasing system.
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Z Co. also supplies video tapes. It agrees to supply @ ` 136 per package under JIT delivery
system. If video tape purchased from Z Co., relevant carrying cost would be ` 3 per package
against ` 3.10 in case of purchasing from Y Tape Co. However Z Co. doesn’t enjoy so sterling a
reputation for quality. X Video Co. anticipates following negative aspects of purchasing tapes
from Z Co. :
(a) To incur additional inspection cost of 5 paisa per package.
(b) Average stock out of 360 tapes packages per year would occur, largely resulting from late
deliveries. Z Co. cannot rush order at short notice. X Video Co. anticipates lost contribution
margin per package of ` 8 from stock out.
(c) Customer would likely return 2% of all packages due to poor quality of the tape and to
handle this return an additional cost of ` 25 per package.
Comment whether X Video Co places order to Z Co

JIT Purchase System
242 |SCM
Concept & Practice
Answer
Comparative Statement of cost for purchasing from Y Co Ltd under current policy & JIT
Particulars Current policy JIT
Purchasing cost (13,000 x 140) = 18,20,000 (13,000 x 140.02) = 18,20,260
Ordering cost (2 x 13 orders) = 26 (2 x 130 orders) = 260
Opportunity (1,000/2 x140x15%) = 10,500 (100/2 x 140.02x15%) =1,050
carrying cost
Other carrying cost (1,000/2 x 3.10) = 1,550 (100/2 x 3.10) = 155
Stock out cost (4 x 50) = 200
Total relevant cost 18,32,076 18,21,925
Comments: As may be seen from above, the relevant cost under the JIT purchasing policy is
lower than the cost incurred under the existing system. Hence, a JIT purchasing policy should
be adopted by the company.
Statement of cost for purchasing from Z Co Ltd.
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Particulars `
Purchasing cost (13,000 x 136) 17,68,000
Ordering cost (2 x 130 orders) 260
Opportunity carrying cost (100/2 x 136 x 15%) 1020
Other carrying cost (100/2 x 3) 150
Stock out cost (8 x 360) 2,880
Inspection cost (13,000 x 0.05) 650
Customer return cost (13,000 x 2% x 25) 6,500
Total Relevant cost 17,79,460
Comments:
The comparative costs are as follows,
Under current policy ` 18,32,076.00
Under purchase under JIT ` 18,21,925.10
Under purchase from Z Co Ltd ` 17,79,460
Packages should be bought from Z Co as it is the cheapest.
SCM
8
Prism Ltd has decided to adopt JIT policy for materials. The following effects of JIT Policy are
identified:
(i) To implement JIT, the company has to modify its production and material receipt facili-
ties at a capital cost of ` 2,00,000. The new machine will require a cash operating cost `
2,16,000 p.a. The capital cost will be depreciated over 10 years.
(ii) Raw material stockholding will be reduced from ` 40,00,000 to ` 15,00,000.
(iii) The company can earn 12% on its long term investments.
(iv) The company can avoid rental expenditure on storage facilities amounting to ` 66,000 per
annum. Property taxes and insurance amounting to ` 44,000 will be saved due to JIT pro-
gramme.
(v) Presently there are 7 workers in the Store department at a salary of ` 10,000 each per
month. After implementing JIT scheme, only 4 workers will be required in this department.
Balance 3 workers’ employment will be terminated.
(vi) Due to receipt of smaller lots of raw materials, there will be some disruption of production.
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The costs of stock outs are estimated at ` 1,54,000 per annum.

(vii) Since the supplier is new having no reputation as yet in the market, an additional inspec-
tion cost of ` 12,000 p.a. has to be incurred.
Required:
Determine the financial impact of the JIT policy. Is it advisable for the company to implement
JIT system?

JIT Purchase System
CMA Final Dec’18
9
Innovation Ltd. has entered into a contract to supply a component to a company which manu-
factures electronic equipments.
Expected demand for the component will be 70 ,000 units totally for all the periods. Expected
sales and production cost will be -
Period 1 2 3 4
Sales (units) 9,500 17,000 18,500 25,000
Variable cost per unit 30 30 32.50 35
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Concept & Practice
Total fixed overheads are expected to be `14 lakhs for all the periods. The production manager
has to decide about the production plan.
The choices are:
Plan 1: Produce at a constant rate of 17,500 units per period. Inventory holding costs will be `
6.50 per unit of average inventory per period.
Plan 2: Use a just-in-Time (JIT) system
Maximum capacity per period normally - 18,000 units
It can produce further up to 10,000 units per period in overtime.
Each unit produced in overtime would incur additional cost equal to 30% of the expected vari-
able cost per unit of that period.
Assume zero opening inventory.
Required
(i) Calculate the incremental production cost and the savings in inventory holding cost by JIT
production system.
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(ii) Advise the company on the choice of a plan.

JIT Production System
10
KP Ltd. (KPL) manufactures and sells one product called “KEIA”. Managing Director is not happy
with its current purchasing and production system. There has been considerable discussion at
the corporate level as to use of ‘Just in Time’ system for “KEIA”. As per the opinion of managing
director of KPL Ltd. –
“Just-in-time system is a pull system, which responds to demand, in contrast to a push system,
in which stocks act as buffers between the different elements of the system such as purchasing,
production and sales. By using Just in Time system, it is possible to reduce carrying cost as well
as other overheads”.
KPL is dependent on contractual labour which has efficiency of 95%, for its production. The
labour has to be paid for minimum of 4,000 hours per month to which they produce 3,800
standard hours.
For availing services of labour above 4,000 hours in a month, KPL has to pay overtime rate
which is 45% premium to the normal hourly rate of `110 per hour. For avoiding this overtime
SCM
payment, KPL in its current production and purchase plan utilizes full available normal working
hours so that the higher inventory levels in the month of lower demand would be able to meet
sales of month with higher demand level. KPL has determined that the cost of holding invento-
ry is ` 70 per month for each standard hour of output that is held in inventory.
KPL has forecast the demand for its products for the first six months of year 2019 as follows:
Month Demand (Std. Hrs.)
Jan’19 3,150
Feb’19 3,760
Mar’19 4,060
Apr’19 3,350
May’19 3,650
Jun’19 4,830
Following other information is given:
(i) All other production costs are either fixed or are not driven by labour hours worked.
(ii) Production and sales occur evenly during each month and at present there is no stock at
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the end of Dec’18.

(iii) The labour are to be paid for their minimum contracted hours in each month irrespective
of any purchase and production system.
Required
As a chief accountant you are requested to COMMENT on managing director’s view.

JIT Production System
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Concept & Practice
Activity Based Costing
Chapter 13
1. ACTIVITY BASED COST MANAGEMENT (ABM)

A. Implementing ABM
B. Benefits of Activity Based Cost Management
C. Difference between ABC and ABM
2. ACTIVITY BASED BUDGETING (ABB)
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SCM
1. ACTIVITY BASED COST MANAGEMENT (ABM)

The term Activity based management (ABM) is used to describe the Cost Management
application of ABC.
The use of ABC as a costing tool to manage costs at activity level is known as Activity Based
Cost Management (ABM). ABM is a discipline that focuses on the efficient and effective
management of activities as the route to continuously improving the value received by
customers.
ABM utilizes cost information gathered through ABC. Through various different types
of analysis, ABM manages activities rather than resources. It determines what drives the
activities of the organisation and how these activities can be improved to increase the
profitability.
A. IMPLEMENTING ABM
Step 1 : Decide what are the organisation’s most important issues and what types of
information would be required to address those issues.
Step 2 : Top Management support is cited to identify critical information needs.
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Step 3 : Incorporate ABC methods into organization’s financial reporting process.

Step 4 : If integrating ABC into the main cost reporting system is not feasible, consider
developing a separate ABC system.
Step 5 : The existing information system should easily support input requirements.
Step 6 : Implementation team should be represented by the people who will be actual
users of the ABM information.
Step 7 : Implement ABM at a high level in order to get concepts across.
B. BENEFITS OF ACTIVITY BASED COST MANAGEMENT

• Provision of excellent basis and focus for cost reduction.
• Provides operational management with a clear view of how to implement an
Activity Based Budget.
• Provision of clear understanding of the underlying causes of business processing
costs.
• Provision of excellent basis for effectiveness of management decision making.
• Identification of key process waste elements, permit management prioritisation
and leverage of key resources.
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Concept & Practice
C. DIFFERENCE BETWEEN ABC AND ABM

The ABC refers to the technique for determining the cost of activities and the output
that those activities produce. It is the logical distribution of overhead i.e. overhead
should be distributed on the consumption of resources consumed by goods and
services. The aim of ABC is to generate improved cost data for use in managing a
company’s activities.
The ABM is a much broader concept. It refers to the management philosophy that
focuses on the planning, execution and measurement of activities as the key to
competitive advantage.
2. ACTIVITY BASED BUDGETING (ABB)

ABB analyse the resource input or cost for each activity. It provides a framework for
estimating the amount of resources required in accordance with the budgeted level
of activity. Actual results can be compared with budgeted results to highlight both in
financial and non-financial terms those activities with major discrepancies from budget for
potential reduction in supply of resources. It is a planning and control system which seeks
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to support the objectives of continuous improvement. It means planning and controlling
the expected activities of the organization to derive a cost-effective budget that meet
forecast workload and agreed strategic goals.
The three key elements of activity based budgeting are as follows:
- Type of work to be done
- Quantity of work to be done
- Cost of work to be done
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1
State with a brief reason whether you would recommend an activity based system of costing in
each of the following situation:
(i) Company K Produces one product. The overhead cost mainly consists of depreciation
(ii) Company L produces 5 different products using different production facilities
(iii) A Consultancy firm consisting of lawyers, accountants and computer engineers provides
management consultancy service to clients.
(iv) Company S produces two different labour intensive products. The contribution per unit in
both products is very high. The BEP is very low. All the work is carried on efficiently to meet
target costs.

Justification for ABC
May 2012
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Answer
(i) Not recommended
The company produces only one product. ABC is recommended for multiple products.
The overhead costs mainly consists of depreciation. So, there is a less chance of cost
reduction which is the main aim of ABC.
(ii) Recommended
As the company is producing 5 different products, using different production facilities,
ABC will be helpful in tracing the cost accurately.
(iii) Recommended
A client may require some or all of the different services, ABC will charge a client only for
the category of services availed.
(iv) Not Recommended
The products are labour intensive, so cost are easily traceable. ABC is recommended for
machine intensive products. Further, the products already have high contribution and low
BEP and also work is being carried on efficiently to meet the target cost. Had the situation
been reverse, ABC could have been thought of.
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Concept & Practice
2
PQ ltd makes two products P and Q, which are similar products with slight difference in dimen-
sions, but use the same manufacturing processes and facilities. Production may be made inter-
changeably after altering machine set up. Production time is the same for both the products.
The cost structure is as follows:
` per unit P Q
Selling price 100 120
Variable manufacturing cost 45 50
(directly linked to units produced)
Contribution 55 70
Fixed manufacturing cost 10 10
Profit 45 60
Fixed cost per unit has been calculated based on the total practical capacity of 20,000 units
per annum (which is either P or Q or both put together). Market demand is expected to be the
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deciding factor regarding the product mix for the next 2 years. The company does not stock
inventory of finished goods.
The company wishes to know whether ABC system is to be set up at a cost of ` 10,000 per month
for the purpose of tracking and recording the fixed overhead costs for allocation to products.
Support your advice with appropriate reasons.
Independent of above, if you are told to assume that fixed costs stated above, consist of non
cash component of depreciation to plant at ` 90,000 for the year, will your advice change?
Explain.

Justification for ABC
Answer
ABC is not recommended for PQ ltd on the following grounds -
a) PQ ltd manufactures only two products which are similar, requiring same production time,
produced from same manufacturing facilities. ABC is recommended for multiple products
which are diff from one another.
b) The contribution of the products are substantially high and the total fixed cost of the com-
pany is (10 x 20,000) ` 2,00,000. Product P can reach BE with ` (2lakh/51) = 3,636 units
whereas Product Q and can reach BEP with ` (2 lakh/70) 2,857 units only. It is far lower than
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the practical capacity of 20,000 units. So, when company is already able to meet its profit
targets smoothly, ABC system is not recommended, which will only increase the total fixed
cost by (12 x 10,000) ` 1,20,000 p.a.
c) The product mix for coming two years will be decided by the market demand. So, ABC sys-
tem or any internal choice of product mix decided through ABC system would not actually
yield revenue for the company.
If the total fixed cost is comprising of depreciation of ` 90,000 , the cash fixed cost will be (200,00
– 90,000) ` 1,10,000. If ABC is implemented, it can at its best, help PQ ltd to reduce the cash fixed
cost of ` 1,10,000 to 0 , but at the same time it will bring in its implementation cost of ` 1,20,000.
So, the trade off is not worthwhile. As the long term plans of PQ ltd are not known, ABC is not
recommended in this situation as well.
3
A company produces two products P and Q and the details is as follows:

P Q
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Units produced 10,000 20,000

Materials cost per unit (`) 4 2.50
Labour cost per unit (`) 3 1.50
No. of runs 200 500
Machine hrs per 100 units 3 2.50
No. of units per order 400 1,000
Packing of Finished goods units per container 10 40
The following costs have been analysed:
Amount
(`)
Machine setup cost 21,000
Machine running cost 32,800
Processing and handling cost 9,000
Packing and distribution cost 18,000
You are required to compute cost per unit under Traditional and Activity Based Costing system.
Under traditional method, processing cost and packing cost are observed as a percentage of
material cost whereas setup and running cost are observed on the basis of machine hours.
252 |SCM
Concept & Practice

Product Cost Statement Cost Driver Computation
4
During the last twenty years, KL’s manufacturing operation has become increasingly automat-
ed, with computer-controlled robots replacing operatives. KL currently manufactures over 100
products of varying levels of design and complexity. A single, plant-wide overhead absorption
rate, based on direct labour hours, is used to absorb overhead costs.
In the quarter ended March 2009 , KL’s manufacturing overhead costs were :
` ‘ 000.
Equipment operation expenses 125
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Equipment maintenance expenses 25
Wages paid to technicians 85
Wages paid to store men 35
Wages paid to dispatch staff 40
Total 310
During the quarter, Rapier Management Consultants were engaged to conduct a review of KL’s
cost accounting systems. Rapier’s report includes the following statement:
‘In KL’s circumstances, absorbing overhead cost in individual products on a labour-hour absorp-
tion basis is meaningless. Overhead costs should be attributed to products using an activi-
ty-based costs (ABC) system. We have identified the following most significant activities:
(a) Receiving component consignment from suppliers;
(b) Setting up equipment for production runs;
(c) Quality inspections;
(d) Dispatching goods orders to customers.
Our research has indicated that, in the short term, KL’s overhead are 40% fixed and 60 percent
variable. Approximately half the variable overheads vary in relation to direct labour hours
worked and half vary in relation to the number of quality inspections. This model applies only
to relatively small changes in the level of output during a period of two years or less’.
Equipment operation and maintenance expenses are apportioned as follows:
Components stores (15%), manufacturing (70%) and goods dispatch (15%)
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Technician wages are apportioned as follows:

Equipment maintenance (30%) setting up equipment for production runs (40%) and quality
inspections (30%).
During the quarter:
(a) A total of 2,000 direct labour hours were worked (paid at ` 12 per hour);
(b) 980 component consignment were received from suppliers;
(c) 1,020 production runs were set up;
(d) 640 quality inspection were carried out; and
(e) 420 goods orders dispatched to customers.
KL’s production during the quarter included a component R for which direct labour hours
worked 25. Direct materials cost ` 1,200. Component consignment received 42. Production
runs 16. Quality inspections 10. Goods orders dispatched 22. Quantity produced 560.
In April 2009 a potential customer asked KL to quote for the supply of a new component Z to a
given specification. 1,000 units of Z are to be supplied each quarter for a two-year period. They
will be paid for in equal instalments on the last day of each quarter. The job will involve an initial
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design cost of ` 40,000 and production will involve 80 direct labour hours, ` 2,000 materials, 20
component consignments, 15 production runs, 30 quality inspections and 4 goods dispatches
per quarter.
KL’s sales director comments: ‘Now we have a modern ABC system, we can quote selling prices
with confidence. The quarterly charges we quote should be the forecast ABC production cost
of the units plus the design cost of the Z depreciated on a straight-line basis over the two years
of the job- to which we should add a 25 per cent mark-up for profit. We can base our forecast
on costs experience in the quarter ended March 2009. KL’s cost of capital is 3 % per quarter. The
annual value @3% in 8 quarters = 7.0197
Requirements:
(a) Calculate the unit cost of component R using KL’s existing cost accounting system.
(b) Calculate the unit cost of components R. using this ABC system.
(c) Calculate the charge per quarter that should be quoted for supply of component Z in a
manner consistent with the sales director’s comments.
Advise KL’s management on the merits of this selling price, having regard to factors you consid-
er relevant.

Product Cost Statement Cost Pool Computation
May 2011
254 |SCM
Concept & Practice
5
A manufacturing company produces Ball Pens that are printed with the logos of various compa-
nies. Each pen is priced at ` 5. Costs are as follows:
Cost Driver Unit Variable Cost Level of Cost Driver
Unit Sold 2.5 -
Setups 225 40
Engineering Hours 10 250
Other data: Total Fixed Costs (Conventional) - ` 48,000 Total Fixed Costs (ABC) - ` 36500
Required:
1. Compute Break Even Point in units using Activity Based Analysis
2. Suppose that company could reduce the setup cost by ` 75/setup and could reduce the
number of engineering hours needed to 215. How many units must be sold to break even
in this cost?
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Break Even with ABC
6
Catalyst Ltd. Makes a single product with the following details:

Description Current Situation Proposed Change
Selling Price (`/unit) 10
Direct Costs (`/unit) 5
Present number of setups per production period, 42
(before each production run, setup is done)
Cost per set up (`) 450 Decrease by ` 90
Production units per run 960 1,008
Engineering hours for production period 500 422
Cost per engineering hour (`) 10
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The company has begun Activity Based Costing of fixed costs and has presently identified two
cost drivers, viz. production runs and engineering hours. Of the total fixed costs presently at Rs.
96,000, after the above, ` 72,100 remains to be analyzed. There are changes as proposed above
for the next production period for the same volume of output.
Required
(i) How many units and in how many production runs should Catalyst Ltd. produce in the
changed scenario in order to break-even?
(ii) Should Catalyst Ltd. continue to break up the remaining fixed costs into activity based
costs? Why?

Break Even with ABC
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7
A company can make any or both of products A and B in a production period not exceeding a
total of 10,000 units due to non-availability of the required material and labour. Until now, the
company had been taking decisions on the product mix, based on the following marginal cost
analysis.
A (` / u) B (`/ u)
Selling Price 100 120
Variable Cost 60 70
Contribution 40 50
Total fixed costs 3,00,000
Since the decisions based on the above approach did not yield the required results, the fixed
costs were analysed as follows for 10,000 units of only A or 10,000 units of only B.
Item of Cost Details for A A (Amt.) B (Amt.) Details for B
Set up cost 10 production runs 40,000 75,000 10 production runs
Distribution cost ` 120/ box 60,000 25,000 ` 200 per box
Step fixed cost ` 4,000 per 2,000 units 20,000 50,000 ` 5,000 per 1,000 units
Total 1,20,000 1,50,000
` 30,000 can be taken as the unanalysed fixed cost, and unavoidable whether A or B or both are
produced.
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Concept & Practice
The following cost reduction measures were taken by the Product Managers of A and B:
A B
Increase in number of units per run to 2,000 units 1,250 units
Increase in the number of units per box distributed to 30 units 125 units
Further, the Management ensured availability of raw material and labour to support a produc-
tion of 15,000 units of either A or B or both together. There was no change to the step costs or
contribution. However, the total unanalysed fixed cost increased to ` 32,000.
(i) Based on the principles of Activity Based Costing, prepare a statement showing the contri-
bution and item wise analysed overheads for each product, arrive at the profitability of A
and B and then the final profits if 15,000 units of only A or 15,000 units of only B are manu-
factured.
(ii) Find the minimum break-even point in units if only product A is manufactured after the
cost reduction.

Break Even with ABC Minimum Break Even Point
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8
Following are the information available regarding data on traditional cost and ABC system. Find
Variances.
Traditional Costing system:
Standard overhead rate ` 11 per labour hr

Standard time 2 hrs per unit
Actual amount spent ` 20,000
Actual output 2,000 uts
Activity based costing system:
Standard cost driver rates:

Set up cost ` 90 per set up
Inspection cost ` 4 per inspection
Material movement cost ` 6 per material movement
Actual cost driver numbers:
No. of Set up 120
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No. of inspections 1,000

No. of material movement 800
Actual amount spent: `
Set up 11,000
Inspection 5,000
Material movement 4,000

Variance Analysis under ABC
9
N & S Co. (NSC) is a multiple product manufacturer. NSC produces the unit and all overheads are
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associated with the delivery of units to its customers.

Particulars Budget Actual
Overheads (`) 4,000 3,900
Output (units) 2,000 2,100
Customer Deliveries (no.’s) 20 19
Required
Calculate Efficiency Variance and Expenditure Variance by adopting ABC approach.

Variance analysis under ABC
258 |SCM
Concept & Practice
Strategic Analysis of Operating Income
Chapter 14
Strategic Analysis of Operating
Income
1. STRATEGIC PROFITABILITY ANALYSIS

A. TYPE 1 - PORTER’S THREE GENERIC STRATEGIES FOR
GROWTH
B. TYPE 2 - PRODUCT DIFFERENTIATION STRATEGY
EFFECT ON PROFITABILITY ANALYSIS
2. DIRECT PRODUCT PROFITABILITY (DPP)
A. Benefits of DPP
B. Indirect costs for DPP
C. Direct Product Profit Statement :
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3. CUSTOMERS PROFITABILITY ANALYSIS
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1. STRATEGIC PROFITABILITY ANALYSIS
A. TYPE 1 - PORTER’S THREE GENERIC STRATEGIES FOR GROWTH

a. Growth effect i.e. Revenue and Cost effect of growth. i.e. volume
b. Price effect i.e. Revenue and cost effect of price.
c. Productivity i.e. efficiency effect of cost.
Particulars LY Profit Growth Effect Price Effect Productivity CY Profit
Revenue *** ***(N 1) *** (N 4) -- ***
Less:
Materials *** *** (N 2) *** (N 5) *** (N 6) ***
Conv. Cost (Fixed) *** -- *** (N 7) -- ***
Ad & S/D OH (Fixed) *** -- *** (N 7) -- ***
Profit *** *** (N 3) ***
Note 1: Sales Volume Variance:
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Excess Revenue received due to excess quantity sold = (AO – BO) × Budgeted SP
Note 2: Excess cost incurred due to excess quantity sold
= (BO – AO) × Budgeted MC per unit
Note 3: Sales Margin Volume Variance (Marginal Approach):
Adding Note 1 and Note 2 we get,
= (AO – BO) × (Budgeted SP – Budgeted Material Cost per unit)
= (AO – BO) × (Budgeted Margin or contribution per unit) = Sales Margin Volume
Variance.
[Assumed Material cost is the only variable cost].
Note 4: Sales Price Variance:
Excess revenue generated due to excess price = (ASP – BSP) × AO
Note 5: Material Price Variance:
Excess cost incurred due to excess price in resource used = (Std Price p.u. – Actual
price p.u.) x AQ
Note 6: Material Usage Variance
= (SQ – AQ) x Std price
Note 7: Expenditure Variance:
For Fixed Cost only expenditure variance is shown i.e. Budgeted Cost – Actual Cost
260 |SCM
Concept & Practice
B. TYPE 2 - PRODUCT DIFFERENTIATION STRATEGY EFFECT ON

PROFITABILITY ANALYSIS
If the market size grows, then definitely, the quantity sold by the company will increase.
By reducing its selling price, the company may capture competitor’s market i.e. its
Market Share would increase. This strategy is known as Product Differentiation Strategy
whereby the loss due to decrease in selling price would be covered by increase in
quantity sold.
PRODUCT DIFFERENTIATION = Price Effect + Market Share
In such a case, changes in operating income in a Balanced Score Card are shown as
below:
Particulars Amount
1. Market Size Variance ****
2. Product Differentiation
Market Share Variance ******
Price Effect on revenue and cost ******
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****
3. Cost Leadership or Productivity Effect ****
Change in Profit (Yr 2 – Yr 1) ****
2. DIRECT PRODUCT PROFITABILITY (DPP)

CIMA describe DPP “used primarily within the retail sector, DPP involves the attribution of
both the purchase price and other indirect costs (for example distribution, warehousing
and retailing) to each product line. Thus, a net profit, as opposed to a gross profit, can be
identified for each product. The cost attribution process utilizes a variety of measures (for
example warehousing space and transport time) to reflect the resource consumption of
individual products.”
A. BENEFITS OF DPP
• Better cost analysis.
• Better pricing decisions.
• Better management of stores and warehouse space.
• The rationalisation of product ranges.
Retail organisations traditionally deducted the bought in cost of goods from the
selling price to give a gross margin. The gross margin is useless measure for controlling
the costs of the organisation itself or making decisions about the profitability of the
different products. This is because none of the costs generated by the retail organisation
itself are included in its calculation. For example, it does not include the storage costs
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of the different goods and these costs vary considerably from one goods to another.
A method was needed which relates the indirect costs to the goods according to the
way the goods uses or creates these costs.
B. INDIRECT COSTS FOR DPP

(i) Overhead Cost: This is incurred through an activity that is not directly linked to a
particular product.
(ii) Volume Related Cost: The cost is incurred in relation to the space occupied by
products. This includes storage and transport costs.
(iii) Product Batch Cost: This cost is often a time-based cost. If product items (that is a
number of identical products which are handled together as a batch) are stocked
on shelves a labour time cost is incurred.
(iv) Inventory Financing Costs: This is the cost of tying up money in stock and is the
cost of the product multiplied by interest rate per day or per week.
C. DIRECT PRODUCT PROFIT STATEMENT :

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Sales ✓
Less : Cost of Goods Sold ✓
Gross Margin ✓
Less : Direct Product Costs ✓
(Warehouse, Transportation, Store etc. - Excluding H.O. Costs)
Direct Product Profit ✓
3. CUSTOMERS PROFITABILITY ANALYSIS

Most firms today understand the source of their revenues but unfortunately, do not
understand the source of profits. Often, attempts to measure profitability center on either
product costs alone or on profitability at the business unit or enterprise level. These
attempts can be severely misleading. What firms fail to do is measure profit at the most
meaningful and controllable level, the customer level. Understanding the underlying
components of cost and addressing specific causes of poor profitability associated with
specific customers will significantly improve bottom-line performance. Undertaking a
customer account profitability improvement initiative is a five-step process:
Analyse the Calculate the Re-engineer/
Calculate the
customer annual Identify and eliminate the
annual costs
base and split revenues retain quality unprotable
of serving the
it into the earned from customers segments
segment
segments the customer
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Concept & Practice
Customer Profitability Analysis is best conducted with a technique known as Activity

Based Costing or ABC analysis. The net profit coming from each customer which can be
calculated by revenue less costs done by this tool. These costs are not only manufacturing
and distribution costs but also sales costs, marketing costs, services cost and any other
related costs which have to be undertaken to service the customer.
Platinum customers
Gold customers
Iron customers
Lead customers
Prot tires Marketing

Investment
Pyramid
After finalisation of cost customers are divided into different profit tiers. This principle is
best observed in the banking industry with credit card as a product. Customers are basically
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classified into four types
• Platinum Customers – Most Profitable
• Gold Customers – Profitable
• Iron Customers – Low Profit but Desirable
• Lead Customers – Unprofitable and Undesirable
A credit card company would always give the best service as well financial and other
benefits to the top two customers. It will at the same time try to attract iron customers and
try to convert these iron customers to platinum or gold customers. Finally, these companies
will have systems in place so as to avoid lead customers completely.
It is found that with customer profitability analysis, the firm can correctly classify customers
and also find out which of the customers it needs to hold on to and acquire more of the
same type, and which customers it needs to let go of. Several times, firms find out that
there are customers which they should have left altogether as the profitability from these
customers is minimum and expenses are more.
Cost calculation is one of the major problem in CPA. Calculating cost per customer becomes
difficult especially in a service environment where manpower as well as time also has a cost
factor associated with it. Time spent with each customer is different and therefore the cost
is different. Furthermore, there are several non-customer related costs too. If these costs
are ignored, then right figures would be difficult to check. The customers will be shown
more profitable than they are.
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1
Following a strategy of product differentiation, Westwood corporation makes a high end kitch-
en range hood, KE8. Here’s Westwood’s data for 2018 and 2019:
Particulars 2018 2019
1. Units of KE8 produced and sold 40,000 42,000
2. Selling price per unit ` 100 ` 110
3. Direct Materials (square feet) 120,000 123,000
4. Direct Material Cost per square feet ` 10 ` 11
5. Manufacturing capacity for KE8 50,000 units 50,000 units
6. Conversion costs ` 10,00,000 ` 11,00,000
7. Conversion cost per unit of capacity (6÷5) ` 20 ` 22
8. Selling and customer service capacity 30 customers 29 customers
9. Selling and customer service costs ` 7,20,000 ` 7,25,000
10. Cost per customer of selling and customer service 24,000 25,000
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capacity (9÷8)
Westwood produced no defective units and reduced direct material usage per unit of KE8 in
2018. Conversion costs in each year are tied to manufacturing capacity. Selling and custom-
er service costs are related to number of customers that the selling and service functions are
designed to support.
Required:
1. Calculate the growth, price – recovery and productivity component that explain the
change in operating income from 2018 to 2019.
2. Suppose during 2018 the market for high end kitchen range hoods grew at 3 % in terms of
number of units and all increases in market share (that is increase in number of units sold
greater than 3 %) are due to Westwood’s product differentiation strategy. Calculate how
much of the change in operating income from 2018 to 2019 is due to the industry market
size factor, cost leadership and product differentiation.

Profitability Analysis Growth Price and Productivity
Effect with Product
Differentiation
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Concept & Practice
2
Oceano T- shirt company sells a variety of T – shirts. Oceano presents the following data for its
first two years of operations 2018 and 2019. For simplicity, assume that all purchasing and sell-
ing costs are included in the average cost per T – shirt and that each customer buys one T - shirt.
Particulars 2018 2019
Number of T – shirts purchased 20,000 30,000
Number of T –shirts lost 400 300
Number of T – shirts sold 19,600 29,700
Average selling price ` 15 ` 14
Average cost per T – Shirt ` 10 `9
Administrative capacity ( No of customers that can be served) 40,000 36,000
Administrative costs ` 80,000 ` 68,400
Administrative cost per customer `2 ` 1.90
Administrative cost depends on the number of customers capacity that Oceano has created to
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support and not the actual number of customers served.
Calculate the growth, price – recovery and productivity components of changes in operating
income between 2018 and 2019.

Profitability Analysis Trader’s Effect
3
Jigyasa India Ltd. (JIL) has 30 retail stores of uniform sizes “Fruity and Sweety Retails” across
the country. Mainly three products namely ‘Butter Jelly’, ‘Fruits and Nuts’ and ‘Icy Cool’ are sold
through these retail stores. JIL maintains stocks for all retail stores in a centralized warehouse.
Goods are released from the warehouse to the retail stores as per requisition raised by the
stores. Goods are transported to the stores through two types of vans i.e. normal and refriger-
ated. These vans are to be hired by the JIL. Costs per month of JIL are as follows:
Amount in `
Warehouse Costs:
Labour and Staff Costs 27,000
Refrigeration Costs 1,52,000
Material Handling Costs 28,000
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Total 2,07,000
Head Office Costs:
Salary and Wages to Head Office Staff 50,000
Office Administration Costs 1,27,000
Total 1,77,000
Retail Stores Costs:
Labour Related Costs 33,000
Refrigeration Costs 1,09,000
Other Costs 47,000
Total 1,89,000
Average transportation cost of JIL per trip to any retail stores are as follows:
Normal Van ` 3,200

Refrigerated Van ` 4,900
The Chief Financial Manager asked his Finance Managers to calculate profitability based on
three products sold through Fruity and Sweety retail stores rather than traditional method of
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calculating profitability.
The following information regarding retail stores are gathered:
Butter Jelly Fruit and Nuts Icy Cool
No. of Cartons per cubic metre 42 28 40
No. of items per cartons (units) 300 144 72
Sales per month (units) 18,000 4,608 1,152
Time in warehouse (in months) 1 1.5 0.5
Time in retail stores (in months) 1 2 1
Selling Price per unit (`) 84 42 26
Purchase Price Per unit (`) 76 34 22
Butter Jelly and Icy Cool are required to be kept under refrigerated conditions.
Additional Information:
Total Volume of all goods sold per month 40,000 cubic metres
Total Volume of all Refrigerated Goods sold per month 25,000 cubic metres
Carrying Volume of Each van 64 cubic metres
Required:
Calculate the profit per unit using Direct Product Profitability Method
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Concept & Practice

Direct Product Profitability
4
A and B are two customers of XYZ Electronics Ltd, a manufacturer of audio players. Selling Price
per unit is ` 5,400. Its cost of production per unit is ` 4,420.
Additional costs are:
Order processing cost ` 2,000 per order

Delivery Costs ` 3,500 per delivery
Details of customers A and B for the period are given below:

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Customer A Customer B
Audio Players Purchased (nos.) 350 500
No. of orders 5 (each of 70 units) 10 (each of 50 units)
No. of deliveries 5 0
The company’s policy is to give a discount of 5% on the selling price on orders for 50 units or
more, and to further give 8% discount on the undiscounted selling price if a customer uses
his own transport to collect the order. Assume that production levels are not altered by these
orders.
Required:
(i) Analyse the profitability by comparing profit per unit for each customer
(ii) Comment on the discount policy on delivery

Customer Profitability Analysis
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5
Oxford Medical Care (OMCC) is a pharmaceutical firm, operating its entire business through its
four customers OX1, OX2, OX3, and OX4. OX1 and OX2 are small pharmaceutical stores while
OX3 and OX4 are large discount stores with attached pharmacies. OMCC uses discount pricing
strategy and prices its products at variable cost plus 25%.
Item Small Pharmaceuticals Large Pharmaceuticals Activity rate
OX1 OX2 OX3 OX4
No. of orders 4 9 6 3 ` 750
Order Size ` 40,000 ` 20,000 ` 4,25,000 ` 4,00,000 -
Average Discount 4.5% 9.5% 17.5% 11.5% -
Regular Deliveries 4 9 6 3 ` 375
Expedite Deliveries 2 0 2 0 ` 1,250
General Administration Cost ` 20,250 ` 48,375
Required:
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(i) Prepare a Customer profitability statement that shows the profit from each customer and
each customer channel.
(ii) Recommend some points to improve OMCC’s profit.

6
Bookmark LLP is a publishing firm that started operations very recently. The firm has published
“Advanced Learner’s Dictionary” this first year, that have been sold to 3 distributors PER, MGH
and WLY. The firm’s financials reflect profits in its first year of operations. The management
is pleased with the results. However, they are interested in finding out how profitable each
customer is. This would help them formulate their sales strategy.
Particulars PER MGH WLY
Sales units p.a. 1,000 950 1,250
Sale price (gross) 250 250 250
Payment terms 3/10 net 30 net 30 3/10 net 30
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Concept & Practice
Particulars PER MGH WLY

Sales returns 0.5% 0% 10%
Delivery terms FOB destination FOB destination FOB shipping point
In order to get market share, PER and WLY have been extended credit terms to avail discount
if payment is made within 10 days. Customer MGH does not have much bargaining power and
hence has been allowed only 30 days’ credit period without any benefit of availing discount for
early payment. Both PER and WLY have made payments within 10 days to avail of the discount
extended.
On the cost front, variable cost of goods sold is `150 per unit. Key metrics of customer assigna-
ble marketing, administrative and distribution costs are as below:
Cost Driver
Activity Activity Driver No. of Units of Activity Driver
Rate (`)
PER MGH WLY
Order taking and processing # of orders 4 2 15 300
Expedited / rush orders # of orders 1 - 5 250
Delivery costs # distance in km. 100 50 - 80
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Sale return processing # of returns 1 - 8 150
Billing cost # of invoices 4 2 15 50
Customer visit # of visits 1 - 5 800
Inventory carrying cost * # 1 per unit 1,000 950 1,250 10
* Assume no opening and closing stock
Fixed cost that are not assignable to any customer is `1,00,000 p.a.
Required
(i) PREPARE the customer wise profitability statement as also the overall profitability state-
ment of Bookmark LLP.
(ii) RECOMMEND a strategy for Bookmark LLP regarding its customers.

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Target Costing
Chapter 15
Target Costing
1. STEPS IN TARGET COSTING
2. VALUE ENGINEERING AND VALUE ANALYSIS
3. DEALING WITH VALUE ANALYSIS / VALUE ENGINEER-

ING
4. TARGET COSTING CONTROL POINTS
5. IMPLEMENTING A TARGET COSTING SYSTEM
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6. VALUE CHAIN ANALYSIS - PORTER’S VALUE CHAIN
7. PORTER’S FIVE FORCES
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Target Costing
1. STEPS IN TARGET COSTING

1. Identify the market requirements – need for a new product or improvement in
existing.
2. Set Target Selling Price based on customer expectations and sales forecasts.
3. Set Target Production Volume based on demand and supply.
4. Establish Target Profit Margin for products based on Company’s long term profit
objectives, goals, etc.
5. Set Target Cost or Allowable Cost for each product
Target Cost = Target SP – Target Profit
6. Determine Current Cost of producing new product, based on available resource and
condition.
7. Set Cost Reduction Target in order to match the current cost with the target cost.
8. Identify Cost reduction opportunities by using Value Engineering and Value
Analysis.
9. Achieve Cost Reduction and target profit by effective implementation of cost
reduction decision.
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10. Focus on further cost reduction possibilities i.e. continuous improvement program.
2. VALUE ENGINEERING AND VALUE ANALYSIS

Value Engineering means searching for opportunities to modify the design of each
component or part of a product to reduce cost but without reducing the functionality or
quality of the product.
Value Analysis means studying the activities that are involved in producing the product
to detect non value adding activities that may be eliminated or minimised to save cost but
without reducing the functionality or quality of the product. It helps to identify –
(a) Value added Cost :- the cost if eliminated, would reduce the utility of the product.
(b) Non Value added Cost :- the cost if eliminated would not reduce the utility of the
product.
Illustration 1. Value adding and Non Value Adding Activities
Identify Value Adding / Non-value Adding activities.
(a) Polishing furniture used by a system engineer in a software firm. - Non Value Adding
(b) Maintenance by a software Co. of receivable management software for a banking company.
- Value Adding
(c) Painting of Pencils manufactured by a Pencil Co. - Value Adding
(d) Customer’s Computer keyboard cleaning by a Computer Repair Centre. - Value Adding
(e) Providing brake adjustments in cars for repairs by a Car Service Station. - Value Adding
SCM
Target Costing
3. DEALING WITH VALUE ANALYSIS / VALUE ENGINEERING

• Can we eliminate functions from the production process?
• Can we eliminate some durability or reliability?
• Can we minimize the design?
• Can we design the product better for the manufacturing process?
• Can we substitute parts?
• Can we combine steps?
• Can we take supplier’s assistance?
• Is there a better way?
The initial value engineering may not uncover all possible cost savings. Thus, Kaizen
Costing is designed to repeat many of the value engineering steps for as long as a product
is produced, constantly refining the process and thereby stripping out extra costs. The cost
reductions resulting from kaizen costing are much smaller than those achieved with value
engineering but are still worth the effort since competitive pressures are likely to force
down the price of a product over time, and any possible cost savings allow a company to
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still attain its targeted profit margins while continuing to reduce cost. It is also called as
Continuous Cost Control.
Illustration 2. Cost Control and Cost Reduction
Classify the following items under the more appropriate category: Category (CC) – Cost Control
Or Category (CR) – Cost Reduction:
Sl. No. Item Category CC/ CR
(i) Costs exceeding budgets or standards are investigated CC
(ii) Preventive function CC
(iii) Corrective function CR
(iv) Measures to standardize for increasing productivity CR
(v) Provision of proper storage facilities for materials CC
(vi) Continuous comparison of actual with the standards set CC
(vii) Challenges the standards set CR
(viii) Value analysis CR
4. TARGET COSTING CONTROL POINTS

Control Points which should be taken care of in all target costing projects:
• Identification of Principal Control Point: Experience shows that there always comes
a point, where the cost of maintaining the design team exceeds the savings gardened
from additional iterations. It is also necessary that most products should be launched
272 |SCM
Concept & Practice
Target Costing
within a reasonably short time or they will miss the appropriate market, where they
will beat the delivery of competing products to the market. This emphasis that the
principal control points over the course of target costing programme should be
properly taken care of.
• Point of Go/No Go Decision: If target costing is not reached, management retains
power to abandon the design project. There comes a point, when actual performance
is very close to expected performance in matter of cost incurrence.
• Milestone can be in terms of Timer or Points: A milestone can be in terms of time, say
one month. It can also be on the points in design process, at which specific activities
are completed.
5. IMPLEMENTING A TARGET COSTING SYSTEM

A target costing initiative requires the participation of several departments. Because there
are so many participants in the process from so many departments, some of whom have
different agendas in regard to what they want the program to produce. Design projects
can be delayed by squabbling or by an inability to drive down design or production costs
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in a reasonably efficient manner. This delay may lead to serious cost overruns in the cost of
the design team itself, which can lead to abrupt termination of the entire targets costing
system by the management team. However, these problems can be mitigated or completely
eliminated by ensuring that the steps listed here are completed when the target costing
system is first installed:
Step 1 : Create a Project Charter:
Step 2 : Obtain a Management Sponsor:
Step 3 : Obtain a Budget:
Step 4 : Assign a Strong Team Manager:
Step 5 : Enroll Full-Time Participants:
Step 6 : Use Project Management Tools:
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Target Costing
6. VALUE CHAIN ANALYSIS - PORTER’S VALUE CHAIN

Firm Infrastructure
Support Human Resource Management
Ma
Activities
rg
Technology Development
in
Procurement
Ma
Inbound Operations Outbound Marketing Service
rg
Logistic Logistic & Sales
n i
Primary Activities
Each activity should have a cost driver.

Two types of Cost Drivers
Structural or Executional
as per underlying economic structure such as as per execution requirement such as capaci-
sale, complexity of production etc. ty utilisation, plant layout work etc.
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Category of activities
a. Unit Level
b. Batch Level
c. Product Level
d. Facility Level
7. PORTER’S FIVE FORCES

(1) Bargaining Power of Customers
(2) Bargaining Power of Suppliers
(3) Threat of New Entrants
(4) Threat of Substitutes
(5) Threat of Competitive Rivalry
Illustration 3. Primary Activities of Value Chain

ABC Ltd. is engaged in business of manufacturing branded readymade garments. It has a single
manufacturing facility at Ludhiana. Raw material is supplied by various suppliers.
Majority of its revenue comes from export to Euro Zone and US. To strengthen its position
further in the Global Market, it is planning to enhance quality and provide assurance through
long term warranty.
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Concept & Practice
Target Costing
For the coming years company has set objective to reduce the quality costs in each of the
primary activities in its value chain.
Required
State the primary activities as per Porter’s Value Chain Analysis in the value chain of ABC Ltd
with brief description.
Answer
Primary activities are the activities that are directly involved in transforming inputs into outputs
and delivery and after-sales support to output. Following are the primary activities in the value
chain of ABC Ltd.:-
1. Inbound Logistics: These activities are related to the material handling and warehousing.
It also covers transporting raw material from the supplier to the place of processing inside
the factory.
2. Operations: These activities are directly responsible for the transformation of raw material
into final product for the delivery to the consumers.
3. Outbound Logistics: These activities are involved in movement of finished goods to the
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point of sales. Order processing and distribution are major part of these activities.
4. Marketing and Sales: These activities are performed for demand creation and customer
solicitation. Communication, pricing and channel management are major part of these
activities.
5. Service: These activities are performed after selling the goods to the consumers.
Installation, repair and parts replacement after sales are some examples of these activities.
Illustration 4. Porters Value Chain and Five Forces

Examine the Validity of following statements along with the reasons:
(i) The concepts, tools and techniques of value chain analysis apply only to all those organi-
zations which produce and sell a product.
(ii) Procurement activities are included in the Primary activities as classified by Porter under
value chain analysis concept.
(iii) As per Porter’s five forces model, bargaining power of buyers does influence the profitabil-
ity of an industry or market.
(iv) Value chain analysis in the strategic framework consists of single cost driver concept.
SCM
Target Costing
Answer
(i) Invalid
The concepts, tools and techniques of value chain analysis apply to organizations which
produce and sell a product and also to organizations which provide a service.
(ii) Invalid
Procurement activities are included in the support activities rather than primary activities.
(iii) Valid
Bargaining power of buyers is one of the factor or force that influences the profitability of a
market or industry. More the bargaining power buyers have, more the pressure on the industry
to not increase the price of product or service. They may even have to reduce the price some-
times.
(iv) Invalid
Value chain analysis in the strategic framework consists of multiple cost drivers concept. In
value chain analysis, a set of unique cost drivers is identified for each value activity instead of
single cost driver application at the overall firm level. Multiple cost drivers may be classified into
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Structural drivers and Executional drivers.
Illustration 5. Primary and Support Activities of Value Chain

Classify the following business activities into primary and support activities under value chain
analysis.
(i) Material Handling and warehousing – Primary
(ii) Purchasing of raw materials, supplies and other consumables – Support
(iii) Order Processing and distribution - Primary
(iv) Selection, placement and promotion of employees - Support
(v) Installation, repair and parts replacement – Primary
(vi) Transforming input into final products – Primary
(vii) General Management, Planning, finance, accounting - Support
(viii) Communication, pricing and channel management - Primary
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Target Costing
1
A company has the capacity of production of 80,000 units and presently sells 20,000 units at
` 100 each. The demand is sensitive to selling price and it has been observed that with every
reduction of ` 10 in selling price, the demand is doubled.
What should be the target cost at full capacity if profit margin on sale is taken at 25%?
What should be the cost reduction scheme by applying value engineering, if at present 40% of
cost is variable with same % of profit?
If Rate of Return is 15% on investment, what will be maximum investment at full capacity?

Target Cost Maximum Investment
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2
Bee manufacturing company sells its product at ` 1,000 per unit. Due to competition its compet-
itors are likely to reduce price by 15%. Bee wants to respond aggressively by cutting price by
20% and expects that the present volume of 1,50,000 units p.a. will increase to 2,00,000. Bee
wants to earn a 10% target profit on sales. Based on a detailed value engineering the compar-
ative position is given below:
Particulars Existing Target
Direct material cost per unit ` 400 ` 385
Direct manufacturing labour per unit ` 55 ` 50
Direct machinery cost per unit ` 70 ` 60
Total ` 525 ` 495
Manufacturing overhead: Existing Target

No. of orders (` 80 per order) 22,500 21,250
Testing hours (` 2 per hour) 4,500,000 3,000,000
Units reworked (` 100 per unit) 12,000 13,000
SCM
Target Costing
Manufacturing overheads are allocated using relevant cost drivers. Other operating costs per
unit for the expected volume are estimated as follows:
Research and Development ` 20

Design and Processing ` 30
Marketing ` 100
Customer service ` 15
Calculate target costs per unit and target costs for the proposed volume showing breakup of
different elements.

Target Cost
RTP
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3
Computo ltd. manufactures two parts P and Q for Computer industry:

P : Annual production and sales of 1,00,000 units at a selling price of ` 100.05 per unit.
Q : Annual production and sales of 50,000 units at a selling price of ` 150 per unit.
Direct and indirect costs incurred on these two parts are as follows:
Particulars P (` ‘000) Q (`’ 000) Total (` ‘000)
Direct material cost (variable) 4,200 3,000 7,200
Labour cost (variable) 1,500 1,000 2,500
Direct machining cost (see note) 700 550 1,250
Indirect costs:
Machine set up cost 462
Testing cost 2,375
Engineering cost 2,250
16,037
Note: Direct machining costs represent the cost of machine capacity dedicated to the produc-
tion of each product. These costs are fixed and are not expected to vary over the long run hori-
zon.
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Target Costing
Additional information is as follows:

Particulars P Q
Production batch size 1,000 units 500 units
Set up time per batch 30 hours 36 hours
Testing time per unit 5 hours 9 hours
Engineering cost incurred on each product ` 8.40 lakh ` 14.10 lakh
A foreign competitor has introduced product very similar to ‘P’. To maintain the company’s share
and profit, Computo Ltd. has to reduce the price to ` 86.25.
The company calls for a meeting and comes up with a proposal to change design of Product P.
The expected effect of new design is as follows:
(i) Direct material cost is expected to decrease by ` 5 per unit.
(ii) Labour cost is expected to decrease by ` 2 per unit.
(iii) Machine time is expected to decrease by 15 minutes; previously it took 3 hours to produce
1 unit of ‘P’. The machine will be dedicated to the production of new design.
(iv) Set up time will be 28 hours for each set up.
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(v) Time required for testing each unit will be reduced by 1 hour.
(vi) Engineering cost and batch size will be unchanged.
Required:
(a) Company management identifies that cost driver for Machine set up is set up hours used
in batch setting and for testing hours is testing time. Engineering costs are assigned to
products by special study. Calculate the full cost per unit for P and Q using Activity based
costing.
(b) What is the mark – up on full cost per unit of P?
(c) What is the Target cost per unit for new design to maintain the same mark – up percentage
on full cost per unit as it had earlier?
(d) Will the new design achieve the cost reduction target? (Assume cost per unit of cost drivers
for the new design remains unchanged).
(e) List four possible management actions that the Computo Ltd. should take regarding new
design.

Target Cost
May 2006
SCM
Target Costing
4
You are a manager of XYZ Paper Mills and have recently come across a particular type of paper
which is being sold at a substantially lower rate by another company, ABC Ltd than the price
charged by your own mill. The value chain for use of one tonne of such paper for ABC Ltd is :
ABC Ltd sells this particular paper to merchant @ ` 1466 per ton. ABC Ltd pays for the freight
which amounts to ` 30 per ton. Average returns and allowances amount to 4% of sales and
approximately equals to ` 60 per ton.
The value chain of your company, through which the paper reaches the ultimate customer is
similar to that of ABC ltd. However, your mill does not sell directly to the merchant, the latter
receiving the paper from huge distribution centre maintained by your company at Haryana.
Shipment Costs from the Mill to the Distribution Centre is ` 11 per ton while the operating costs
in the Distribution Centre are estimated at ` 25 per ton. The return on investments required by
the Distribution Centre for the investments made, amount to an estimate of ` 58 per ton.
C Block
Calculate the Mill Manufacturing Target Cost for this particular paper for XYZ ltd. Assume that
the return on investment expected by XYZ Ltd is ` 120 per ton of paper.

Target Cost
RTP
5
Two identical companies, A and B manufacture and sell an identical product with the same cost
structure. The selling price is ` 10 per unit and the variable cost is ` 6 per unit – same in both
cases. The capacity is 25,000 units in both companies and the Fixed Overhead for both A and B
are ` 35,000. Both the companies are aiming at a year end profit of ` 15,000.
The year is almost coming to close. Company A has already sold 10,000 units and can make and
sell additional 15,000 unit while Company B has already made and sold 20,000 units. Fortu-
nately at this junction, Company C wants 5,000 units of the same product. It invites competitive
quotations from Co. A and Co. B
Both Company A and B are keen to get the order from C.
Which Company, in your opinion, has the better chance of getting the offer from Company C?
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Concept & Practice
Target Costing

Impact of Target on Future Business
RTP
6
A company has sales of 1,00,000 units at a price of ` 150 per unit and profit of ` 30 lakhs in the
current year. Due to stiff competition, the company has to reduce its price of product next year
by 8% to achieve same volume of sales as in the current year. The cost structure and profit for
the current year is given below:
Particulars (` Lakhs)
Direct material 50
Direct wages 30
Variable factory overhead 15
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Fixed overheads including Sales & Admin.
Expenses 25
Total cost 120
To achieve the target cost to maintain the same profit, the company is evaluating the proposal
to reduce the labour cost and fixed factory overhead. A vendor supplying the machine suitable
for the company’s operations has offered an advanced technology semi-automatic machine of
` 10 lakhs as replacement of old machine worth ` 3 lakhs. The vendor is agreeable to take back
the old machine at ` 2.25 lakhs only. The company’s policy is to charge depreciation at 10%
on WDV. The maintenance charge of the existing machine is ` 0.80 lakhs per annum whereas
there will be warranty of services free of cost for the new machine for first two years. There are
9 supervisors whose salary is ` 1.20 lakhs each per annum. The new machine having conveyor
belt is expected to help in cost cutting measures in the following ways:
(1) Improve productivity of workers by 25%.
(2) Cut down material wastage by 1 %.
(3) Elimination of services of supervisors because of automatic facilities of the machine.
(4) Saving of packaging cost by ` 1.35 lakhs.
Assuming cost of capital to be 12%, calculate how many supervisors should be removed from
the production activities to achieve the target cost.

Target Cost Replacement of Machine
CA Final Old Nov’18
SCM
Pricing Strategies
Chapter 16
Pricing Strategies
1. TECHNIQUES OF PRICING
2. PRICING UNDER DIFFERENT MARKET STRUCTURES
A. Perfect Competition
B. Monopoly
C. Monopolistic Competition
D. Oligopoly
3. PRICING STRATEGIES
A. Skimming Pricing Policy
B. PENETRATION PRICING POLICY
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C. COMPETITIVE PRICING
D. Loss Leader
E. STRATEGIC PRICING OF NEW PRODUCTS
F. Marketing Strategies to Create Value
4. PRICING IN PERIODS OF RECESSION
5. PRICING BELOW MARGINAL COST
6. PRINCIPLES OF PRODUCT PRICING
7. PRICE ADJUSTMENT POLICES
8. VALUE- BASED PRICING METHOD - OBJECTIVE
VALUE OR TRUE ECONOMIC VALUE (TEV)
9. STRUCTURED APPROACH TO PRICING DECISIONS
10. PRICING OF SERVICES: ISSUES
11. PARETO ANALYSIS
A. USEFULNESS OF PARETO ANALYSIS
B. APPLICABILITY OF PARETO ANALYSIS TO BUSINESS
SITUATIONS
C. LIMITATIONS OF PARETO ANALYSIS
12. PROFIT MAXIMIZATION MODEL
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Concept & Practice
Pricing Strategies
1. TECHNIQUES OF PRICING
(a) Absorption Costing or Traditional Pricing technique for establish product:
S.P = prime cost (actual) + overhead recovered + mark up
(b) Conversion cost method:
S.P = total conversion cost + mark up on conversion cost
(c) Standard Cost Method:
S.P = Standard Cost + mark up
(d) Marginal Cost Method:
S.P = total variable cost + mark up on variable cost
(e) Differential Cost Method:
S.P = Differential Cost + mark up.
(f) Relevant cost technique:
Minimum sale price = variable cost + discretionary cost + opportunity cost.
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(g) Learning Curve Method or Experience curve method:
S.P = Static cost + Reducible cost + Mark up
(h) Return on investment method: (ROCE or ROI):
S.P = total cost + mark up on capital employed
(i) Activity Based Costing:
S.P = Prime cost + overhead on cost driver + mark up
(j) Life Cycle Costing:
S.P = total cost on estimated life + mark up
(k) Target Costing:
Target SP = Target Cost + Target Profit
2. PRICING UNDER DIFFERENT MARKET STRUCTURES

The determination of optimal price can be considered under the following market
structures:
A. PERFECT COMPETITION
Under perfect competitive market, there are large numbers of sellers selling a
homogeneous product using identical production process and all of them have
perfect information about the market and price. Perfect market allows free entry and
exit of firms into and out of the industry.
SCM
Pricing Strategies
Under this type of market, firm has no pricing policy of its own as the sellers are price
takers (i.e. it has to accept the price determined by the market) and sell as much as
they are capable of selling at the prevailing market price. Since each firm produces
and sells a homogeneous product, it cannot increase its price beyond the market
price. If it does so then it has to lose all of its market demand to the competitors.
There is no control over market price which will equate the quantities available with
the quantities which the buyers are willing to buy. The firm has to take a decision in
favour of the quantity to sell. The firm can continue to produce so long as its marginal
cost is less than or equal to its selling price, upto the point at which the marginal cost
is equal to price, increase in output will add to revenue and thereafter the increase will
add to cost.
B. MONOPOLY
Monopoly is a market condition where there is only one supplier or producer of a
homogeneous product for which there is no close substitute but has many buyers.
Under the monopoly, a firm is a price setter i.e. it can fix any price but here also the
pricing is done taking elasticity of demand for the product into consideration. That
means though the seller/ producer can fix any price but it will go for the price where
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demand for the product and consequent profit will be maximum.
C. MONOPOLISTIC COMPETITION
The monopolistically competitive market is one in which there are large number of
firms producing similar but not identical products. Since there is limit to the growth
of competitors the excess profits earned by monopolistic situation attracts new
competition. This will have a long-run effect on the excess profits which will tend to
diminish because of the price competition with close substitutes. The company will,
however, have to compare marginal cost and marginal revenue in maximising its
profits.
Under monopolistic condition, consumers may buy more at a lower price than at higher
price. The profit can be maximised by equating marginal revenue with marginal cost.
D. OLIGOPOLY
A market structure where there are few firms producing or selling homogenous or
identical product. In this type of market structure the firms are aware of the mutual
interdependence of investment, production process, advertising and sales plan of its
rival firm. Hence, any change in any variable by a firm is likely to have an equal reaction
on the part of other competing firms. It is therefore, clear that the oligopolistic firm,
while determining the price for its product, consider not only the demand for the
product but also the reactions of the other firms in the industry to any action or
decision it may take.
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If a firm does not follow or adapt its pricing policy in consonance with its competitor,
the shift in the sales will be sensitive. That means demand will shift towards the lower
price. Thus, each firm will study the potential reaction before increasing or decreasing
the selling price. The firms in oligopolistic market maintain the price of the product
either by close analysis of each other’s behavior or by means of cooperation and
collusion.
Pricing Strategies of Oligopolies
Oligopolies may pursue the following pricing strategies:
• Predatory Pricing: Keeping price artificially low, and often below the full cost of
production.
• They may also operate a Limit-Pricing Strategy to discourage entrants, which is
also called entry forestalling price.
• Oligopolists may collude with rivals and raise price together, but this may attract
new entrants.
• Cost-Plus Pricing: A straightforward pricing method, where a firm sets a price by
calculating average production costs and then adding a fixed mark-up to achieve
a desired profit level. There are different versions of cost-plus pricing, including
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full cost pricing, where all costs - that is, fixed and variable costs - are calculated,
plus a mark-up for profits, and contribution pricing, where only variable costs are
calculated with precision and the mark-up is a contribution to both fixed costs
and profits.
Non-Price Strategies
Non-price competition is the favoured strategy for oligopolists because price
competition can lead to destructive price wars – examples include:
• Trying to improve Quality & After Sales Servicing, such as offering extended
guarantees.
• Spending on Advertising, Sponsorship, and Product Placement.
• Sales Promotion, such as buy-one-get-one-free, is associated with the large
supermarkets, which is a highly oligopolistic market, dominated by three or four
large chains.
• Loyalty Schemes, which are common in the supermarket sector, such as Reliance’s
One Card.
3. PRICING STRATEGIES
A. SKIMMING PRICING POLICY

It is a policy of high price during the early period of a product’s existence. This can be
synchronized with high promotional expenditure and in the later years the prices can
be gradually reduced.
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Pricing Strategies
The reasons for following such a policy are:

Inelastic Demand: The demand is likely to be inelastic in the earlier stages till the
product till the product is established in the market.
High Profit at initial stage: The charging of high price in the initial periods, serves
to skim the cream of the market that is relatively insensitive to price. The gradual
reduction in price in the later year will tend to increase the sales.
Demand not known: This method is preferred in the beginning because in the initial
periods when the demand for the product is not known the price covers the initial
cost of production.
Financing High Cost of Capital: High initial capital outlays, needed for manufacture,
result in high cost of production. Added to this, the manufacturer has to incur huge
promotional activities resulting in increased costs. High initial prices will be able to
finance the cost of production particularly when uncertainties block the usual sources
of capital.
B. PENETRATION PRICING POLICY

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The circumstances in which penetration policy should be adopted are as follows:

(i) When the demand of the product is elastic to price, In other words, the demand
of the product increases when price is low.
(ii) When there are substantial saving on large-scale production. Here increase in
demand is sustained by the adoption of low pricing policy.
(iii) When there is threat of competition. The prices fixed at a low level act as an entry
barrier to prospective competitors.
(iv) This is only an entry strategy. The prices are regularised by companies after
gaining a market share.
C. COMPETITIVE PRICING
Where a company sets its price mainly on the consideration of what its competitors
are charging, its pricing under such situation is called competitive pricing. Two types
of competitive pricing are:
a. Going rate pricing: Under this method, the firm tries to keep its price at the
average level charged by the industry. Such pricing is useful where it is difficult to
measure costs. Adoption of such pricing will not only yield fair return but would
be least disruptive for industry’s harmony. Under highly competitive conditions
in homogeneous product market (such as food; raw materials and textiles) the
company has no pricing decision to make.
b. Sealed bid pricing: competitive pricing is adopted in situations where firms
compete for jobs on the basis of bids. The bid is the firms offer price, and it is
a prime example of pricing based on the expectations of how competitors will
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price rather than on a rigid relation based on the concerns own costs or demand.
The objective of the firm in bidding situation is to get the contract and therefore
it tries to set its prices lower than the other bidding firms.
c. Cost plus pricing : favourable to get a better quality job in the competitive
market situation e.g. Government contract for infrastructure
D. LOSS LEADER
Where a product can be enriched by a series of optional extras, which a customers of the
main product are at liberty to add on for additional advantages, the main product may
be offered at a relatively low price. If the price is set below cost, the product becomes
a loss leader. It leads the customers to buy the extras or optional advantageous spare
parts which are highly priced.
When a product range consists of one or more main products and a series of related
optional ‘extract’, which the customer can ‘add on’ to the main product, the supplier can
set a relatively low price for the main product and a high one for the ‘extras’. Obviously,
the aim is to stimulate sufficient demand for the former to ensure the target return
from sales of the latter. The strategy has been used successfully by aircraft engine,
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gas turbine manufacturers, who win an order with a very competitively priced main
product that can only be serviced by their own, highly priced spare parts.
Gillette did not invent the safety razor but the market strategy Gillette adopted helped
to build market share. Gillette razors were sold at 1/5 of the cost to manufacture them
but only Gillette blades fitted and these were sold at a price of 5 cents. The blades cost
only 1 cent to manufacture and so Gillette made large profits once it had captured the
customer.
E. STRATEGIC PRICING OF NEW PRODUCTS

The pricing of new product poses a bigger problem because of the uncertainty involved
in the estimation of their demand. In order to overcome this difficulty experimental
sales are conducted in different markets using different prices to see which price is
suitable. A company may, for example, choose three different markets and by using
the same amount of sales promotional activities, ascertain what the right price is. In
such circumstances, it may even prove that the highest price yielding the largest unit
contributory margin need not necessarily maximise the profits. A lower price may well
go to maximise the profits. But at the same time if a product is priced very low to
attract more demand, it may be difficult in the future to raise the price as it may not be
acceptable to the consumers. So, pricing of a new product is very critical issue which
should be decided after a thorough market study and consumer behavior analysis.
A new product is analysed into three categories for the purpose of pricing:
Revolutionary Product: A product is said to be revolutionary when it is new for
the market and has the potential to create its own value. This type of product has
revolutionary impact on the market and consumer behaviour. It replaces the existing
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method or technology and the approach to doing a work is quite different and unique.
These products enjoy the benefit of product differentials and have the potential of
being market leader.
Revolutionary product may enjoy the premium price as a reward for its innovation
and taking first initiative.
Evolutionary Product: A product introduces upgraded version with few additional
characteristics of the product is known as evolutionary product.
The evolutionary products may be priced taking cost-benefit, competitor, and demand
for the product into account.
Me-too Product: A product is said to be me-too product when its emergence is a
result of the success of a revolutionary product. These types of products are very
similar (in ordinary language imitation) to revolutionary and/ or evolutionary products
of other firms. The firm while producing me-too products, generally follows the similar
production process and technology that is used by the other firms. These are known
as market followers.
The me-too products are price takers as the price is determined by the market mainly
by the competitive forces.
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F. MARKETING STRATEGIES TO CREATE VALUE

Creating value for the customers is one of the important objectives of a firm. A firm
makes all the efforts to create value and to achieve this it formulates its marketing
strategy in that direction. Understanding customers’ wants and needs is foundation
for building this value. To create value, a firm makes the following marketing strategies:
• First it develops a product that satisfy the wants and needs of the customers,
• After identification and development, it designs a promotion program to
convey the value of the products to the customers.
• It chooses the right distribution channel through which its product will reach to
the customers
• At last it has to design a pricing strategy that creates incentive to purchaser to
buy the product and to seller to sell the product.
4. PRICING IN PERIODS OF RECESSION

In periods of recession, a firm may sell its articles at a price less than the total cost but
above the marginal cost for a limited period.
The advantages of this practice are:
• The firm can continue to produce and use the services of skilled employees who are
well trained and will be difficult to re-employ later if discharged.
• Plant and machinery can be prevented from deterioration through idleness.
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• The business would be ready to take advantage of improved business conditions later.
• This avoids the competition of securing the business of the firm.
One thing to remember here is that a situation like this should not lead to a drastic price
cutting and the orders accepted should not cover a long period extending over the
production facilities of a period when business conditions improve.
5. PRICING BELOW MARGINAL COST

Firm may also be justifiable to sell the product at a price below marginal cost for a limited
period provided the following conditions prevail:
• Where materials are of perishable nature.
• Where stocks have been accumulated in large quantities and the market prices have
fallen. This will save the carrying cost of stocks.
• To popularize a new product.
• Where such reduction enables the firm to boost the sales of other products having
larger profit margin.
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6. PRINCIPLES OF PRODUCT PRICING
As already stated, cost should not be considered as an important determinant of price. The
tendency should be to lower the price in such a way so as to choose a right combination of
price and output to maximise profits. The important determinants of price, therefore, are
competitive situations prevailing in the market and elasticities.
Taking the standard products into consideration, the pricing principles are much the
same whether the product is a new one or the one already well established in the market.
However, the environmental situation and information base are different.
To arrive at a right price, the following important points to be kept in the mind:
(a) Price Customization
Pricing of a product is some time customised keeping taste, preference and perceived
value of a consumer into consideration. Price customisation is done in various ways:
• Based on product line: Based on the requirement of the consumer products can
be customized and accordingly the prices. For example, some may like to have
a smartphone with 16 GB over 32 GB. In this case pricing for the product can be
based on memory specification.
• Based on customer’s past behaviour: A customer with good payment record
may be given more discounts then the others.
• Based on demographics: Different pricing may be adopted based on age or social
status. For example, railway fare concession for senior citizen and concessional
price tickets for military personnel.
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• Based on time differential: Pricing for a product or service is also done on the
basis of time differential i.e. different price for different time period. For example,
discounted price for data usage provided by a broadband service provider if
subscription paid for six months at a time.
Apart from above pricing principles, other macro economic and legal factors should
also be given due importance while chalking out a pricing strategies.
(b) Price Sensitivity
It measures the customer’s behaviour to the change in price of a product. Nagle1 has
identified nine factors that contribute to price sensitivity. These factors are:
• Unique Value Effect- More unique the product, lower is the price sensitivity.
• Substitute Awareness Effect- If the buyers are aware of substitutes and these
perform the same function, then the buyer’s price sensitivity will be high.
• Difficult Comparison Effect- Price sensitivity will be low if the buyer has difficulty
comparing two alternatives.
• Total Expenditure Effect- If the expenditure on the product represents a low
proportion of the consumer income, the price sensitivity will be less visible for
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such a product.
• End- Benefit Effect- Buyers are less price sensitive where the expenditure on the
product is low compared to the total cost of the end product.
• Shared Cost Effect- If the cost of the product is shared by another party, the
buyer will have less prone to price sensitivity.
• Sunk Investment Effect- Price sensitivity is low in products which are used along
with assets previously bought.
• Price Quality Effect- Higher the perceived quality of the product, lower the price
sensitivity.
• Inventory Effect- If the product cannot be stored, the buyer will be less price
sensitive.
One of the methods more commonly used for measuring price sensitivity is controlled
experimentation. In this method, customers are offered different brands at different
prices and customer’s responses are obtained. Then the company’s brand prices are
changed and customer’s response at each price level is recorded. The price at which
demand for the product starts declining is the level where price sensitivity begins and
based on the response level, sensitivity can be measured. It depends on the nature of
the product and buyer characteristics.
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7. PRICE ADJUSTMENT POLICES

(i) Distributor’s Discounts – It means price deductions that systematically make the net
price vary according to buyer’s position in the chain of distribution.
(ii) Quantity discounts are price reductions related to the quantities purchased.
(iii) Cash discounts are price reductions based on promptness of payment.
(iv) Price Discrimination – charging different prices and it takes various forms according
to whether the basis is customer, product, place or time.
(v) Geographic Pricing – Pricing policies may be established whereby the buyer pays all
the freight expense, the seller bears the entire cost, or the seller and buyer share this
expense. The strategy chosen can influence the geographic limits of a firm’s market,
locations of its production facilities, sources of its raw materials, and its competitive
strength in various geographic markets.
(a) Point of production pricing: Price not including freight charges.
(b) Uniform delivered pricing: Uniform price at all locations including delivery
charges.
(c) Zone delivered pricing: Different prices for different geographical zones
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depending on uniform fright charges to that zone.
(d) Freight absorption pricing: Prices are inclusive of freight that a competitor
located near the client would charge.
8. VALUE- BASED PRICING METHOD - OBJECTIVE VALUE OR

TRUE ECONOMIC VALUE (TEV)
There is an increasing trend to price the product on the basis of customer’s perception
of its value. This method helps the firm in reducing the threat of price wars. Marketing
research is important for this method. It is based on:
(a) Objective Value or True Economic Value : This is a measure of benefits that a product
is intended to deliver to the consumers relative to the other products without giving
any regard whether the consumer can recognize these benefits or not. True economic
value for a consumer is calculated taking two differentials into consideration:
TEV = Cost of the Next Best Alternative + Value of Performance Differential
Cost of the next best alternative is the cost of a comparable product offered by some
other company.
Value of performance differential is the value of additional features provided by the
seller of a product.
A firm’s product may be superior to the next best alternative in some dimensions but
inferior in others.
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(b) Perceived Value : This is the value that consumer understands the product deliver to
it. It is the price of a product that a consumer is willing to spend to have that product.
At the time of fixing price, it is to be kept in the mind that any price which set below
the perceived value but above the cost of goods sold give incentives to both buyers
and the seller.
This can be understood with the help the diagram given below.
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Illustration 1. True Economic Value Computation

A customer wants to buy a System for a single year (after which it will be scrapped) with plans
to use it for 2,500 hrs.
Cost Structure (similar products):
Particulars System-X System-X2
Operating Cost/ hour `5 ` 7.50
Probability of System Crash 10% 0.5%
Price ` 37,500 ?
Find the TEV for the System-X2 if the cost of a System Crash to the buyer is ` 1,00,000.
Answer
Computation of TEV
Particulars `
Operating Cost ` (6,250)
2,500 hrs. × (5.00 - 7.50)
System Crash Savings ` 9,500
1,00,000 × (10.00% - 0.50%)
Price of Next Best Alternative ` 37,500
TEV ` 40,750
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9. STRUCTURED APPROACH TO PRICING DECISIONS

Logical and acceptable way of structuring the process:
Step 1 : Company and Marketing Objectives
Step 2 : Set Pricing Objectives and Policy
Step 3 : Assess Target Markets
Step 4 : Assess Costs/ Cost Structure
Step 5 : Assess Customer’s Demand
Step 6 : Assess Competitors
Step 7 : Select Pricing Method
Step 8 : Select Specific Pricing
10. PRICING OF SERVICES: ISSUES

• When services are uniquely tailored to each customer’s needs, the pricing cannot be
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easy. Each service transaction is likely to have distinct pricing structure.
• In certain services customer’s participation is essential. The customer may have to
incur certain intangible costs over and above monetary cost while making use of a
service. The pricing decision in such services should accommodate the intangible
costs that a customer may have to bear with.
• Some of the services like health care, education, communication, transport, etc. fall
within the larger domain of government. Therefore, price of those services tends to be
regulated.
• Some services pricing is determined in a collective manner. Trade association,
professional bodies, or other institutions may impose broad guidelines for fixing the
price.
11. PARETO ANALYSIS

Pareto analysis is based on the 80.20 rule that was a phenomenon observed by Vilfred
Pareto, an Italian Economist. According to him 80% of wealth of Milan in Italy was owned
by 20% of its citizens. The phenomenon can be observed in many different business
situations & the management can follow it in various circumstances to direct management
attention to the key control mechanism or planning aspects.
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A. USEFULNESS OF PARETO ANALYSIS

It helps to establish top priorities & to identify both profitable and unprofitable targets
it helps to:
a. Prioritize problems, goals and objectives
b. Identify root causes
c. Select and define key quality improvement programs
d. Select key customer relations and service programs
e. Select key employee relations improvement programs
f. Select and define key performance improvement programs
g. Maximize research and product development time
h. Verify operating procedures and manufacturing processes
i. Product or services sales and distribution
B. APPLICABILITY OF PARETO ANALYSIS TO BUSINESS SITUATIONS

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The Pareto analysis is generally applicable to the following business situation.

(i) Pricing of a product: In practice, it has been observed that 20% of products of
a firm may account for 80% of total sales revenue. Under such circumstances the
firm can adopt more sophisticated pricing method for small portion of products
that jointly accounts for approximately 80% of total sales revenue. For the
remaining 80% of the products the firm may use cost bases pricing method.
(ii) Customer profitability: Customers can also be analyzed instead of products,
for their relative profitability It has been often found that 20% of customers may
generate 80% of sales revenue profit. Such an analysis is useful for the evaluation
of portfolio of customer profile.
(iii) Stock control: Approximately 20% of the total investment in quantity of stock
may account for about 80% of its investment. Since the number of items is small
therefore the management of a firm may be able to control most of the monetary
investment in them.
(iv) Applicability in activity based costing: In ABC it is often said that 20% of an
organisation cost drivers are responsible for 80% of the total overhead cost. By
analyzing, monitoring and controlling those cost drivers that cause most cost a
better control and understanding of overheads may be obtained.
(v) Quality control: Pareto analysis seeks to discover from an analysis of defect
report or customer complaints which “vital few” causes are responsible for most
of the reported problems. Often 80% of underlying problems can usual be traced
to 20% of the various underlying causes.
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C. LIMITATIONS OF PARETO ANALYSIS

Potential cost is involved and Product & customer of low rank is neglected.
Illustration 2. Pareto Analysis - Ranking
ABC Ltd manufactures and sells seven products. The following data relates to the latest
period:
Product Contribution (` in ‘000)
P 96
Q 36
R 720
S 240
T 12
U 60
V 24
Analyse which product requires most control as per Pareto.
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Answer
The first step is to rearrange the products in descending order of contribution and calculate the
cumulative contribution.
Contribution Cumulative contribution
Product Cumulative %
(` ‘000) (`’000)
R 720 720 61
S 240 960 81
P 96 1056 89
U 60 1,116 94
Q 36 1,152 97
V 24 1,176 99
T 12 1,188 100
It shows that more than 80 percent of the total contribution is earned by two products: R and S.
The position of these products needs protecting, perhaps through careful attention to brand-
ing and promotion. The other products require investigation to see whether their contribution
can be improved through increased prices, reduced costs or increased volumes.
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12. PROFIT MAXIMIZATION MODEL

Pricing model is a mathematical model which uses economic theory of pricing.
(i) As per economic theory of pricing, Profit is Maximum at a level of output where
Marginal Revenue (MR) is equal to Marginal Cost (MC) i.e.
Marginal Revenue (MR) = Marginal Cost (MC)
This model determines the level of production up to which production can be
continued.
(ii) The Basic Price equation, which is used to determine the Price where Profit is Maximum.
The equation is written as:
P = a – bQ
(iii) The Marginal Revenue equation is written as
Marginal Revenue (MR) = P = a – 2bQ
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1
The following independent situations relate to new product pricing. Classify the products into
the appropriate category: Revolutionary Product (RP), or Evolutionary Product (EP) or a Me-Too
Product (MP) and state the corresponding pricing to be followed:
Sl. No. Situation RP/EP/MP Pricing
I II III IV
(i) Adjustable work table like a stool, has been successfully
capturing the market. Company X makes a small variant of this
product and is trying to enter the market.
(ii) R & D has just been completed on an innovative computer
processor in the shape of a pen, with accompanying pen-like
devices to act as keyboard projector and monitor projector. This
is expected to get the laptops out of business due to extreme
ease of portability of just 3 pen-like light weight devices.
(iii) A successful mobile manufacturing company has built into its
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latest mobile phone, an additional sliding screen and improved
its processor capabilities so that the phone is almost a laptop.
You may present only columns I, III & IV. You are required to explain the pricing in one sentence.

Revolutionary Product, or Evolutionary
Product or a Me-Too Product
CA Final Old May’17
Answer
New Product Pricing
(i) Me-too Product (MP) Market Price that is determined by competitive forces
for the successful product.
(ii) Revolutionary Product (RP) Premium Pricing, It can expect to make a tidy profit as a
reward for innovation and taking its first initiative.
(iii) Evolutionary Product (EP) Demand Based Pricing, Price higher than the earlier
version to justify its Costs and Benefits subject to what
amount can be stepped up in the market.
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2
State the pricing policy most suitable in each of the following independent situations:
(i) The company makes original equipment and does defence contract work. There are other
companies which also undertake such projects.
(ii) The product made by a company is new to the market. It is expected to enjoy a long term
demand. Competition is expected very soon, since the product will be desirable to most
customers.
(iii) Stock of processed ready to eat products, whose shelf life will soon be over in the next 2
months. The product is going to be discontinued.
(iv) A company sells a homogeneous product in a highly competitive market.
(v) ‘A’ is a new product for the company and the market and meant for large scale production
and long term survival in the market. Demand is expected to be elastic.
(vi) ‘B’ is a new product for the company, but not for the market. B’s success is crucial for the
company’s survival in the long term.
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(vii) ‘C’ is a new product to the company and the market. It has an inelastic market. There needs
to be an assured profit to cover high initial costs and the usual sources of capital have un-
certainties blocking them.
(viii) ‘D’ is a perishable item, with more than 80% of its shelf life over.

Pricing Strategies Case Study
3
The share of production and the cost based selling price computed separately for a common
product for each of the four companies in the same industry are as follows :
Company
A B C D
Share of production (%) 40 25 20 15
Costs :
Direct Material (`/Unit) 75 90 85 95
Direct Labour (`/Unit) 50 60 70 80
Depreciation (`/Unit) 150 100 80 50
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Company
A B C D
Other Overheads (`/Unit) 150 150 140 120
Total (`/Unit) 425 400 375 345
Fair Price (`/Unit) 740 615 550 460
Capital Employed per Unit :
(a) Net Fixed Assets (`/Unit) 1,500 1,000 800 500
(b) Working Capital (`/Unit) 70 75 75 75
Total (`/Unit) 1,570 1,075 875 575
Required :
What should be the uniform price that should be fixed for the common product?

Uniform Pricing
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4
Generation 2050 Technologies Ltd. develops cutting-edge innovations that are powering the
next revolution in mobility and has nine tablet smart phone models currently in the market
whose previous year financial data is given below:
Sales Profit-Volume
Model
(`’000) (PV) Ratio
Tab - A001 5,100 3.53%
Tab - B002 3,000 23.00%
Tab - C003 2,100 14.29%
Tab - D004 1,800 14.17%
Tab - E005 1,050 41.43%
Tab - F006 750 26.00%
Tab - G007 450 26.67%
Tab - H008 225 6.67%
Tab - I009 75 60.00%
Required
(i) Using the financial data, carry out a Pareto ANALYSIS (80/20 rule) of Sales and Contribution.
(ii) DISCUSS your findings with appropriate RECOMMENDATIONS.
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Pareto Analysis Recommendations
5
The following information is given about the type of defects during a production period and
the frequencies of their occurrence in a spectacle manufacturing company:
No. of
Defect
items
End Frame not equidistant from the centre 10
Non-uniform grinding of lenses 60
Power mismatches 20
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Scratches on the surface 110

Spots / Stains on lenses 5
Rough edges of lenses 70
Frame colours-shade differences 25
Required
PREPARE a frequency table so that a Pareto Chart can be constructed for the defect type. Also,
IDENTIFY key areas of focus.

Pareto Analysis
Answer
Statement Showing “Pareto Analysis of Defects”
No. of % of Total Cumulative

Defect Type
Items Items Total
Scratches on the surface 110 36.67% 36.67%
Rough edges of lenses 70 23.33% 60.00%
Non-uniform grinding of lenses 60 20.00% 80.00%
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Frame colours-shade differences 25 8.33% 88.33%

Power mismatches 20 6.67% 95.00%
End frame not equidistant from the centre 10 3.33% 98.33%
Spots/ Strain on lenses 5 1.67% 100.00%
300 100.00%
The company should focus on eliminating scratches on the surface, rough edges of lenses and
grinding of lenses related defects which constitute 80% portion, according to Pareto Theory.
6
The budgeted cost data of a product manufactured by Ayudhya Ltd. is furnished as below:
Budgeted units to be produced 2,00,000

Variable cost 32 per unit
Fixed cost 16 lacs
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It is proposed to adopt cost plus pricing approach with a mark-up of 25% on full budgeted cost basis.
However, research by the marketing department indicates that demand of the product in the
market is price sensitive. The likely market responses are as follows:
Selling price (` per unit) 44 48 50 56 60

Annual Demand (units) 1,68,000 1,52,000 1,40,000 1,28,000 1,08,000
Required
ANALYSE the above situation and DETERMINE the best course of action.

Profitability under Cost plus pricing
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Answer
Analysis of Cost plus Pricing Approach
The company has a plan to produce 2,00,000 units and it proposed to adopt Cost plus Pric-
ing approach with a markup of 25% on full budgeted cost. To achieve this pricing policy, the
company has to sell its product at the price calculated below:
Qty. 2,00,000 units

Variable Cost (2,00,000 units × ` 32) 64,00,000
Add: Fixed Cost 16,00,000
Total Budgeted Cost 80,00,000
Add: Profit (25% of ` 80,00,000) 20,00,000
Revenue (need to earn) 1,00,00,000
` 10 , 00 , 000 ` 50 p.u.
Selling Price per unit
2, 00 , 000 units
However, at selling price ` 50 per unit, the company can sell 1,40,000 units only, which is 60,000
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units less than the budgeted production units.

After analyzing the price-demand pattern in the market (which is price sensitive), to sell all the
budgeted units market price needs to be further lowered, which might be lower than the total
cost of production.
Statement Showing “Profit at Different Demand & Price Levels”
I II III IV Budgeted
Qty. (units) 1,68,000 1,52,000 1,40,000 1,28,000 1,08,000
` ` ` ` `
Sales 73,92,000 72,96,000 70,00,000 71,68,000 64,80,000
Less: Variable Cost 53,76,000 48,64,000 44,80,000 40,96,000 34,56,000
Total Contribution 20,16,000 24,32,000 25,20,000 30,72,000 30,24,000
Less: Fixed Cost 16,00,000 16,00,000 16,00,000 16,00,000 16,00,000
Profit (`) 4,16,000 8,32,000 9,20,000 14,72,000 14,24,000
Profit (% on total cost) 5.96 12.87 15.13 25.84% 28.16%
Determination of the Best Course of Action
(i) Taking the above calculation and analysis into account, the company should produce and
sell 1,28,000 units at ` 56. At this price company will not only be able to achieve its desired
mark up of 25% on the total cost but can earn maximum contribution as compared to
other even higher selling price.
(ii) If the company wants to uphold its proposed pricing approach with the budgeted quantity,
it should try to reduce its variable cost per unit for example by asking its supplier to provide
a quantity discount on the materials purchased.
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7
An organisation manufactures a product, particulars of which are detailed below:
Annual Production 20,000 units

Material cost ` 60,000
Other variable cost ` 1,20,000
Fixed cost ` 40,000
Apportioned Investment ` 2,00,000
Determine the unit selling price under each of the following strategies. Assume that the organ-
ization’s tax rate is 25%.
(a) 20% return on investment;
(b) 30% mark-up based on total cost;
(c) 20% profit on sales price;
(d) 15% profit on list sales when trade discount is 35%;
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(e) 40% mark-up based on incremental cost;
(f) 50% mark-up based on value added by manufacturer.

Pricing Techniques
8
Metal Products Ltd. have received an enquiry for the supply of 2,00,000 numbers of a special
type of machine screw. Capacity exists for manufacture of the screws in the company’s unit
no.3, but a fixed investments of ` 60,000 and working capital to the extent of 25% of sales value
will be required if the job is undertaken. The costs are estimated as follows:-
Raw materials 20,000 lbs @ ` 2.30 per lb

Labour hours 18,000 hrs of which 2,000 would be overtime hours payable at
double the labour rate.
Labour rate ` 1 per hour
Factory overhead ` 1 per labour hour
Selling and distribution cost ` 23,000
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Material recovered as scrap ` 2,000

at end of operation
Expected rate of return 25 percent on capital employed
Prepare a cost and price statement indicating the price which should be quoted to the customer.

Pricing on ROCE Working capital as a
percentage of sales
9
A small scale unit has a capacity to make 10,000 units of a product. The actual cost in 2018 is
given below:
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Direct material ` 50 per unit

Direct labour ` 12 per unit
Variable overheads ` 4.5 per unit
Fixed factory overheads ` 25,000
The company’s budget for the next year was to be prepared for the following data:
(a) A wage agreement is entered into where the wage will be linked to an index. The labour
rate presently comprises of 50 % basic pay and balance as D.A. The formula is to link the
existing D.A. to price index.
(b) The sale is estimated to touch 80 % capacity.
(c) The average fixed assets (net) will be ` 2,25,000 and working capital would be 25 % of value
of sales.
(d) Company expects a return of 15 % on capital employed.
(e) The price indices for the base period 2018 and for 2019 are as follows:
2018 2019
Cost of living index for D.A. 420 525
Copper 450 600
Aluminium 400 480
(f) The material used is 60 % copper and 40 % aluminium.
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Determine the price at which product will be sold in 2019.

Pricing on ROCE CLI
10
The profit for the year of Push On Ltd. works out to 12.5% of the capital employed and the
relevant figures are as under:-
Sales ` 5,00,000
Direct Materials ` 2,50,000
Direct Labour ` 1,00,000
Variable Overheads ` 40,000
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Capital Employed ` 4,00,000
The new Sales Manager who has joined the company recently estimates for next year a profit of
about 23% on capital employed, provided the volume of sales is increased by 10% and simul-
taneously there is an increase in selling price of 4% and an overall cost reduction in all the
elements of cost by 2%.
Find out by computing in details the cost and profit for next year, whether the proposal of Sales
Manager can be adopted.

Evaluation based on ROCE Fixed Cost as a balancing
figure
SCM
Pricing Strategies
11
What’s my Price Ltd, manufactures Product ‘S’ in departments A and B which also manufactures
other products using the same machines. The particulars per unit of the Product ‘S’ are as under:
Particulars Dept A Dept B
Direct Materials 8 kg @ ` 3 per kg 4 kg @ ` 5 per kg
Direct Labour 2 hrs @ ` 2 per hr 3 hrs @ ` 10 per hr
Overheads DLHr DLHr
Overhead Rates
Fixed ` 6 per hr ` 3 per hr
Variable ` 5 per hr ` 2 per hr
Value of Plant ` 16 lakh ` 8 lakh
Variable selling and distribution overheads relating to Product ‘S’ amount to ` 20,000 per month.
The product requires a Working Capital of ` 3,00,000 at the target volume of 1,000 units per
month occupying 25% of the practical capacity.
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Required:
(a) Using the return on investment pricing formula, find the price of Product ‘S’ to yield a
contribution to cover 24% p.a. rate of return on investment.
(b) If product ‘S’ is a well established product in the market, what should be the basis of fixation
of Price. Set the minimum price on that basis.
(c) If product ‘S’ is a new product about to be launched in the market, what should be the basis
of fixation of price. Set the minimum price on that basis.

Pricing based on ROCE ROCE = Contribution
306 |SCM
Concept & Practice
Pricing Strategies
12
Joy Limited a toy manufacturing company is going to launch two new battery operated toys in
the market. Both the products will be manufactured in Division BT. The estimated data are as
under :
Toy A Toy B
Annual Production (units) 48,000 72,000
Direct Material (` per unit) 126 158
Direct labour (` 60 per hour) 30 40
Factory overheads (60% variable) are 80% of direct wages. Administrative overheads (100%
fixed) are 10% of factory cost. Selling overheads (50% fixed) are ` 12 and ` 18 per unit of Toy A
and Toy B respectively.
The fixed capital investment in the Division BT is ` 30 lakhs. Gross working capital requirement
is equivalent to 20% of cost of sales and current liabilities are 10 % of total cost of production.
15% return on capital employed is expected.
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Required:
Fix selling price of Toy A and Toy B so that contribution per labour hour is same for both the
products.
Show amount to the nearest Rupee.

Pricing based on ROCE ROCE of Department
13
ABC Ltd. has developed a new product which is about to be launched into the market. The vari-
able cost of selling the product is ` 17 per unit. The marketing department has estimated that
at a sale price of ` 25, annual demand would be 10,000 units. However, if the sale price is set
above ` 25, sales demand would fall by 500 units for each ` 0.50 increase above ` 25. Similarly, if
the price is below ` 25, demand would increase by 500 units for each ` 0.50 stepped reduction
in price below ` 25.
Determine the price which would maximise ABC Ltd’s profit in the next year.
SCM
Pricing Strategies

Calculus Based Pricing
14
Aditya LLP produces a product X, the market for the product X is competitive and the prevailing
market price for a unit of product X is ` 40. The following table presents the marginal cost and
profit for the product X:
Units Total Revenue (`) Total Cost (`) Marginal Cost (`)
0 0 20 -
1 40 30 10
2 80 50 20
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3 120 85 35
4 160 125 40
5 200 170 45
6 240 217 47
At what quantity the profit would be maximum?

MR = MC
Answer
The marginal cost for producing 4th unit is equal to the price per unit. Thus, Aditya LLP can
maximize its profit at 4th unit level.
308 |SCM
Concept & Practice
Pricing Strategies
15
A manufacturing company has an installed capacity of 1,50,000 units per annum. Its cost struc-
ture is given below:
Material costs ` 10 per unit

Labour (Minimum ` 1,00,000 per month) ` 10 per unit
Variable Overheads ` 4 per unit
Fixed overheads: ` 1,92,300 per annum.
Semi – variable overheads ` 60,000 per annum at 75 % capacity, which increases by ` 4,000 per
annum for every 5 % increase in capacity utilisation for the year as a whole. The capacity utili-
sation for the next year is estimated at 75 % for three months, 80 % for next six months and 90
% for the remaining part of the year. If the company is planning to have a profit of 20 % on the
selling price, calculate the selling price per unit?

Pricing Techniques Semi-variable Overheads
C Block
16
A Company manufacturing agricultural Tractors has a capacity to produce 6,000 tractors annu-
ally. The capital employed in the project as on date is ` 20 crores.
With increasing cost of production and reducing margins the company is fast narrowing its
margin of safety. The return on capital employed fell from 10% in the previous year to 6% in
the current year, i.e., the current year profit is ` 1.20 crores. The company wants to maintain the
original cut off rate of 12% and various possibilities have been examined for this purpose.
The company is at present manufacturing and marketing 6,000 tractors annually though there
is imbalance in the plant. The company has the following major production departments with
percentage capacity utilisation for the present production:
Production Department Capacity Utilised
Machine Shop 75 %
Assembly Shop 100 %
Heat Treatment Shop 75 %
Induction hardening 50 %
SCM
Pricing Strategies
The Company operates a single shift of 8 hours per day on an average for 300 days in a year. For
technical reason the plant will have to operate on single shift basis only. The two alternatives
which have emerged after a detailed study are:
(a) To hire out the surplus capacity in the productions shops for which constant demand
exists. The following income and expenditure projections are drawn out:
Hire Charges per hr (`) Incremental cost per hr (`)
Machine shop 10,000 2,000
Heat Treatment shop 7,500 1,500
Induction hardening 5,000 1,000
(b) To increase the installed capacity to 8,000 tractors by spending ` 2 crores on additional
machinery for the assembly shop. The incremental revenue from the additional sale will
be ` 5,000 per tractor. The cost of additional finance will be 12% being the cost of existing
capital employed. In addition tax benefits on an average will work out to 1% of additional
investment
Decide.
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Evaluation based on ROCE
May, 2000
17
C ltd, an Indian company, has entered into an agreement of strategic alliance with Z inc of
United States of America for the manufacture of personal computers in India. Broadly, the terms
of agreement are:
(a) Z will provide C with kits in a dismantled condition. These will be used in the manufacture
of the personal computer in India. On a value basis, the supply, in terms of the FOB price
will be 50 % thereof.
(b) C will procure the balance of materials in India.
(c) Z will provide to C with designs and drawings in regard to the materials and supplies to be
procured in India. For this C will pay Z a technology fee of ` 3 crores.
(d) Z will also be entitled to a royalty at 10 % of the selling price of the computers fixed for
sales in India as also reduced by cost of standard items procured in India and also the cost
of imported kits from Z.
(e) C will furnish to Z detailed quarterly returns:
310 |SCM
Concept & Practice
Pricing Strategies
Other informations available are:

i. FOB price agreed $ 510.
ii. Exchange rate to be adopted $ 1 = ` 47.059
[Note: In making the calculations, the final sum may be rounded to the next rupee]
iii. Insurance and Freight ` 500 per kit.
iv. Customs duty leviable is 150 % of the CIF prices, but as a concession, the actual rate levia-
ble has been fixed at 30 % of CIF.
v. The technology agreement expires with the production of 2,00,000 computers.
vi. The quoted price on kits includes a 20 % margin of profits on cost to Z.
vii. The estimated cost of materials and supplies to be obtained in India will be 140 % of the
cost of supplies made by Z.
viii. 48 % of the value in rupees of the locally procured goods represents cost of the standard
items.
ix. Cost of assembly and other overheads in India will be ` 2,000 per personal computer.
Required:
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Calculate the selling price of a personal computer in India bearing in mind that C has targeted
a profit of 20 % to itself on the selling price.

Pricing Technique Royalty Calculation
November, 2001
SCM
Learning Curve Theory
Chapter 17
1. APPLICABILITY
2. DEFINITION OF LEARNING CURVE
3. ASSUMPTION OF LEARNING CURVE
4. THE LEARNING CURVE RATIO
5. THE LEARNING CURVE EQUATION
C Block
312 |SCM
Concept & Practice
1. APPLICABILITY
a. It is applicable only to those operations where human efforts are involved. Thus, it can
be said that it is not applicable to automated operations involving machines or highly
experienced workers as time taken can never be zero.
b. Applicable only when the production is doubled.
c. Only Labour Related Costs are affected due to learning curve theory.
Note:
Labour Related Costs –
As per Variable Costing or Marginal Costing: Direct Labour and Variable Overhead
(since they are based on input hours)
As per Absorption Costing: Direct Labour, Variable Overhead and Fixed Overhead (as
they are recovered or absorbed on the basis of labour hours)
2. DEFINITION OF LEARNING CURVE
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A learning curve is a line displaying the relationship between unit production time and the
cumulative number of units produced.
The learning curve measures the experience gained in production by an organisation.
As more units are produced, the people invited in production become more efficient
than before. With experience it takes lesser time to produce the next lot which leads to
progressive decrease in man- hour cost.
3. ASSUMPTION OF LEARNING CURVE

1. The amount of time required to complete a given task or unit of a product will be less
each time the task is undertaken.
2. The unit time will decrease at a decreasing rate.
3. The reduction in time will follow a predictable pattern.
Each of these assumptions was found to hold true in the airplane industry, where learning
curve was first applied. In this application it was observed that, as output doubled, there was a
20 percent reduction in direct production worker hours per unit between doubled units. Thus, if
it took 1,00,000 hours for Plane 1, it would take 80,000 hours for Plane 2, 64,000 hours for Plane
4, and so forth. Because the 20 percent reduction meant that, say, Unit 4 took only 80 percent of
the production time required for Unit 2, the line connecting the coordinates of output and time
was referred to as an “80% learning curve”.
SCM
4. THE LEARNING CURVE RATIO

In the initial stage of a new product or a new process, the learning effect pattern is so
regular that the rate of decline established at the outset can be used to predict labour cost
well in advance. Such learning effect can be computed using the following ratio:
Average labour cost of first 2N units
Learning curve ratio =
Average labour cost of first N units
Interpretation:
A learning curve ratio of 80 % implies that, as the output doubles, the average cost for all
the units produced so far reduces to 80 % of the previous cost.
LEARNING CURVE RATIO + IMPROVEMENT OR EXPERIENCE RATIO = 1
5. THE LEARNING CURVE EQUATION

The learning experience can be expressed mathematically as below:
Y = K × XS
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Or log Y = log K + S log X

Y = the average time or cost for x no. of lots.
X = the no. of lots produced so far for which average time or cost is to be computed.
K = the time or cost of the first lot produced.
S = Learning Co efficient or Learning Index = log LCR ÷ log 2
314 |SCM
Concept & Practice
1
The following information is provided by a firm. The factory manager wants to use appropriate
average learning rate on activities, so that he may forecast costs and prices for certain levels of
activity.
(i) A set of very experienced people feed data into the computer for processing inventory
records in the factory. The manager wishes to apply 80% learning rate on data entry and
calculation of inventory.
(ii) A new type of machinery is to be installed in the factory. This is patented process and the
output may take a year for full fledged production. The factory manager wants to use a
learning rate on the workers at the new machine.
(iii) An operation uses contract labour. The contractor shifts people among various jobs once
in two days. The labour force performs one task in 3 days. The manager wants to apply an
average learning rate for these workers.
(iv) A job involves one type of manual labour work. It is believed that the job will be regular for
next few years. The manager wants to apply a learning index to calculate future job cost.
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(v) A labour intensive sculpted product is carved from the metal provided to the staff. The
metal is sourced from different suppliers since it is scarce. The alloy composition of the
input metal is quite different among the suppliers.
(vi) Pieces of hand-made furniture are assembled by the company in a far off location. The
labourers do not know anything about the final product which utilizes their work. As a
matter of further precaution, rotation of labour is done frequently.
(vii) Skilled workers have been employed for a long time. The company has adequate market
for the craft pieces done by these experts.
(viii) A company find, that it always has an adverse usage of indirect material. It wants to apply
learning curve theory to improve the way standards have been set.
You are required to advise to the manager with reasons on the applicability of the learning
curve theory on the above information.

Applicability and Non-applicability
SCM
Answer
(i) LCT is not applicable on data entry because it is being done by very experienced people.
LCT is not applicable on calculation of inventory as the processing is being done by
computer.
(ii) LCT is applicable on the workers at the new machine as they will learn different improved
ways of operating the machine.
However,the benefits of learning may not be utilized in production cost as production may
take a year to start full fledgedly.
(iii) LCT is not applicable as the labour are contractual & are rotated frequently.
(iv) LCT is applicable as the job is manual & will be regular in future.
(v) LCT is not applicable as the metal may be of different alloy composition each time so that
the time for 1st unit may not be same with second unit.
(vi) LCT is not applicable as rotation of labour is done frequently.
(vii) LCT is not applicable as the skilled workers have been employed for a long time, so they
must have already become experienced in their jobs.
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(viii) LCT is applicable on waste reduction of indirect material. However its benefit may not be
significant on overall cost of production.
2
State whether and why the following are valid or not for learning curve theory:
(i) Learning curve theory applies to a division of a company which is fully automated.
(ii) Learning curve theory helps in setting standards.
(iii) Learning curve helps in pricing decisions.
(iv) Experienced workmen are more prone to learning effect.

Applicability and Non-applicability
316 |SCM
Concept & Practice
3
From the following information calculate LCR:

Hours taken to produce 100 units = 20,000 hrs
Hours taken to produce 200 units = 30,000 hrs

Learning Curve Ratio or Learning Rate
4
A company developing a new product makes a model for testing, and then a demonstration
model and then goes for a regular production. The time taken to make the model is 300 hours
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and from past experience of similar models, it is known that a 90 % learning curve applies. Find
the average time for each of the first two production models.

Using Learning Rate to find Average Time
5
XYZ co. has observed that a 90 % learning curve ratio applies to all labour related costs each
time a new model enters production. It is anticipated that 320 units will be manufactured
during the year. Given that time taken for the first lot of 10 units is 1000 hours. You are required
to determine:
1. Average time per unit
2. Total time
3. Incremental time

Incremental Time Calculations by Direct
Prediction
SCM
6
Consider Question 5 above and the following additional information:

Direct labour cost - ` 8 per hour
Variable overhead cost – ` 2 per hour
Given log 0.9 = - 0.0457, log 2 = 0.3010, 10 - 0.1518 =0.705, 20 - 0.1518 = 0.635
Required:
a. Total labour and labour related cost for producing 320 units.
b. Average cost of first 40 units, 80 units and incremental cost from 41 to 80 units.
c. Average cost of first 100 units, 200 units and incremental cost from 101 to 200 units.

Using Learning Curve Equation
C Block
7
You are to prepare a bid for supplying 800 units of a new product which will be produced in
batches of 100 units. The cost for the first batch of 100 units is on an average ` 100 per unit.
Assume a 90 % learning curve ratio, determine the following: log 0.9 = - 0.0457, log 2 = 0.3010,
9 - 0.1518 =0.716
a. The labour cost for fulfilling this contract
b. The incremental labour cost of producing an additional 800 units.
c. The incremental labour cost of producing an additional 100 units from 801 to 900 units.

Using Learning Curve Equation
318 |SCM
Concept & Practice
8
A company has 20 direct workers, who work for 25 days in a month of 8 hours a day. The esti-
mated downtime is 25 % of the total available time. The company received an order for a new
product. The first unit of the new product requires 60 direct labour hours to manufacture the
product. The company’s expects 80 % (index : -0.322) learning curve for this type of work. The
company uses standard absorption costing and the cost data are as under:
Direct Material ` 100 per unit
Direct Labour ` 10 per hour
Variable Overheads ` 2 per hour
Fixed Overheads ` 15,000 per month
Required:
(i) Calculate the cost per unit of the first order of 40 units.
(ii) If the company receives a repeat order for 20 units, what price will it quote to yield a profit
of 25 % on selling price?
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Selling Price Computation Repeat Order Price
9
M ltd manufactures a special product purely carried out by manual labour. It has a capacity of
20,000 units. It estimates the following cost structure:
Direct material ` 30 per unit
Direct labour (1 hour per unit) ` 20 per unit
Variable overhead ` 10 per unit
Fixed overhead at maximum capacity ` 1,50,000
It is estimated that at the current level of efficiency, each unit requires one hour for the first
5,000 units. Subsequently it is possible to achieve 80 % learning rate. The market can absorb
5,000 units at ` 100 per unit. What should be the minimum selling price acceptable for an order
of 15,000 units for a prospective client?

Selling Price Computation Minimum Selling Price
SCM
10
An electronics firm which has developed a new type of fire alarm system has been asked to
quote for a prospective contract. The customer requires separate price quotations for each of
the following possible orders:
Order Number of fire alarm system
First 100
Second 60
Third 40
The firm estimates the following cost per unit for the first order:
Direct materials ` 500

Direct Labour
Dept A (Highly Automatic) 20 hrs @ ` 10 per hr
Dept B (Skilled labour) 40 hrs @ ` 15 per hr
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Variable overheads 20 % of direct labour

Fixed overheads absorbed
Dept A ` 8 per hr
Dept B ` 5 per hr
Determine a price per unit for each of the three orders, assuming the firm uses a mark up of 25
% on total costs and allows for an 80 % learning curve.
Extract from 80 % learning curve table:
X 1.0 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2.0

Y (%) 100.0 91.7 89.5 87.6 86.1 81.4 83.0 81.5 80.0
X represents the cumulative total volume produced to date expressed as a multiple of initial
order.
Y is the learning curve factor, for a given X value, expressed as a percentage of average cost of
the initial order.

Learning Curve Table
320 |SCM
Concept & Practice
11
Great Eastern Appliance Ltd. (GEAL) manufactures consumer durable products in a very highly
competitive market. GEAL is considering launching a new product ‘Kitchen Care’ into the market
and gathered the following data :
Expected Market price ` 5,000 per unit

Direct material cost ` 1,850 per unit
Direct labour cost ` 80 per hour
Variable overhead cost ` 1,000 per unit
Packing machine cost (specially to be purchased for this product) – ` 5,00,000
GEAL expects the selling price of the new product will continue throughout products life and
total of 1,000 units can be sold over the entire lifetime of the product.
Direct labour cost are expected to reduce as the volume of output increase due to the effects
of 80% learning curve (index is –0.3219). The expected time to be taken for the first unit is 30
hours and the learning effect is expected to end after 250 units have been produced. Units
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produced after first 250 unit will take the same time as the 250th unit.
You are required to :
(i) Calculate the expected total labour hours over the life time of the product ‘Kitchen Care’
(ii) Profitability of product ‘Kitchen Care’ that GEAL will earn over the life time of the product.
(iii) Average target labour cost per unit over the life time of the product if GEAL requires
average profit of ` 800 per unit, to achieve its long term objectives.
Note : 250 –0.3219 = 0.1691, 249 –0.3219 = 0.1693

Profitability Calculation Life Cycle Costing
SCM
12
Genting Mfg Co. has developed a product for which the following standard cost estimates have
been made for the first batch to be manufactured in Jan’ 13 :
`
Direct materials (100 Kgs. @ ` 55 per Kg.) 5,500
Direct Labour (100 hours @ ` 40 per hour) 4,000
Variable overhead (100 hours @ ` 75 per hour) 7,500
17,000
From experience the firm knows that labour will benefit from a learning effect and the labour
time will be reduced. This is expected to approximate to an 80% learning curve. In addition,
the growing expertise of labour is expected to improve the efficiency with which materials are
used. The usage of materials is expected to approximate to a 95% learning curve
The actual production for Jan’ 13 was 320 batches. During Jan’ 13 following results were record-
ed for the 320th batch made :
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Direct Materials (80 Kgs.) ` 4,000

Direct Wages (20 hours) ` 1,000
Variable Overhead ` 1,800
You are required to calculate variances in connection with 320th batch.

[Note : Learning Coefficient is –0.322 and –0.074 for learning rate of 80% and 95% respectively,
log2 = 0.30103, log319 = 2.50379, Antilog of 1.81462 = 65.26, Antilog of 1.81472 = 65.27, Anti-
log of 1.19334 = 15.61, Antilog of 1.19378 = 15.62]

Variance Analysis using Learning Curve Learning effect on Materials
Effect
13
B-Parts Inc., USA based firm, has just invented a new part ‘B-20’. New part has a budgeted total
profit of ` 75,000 from the first 256 parts. The time taken to produce the first part was 112.50
hours. The labour rate is `20 per hour. A 90% learning curve is expected to apply indefinitely.
Required
Calculate the sensitivity of the budgeted total profit from the first 256 parts to changes in the
learning rate.
322 |SCM
Concept & Practice

Sensitivity of Learning Rate
14
Marketing manager of Arnav Ltd. has conducted a market research on the price-demand
relationship for its consumer durable product ‘Leo-9’. Leo-9 is a recently launched product.
The price-demand pattern will be as follows:
Price per unit (`) Demand (units)

11,100 1,000
10,700 2,000
9,600 3,000
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8,700 4,000
Leo-9 is produced in batches of 1,000 units. Production manager of Arnav Ltd. has also
researched and studied the production pattern and has believe that 50% of the variable manu-
facturing cost would have learning and experience curve effect. This learning & expe-
rience curve effect will be continued upto 4,000 units of production at a constant rate. But after
4,000 units of production, unit variable manufacturing cost would be equal to the unit cost at
the 4th batch. The manufacturing unit cost of the first batch will be `4,400 of which only 50%
is subjected to learning and experience curve effect. The average unit variable cost of all 4
batches will be `4,120.
Required
(i) Calculate the rate of learning that has been expected by the Production manager.
(ii) Calculate the price at which Arnav Ltd. should sell the Leo-9 in order to maximise its con-
tribution.
Note:
log0.93 = -0.0315, log2 = 0.3010, 2-0.1047 = 0.9299, 3-0.1047 = 0.8913, 4-0.1047 = 0.8649

Learning Rate Computation
SCM
Life Cycle Costing
Chapter 18
Life Cycle Costing
1. PRODUCT LIFE CYCLE

2. LIFE CYCLE CHARACTERISTICS
3. BENEFITS OF PRODUCT LIFE CYCLE COSTING
4. USES OR IMPORTANCE OF THE PRODUCT LIFE
CYCLE
C Block
324 |SCM
Concept & Practice
Life Cycle Costing
1. PRODUCT LIFE CYCLE

Each product has a life cycle. The life cycle of a product varies from a few months to several
years. Product life cycle is thus a pattern of expenditure, sales level, revenue and profit over the
period from new idea generation to the deletion of product from product range.
The life cycle of a product consists of four phases/ stages viz., Introduction; Growth; Maturi-
ty; Saturation and Decline.
Annual Sales Volume
Time
I: Introduction II: Growth III: Maturity or IV: Decline
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Stabilization
STAGE I: INTRODUCTION STAGE

Stage one is where the new product is launched in the market. As the product is novel, there
is minimal awareness and acceptance of it. Competition is almost negligible and profits are
nonexistent. The length of the introduction stage differs from product to product depending
on various factors.
Characteristics
Decisions about the prod- High distribution and pro- Profits are low or negative
uct branding, packaging motional expenses due to low initial volume
and labelling
Pricing may be low pene- Huge efforts to attract var- Aggressive promotional ef-
tration or high skimming ious marketing channels forts to increase awareness
pricing
Product refinements are Few competitors produce Focus on those buyers who
not possible basic version of products are the most ready to buy
Strategies
• Attracting customers by raising awareness of the product through promotion activities.
• Inducing customers to try and buy the product.
• Strengthening or expanding channel and supply chain relationships.
SCM
| 325
Concept & Practice
Life Cycle Costing
• Building on the availability and visibility of the product that boost channel intermediaries
to support the product.
• Setting price in alignment with the competitive realities of the market.
STAGE II: GROWTH STAGE

The next stage in the product life cycle is growth stage. Sales begin to expand rapidly because
of greater customer awareness. Competitors enter the market often in large numbers. As a
result of competition, profit starts declining near the end of the growth stage.
Characteristics
High volume of business Sales increase at an in- New channels to handle ad-
and increase in competi- creased rate in early ditional volumes and new
tion growth stage markets
Shift of emphasis from Overall strategy for trade- Improving and/or adding
product awareness to off between high profits features or strategic lower-
product conviction and high market share ing of prices to attract more
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buyers
Same promotional spend- Educating market is main The length of the growth
ing or slightly higher goal stage varies according to
the nature of the product
and competitive reactions
Strategies
• Establish a clear brand identity through promotional campaigns.
• Maintain control over product quality to assure customer satisfaction.
• Maximize availability of the product through strong distribution channel.
• Find the ideal balance between price and demand as per price elasticity.
• Overall strategy shifts from acquisition to retention of customers, from motivating product
trial to generating repeat purchases and building brand loyalty.
• Development of long-term relationships with customers and partners for the maturity stage.
• Value-based pricing strategies may be considered.
• Leverage the product’s perceived differential advantages to secure a strong market posi-
tion.
326 |SCM
Concept & Practice
Life Cycle Costing
STAGE III: MATURITY STAGE

During the stage of maturity sales continue to increase, but at a decreasing rate. When sales
level off, profits of both producers and middlemen decline. The main reason is intense price
competition; some firms extend their product lines with new models. This stage poses difficult
challenges.
Characteristics
Overcapacity in the Intensified competition Population growth and

industry replacement demand gov-
ern future sales
Some laggard buyers still Profits start to decline No new distribution

enter the market channels to fill
Customers start moving Strong marketing High R & D budgets

towards other products challenges
and substitutes
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Strategies
• Strong marketing efforts are needed to win over the competitor’s customers.
• Product features may be improved or enhanced to differentiate product from that of the
competitors.
• Prices may have to be reduced to attract the price-sensitive consumers.
• Various sales promotion incentives are necessary for the consumers as well as dealers to
maintain their interest in the product.
• Distribution becomes more intensive and incentives may be offered to encourage product
over competing products.
STAGE IV: DECLINE STAGE

Decline in sales volume characterizes this last stage of the product life cycle. The need or
demand for product disappears. Availability of better and less costly substitutes in the market
accounts for the arrival of this stage.
Characteristics
Sales decline for a num-

Sales of most product ber of reasons, including
forms drop to zero or may technological advances,
remain at a low level consumer’s shift in taste,
etc
SCM
Life Cycle Costing
Profits start declining and No of organisations pro-

at times become negative ducing the products drops
Strategies
• The product can be maintained in the market by differentiation, keeping low cost for some
more time by adding certain new features and finding new uses.
• The firm can continue to offer the product to its loyal customers (niche segment) at a
reduced price.
• Firm can even discontinue the product.
• Use the product as replacement product for launching another new product successfully
in the market.
• The various marketing decisions in the decline stage will depend on the fact that, whether
it is being revived, or given a new lease of file, or left unchanged if it is being liquidated.
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• The price may be maintained or reduced drastically if liquidated.

Strategies - Summary
Introduction Growth Maturity Decline
Product Offer basic Offer product Diversify brands Phase out weak
product extensions, service and models items
& warranty
Price Cost plus profit Price to penetrate Price to match or Price cutting
market beat competitors
Advertising Build product Build awareness Stress on brand Reduce level to
awareness & interest in mass differences and keep hard core
amongst early market benefits loyalty
adopters &
dealers
Distribution Build selective Build Intensive Build more Go selective:
distribution distribution intensive Phase out unprof-
distribution itable outlets
Sales Use heavy sales Reduce to take Increase to Reduce to mini-
Promotion promotion to advantage of encourage brand mal level
entice trial heavy consumer switching
demand
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Concept & Practice
Life Cycle Costing
2. LIFE CYCLE CHARACTERISTICS

Introduction Growth Maturity Decline
Objectives Create prod- Maximise Maximise profits Reduce expendi-
uct awareness market share while defending tures & milk the
& trial market share brand
Sales Low sales Rapidly rising Peak sales Declining sales
Costs per High cost per Average cost Low cost per Low cost per
Customer customer per customer customer customer
Profits Negative Rising profits High profits Declining profits
Customers Innovators Early adopters Middle majority Laggards
Competitors Few Growing Steady number Declining number
number beginning to
decline
Characteristics of Product Life Cycle
The major characteristics of product life-cycle concept are as follows:
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• The products have finite lives and pass through the cycle of development, introduction,
growth, maturity, decline and deletion at varying speeds.
• Product cost, revenue and profit patterns tend to follow predictable courses through
the product life cycle. Profits first appear during the growth stage and after stabilising
during the maturity stage, decline thereafter to the point of deletion.
• Profit per unit varies as products move through their life cycles.
• Each stage of the product life-cycle poses different threats and opportunities that give
rise to different strategic actions.
• Products require different functional emphasis in each stage-such as an R&D emphasis
in the development stage and a cost control emphasis in the decline stage.
• Finding new uses or new users or getting the present users to increase their
consumption may extend the life of the product.
3. BENEFITS OF PRODUCT LIFE CYCLE COSTING

The benefits of product life cycle costing are summarized as follows:
• The product life cycle costing results in earlier actions to generate revenue or to lower
costs than otherwise might be considered. There are a number of factors that need to
the managed in order to maximise return on a product.
• Better decisions should follow from a more accurate and realistic assessment of
revenues and costs, at least within a particular life cycle stage.
• Product life cycle thinking can promote long-term rewarding in contrast to short-term
profitability rewarding.
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Life Cycle Costing
• It provides an overall framework for considering total incremental costs over the entire
life span of a product, which in turn facilitates analysis of parts of the whole where cost
effectiveness might be improved.
• It is an approach used to provide a long-term picture of product line profitability,
feedback on the effectiveness of life cycle planning and cost data to clarify the
economic impact of alternatives chosen in the design, engineering phase etc.
• It is also considered as a way to enhance the control of manufacturing costs. The thrust
of product life cycle costing is on the distribution of costs among categories changes
over the life of the product, as does the potential profitability of a product. Hence it is
important to track and measure costs during each stage of a product’s life cycle.
• Product life cycle costing traces research and design and development costs etc.,
incurred to individual products over their entire life cycles, so that the total magnitude
of these costs for each individual product can be reported and compared with product
revenues generated in later periods.
4. USES OR IMPORTANCE OF THE PRODUCT LIFE CYCLE

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(i) as a Planning tool, it characteristics the marketing challenges in each stage and
posses major alternative marketing strategies.
(ii) as a Control tool, the launched PLC concept allows the company to measure product
performance against similar products launched in the post.
(iii) as a Forecasting tool, it is less useful because sales histories exhibit diverse patterns
and the stages vary in duration
Life Cycle Costing involves identifying the costs and revenue over a product’s life i.e. from incep-
tion to decline. Life cycle costing aims to maximize the profit generated from a product over its
total life cycle. Understanding this can be a useful analysis tool and can help to suggest which
strategies the organisation needs to adopt in order to compete successfully.
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Concept & Practice
Life Cycle Costing
1
JK Ltd., is following Life Cycle Costing. Its four Products P4, P3, P2, P1, are in the market respec-
tively in Introduction, Growth, Maturity and Decline stages (phases). The Management wants to
analyse the marketing challenges faced by the products to take strategical measures to stabi-
lize the products in the market. For this purpose the Board directed the Secretary to get a prod-
uct-wise report from the marketing chief of each product. The chiefs were asked to give one
characteristic prossessed by the product because of which the product is being classified in the
respective stage and two strategical measures to be taken to overcome the market challenges
faced at that stage (phase). The Secretary received the report from all the chiefs and handed
them over to the computer operator to get it printed in a tabulated form. But the operator,
without understanding the significance of the products, phases, characteristics and strategies,
mixed all the twelve items [(1+2)*4] and got it printed as a list as given below:
(i) Over capacity in the industry.
(ii) The company can continue to offer the product to our loyal customers at a reduced price.
(iii) Few competitors produce basic version of our products
(iv) Product features may be improved or enhance to differentiate our product from that of the
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competitors.
(v) Attracting customers by raising awareness about our product through promotion activi-
ties.
(vi) High volume of business and increase in competition.
(vii) Use the present products as replacement product for launching another new product suc-
cessfully in the market.
(viii) Value-based pricing strategies may be considered.
(ix) Profits start declining and at times become negative.
(x) Maintain control over product quality to assure customer satisfaction.
(xi) Strengthening or expanding channel and supply chain relationships.
(xii) Prices may have to be reduced to attract the price-sensitive customers.
The items are required to be tabulated as in the format given below:
Required:
(i) Complete the table given below by entering the twelve items under appropriate category
columns. You need not rewrite the items. Write the serial numbers of the items only in col-
umns (3) and (4).
Products (1) Phases(Stages) (2) Characteristics (3) Strategies (4)
P4 Introduction
P3 Growth
P2 Maturity
P1 Decline
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Life Cycle Costing
(ii) List down the importance (any four) of Product Life Cycle Costing.
(iii) State the benefits (any four) of Product Life Cycle Costing.

Life Cycle Characteristics and Strategies
2
Rapid Heal Tech Ltd. (RHTL) is a leading IT security solutions and ISO 9001 certified company. The
solutions are well integrated systems that simplify IT security management across the length
and depth of devices and on multiple platforms. RHTL has recently developed an Antivirus
Software and company expects to have life cycle of less than one year. It was decided that it
would be appropriate to adopt a market skimming pricing policy for the launch of the product.
This Software is currently in the Introduction stage of its life cycle and is generating significant
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unit profits.
Required
(i) Explain, with reasons, the changes, if any, to the unit selling price that could occur when
the Software moves from the Introduction stage to Growth stage of its life cycle.
(ii) Also suggest necessary strategies at this stage.
Answer
Following acceptance by early innovators, conventional consumers start following their lead.
New competitors are likely to now enter the market attracted by the opportunities for large
scale production and profit. RHTL may wish to discourage competitors from entering the
market by lowering the price and thereby lowering the unit profitability. The price needs to be
lowered so that the product becomes attractive to different market segments thus increasing
demand to achieve the growth in sales volume.
Strategies at this stage may include the following
(i) Improving quality and adding new features such as Data Theft Protection, Parental Con-
trol, Web Protection, Improved Scan Engine, Anti Spyware, Anti Malware etc.
(ii) Sourcing new market segments/ distribution channels.
(iii) Changing marketing strategy to increase demand.
(iv) Lowering price to attract price-sensitive buyers.
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Concept & Practice
Life Cycle Costing

Strategies during Life Cycle
3
Examine the Validity of following statements:

(i) In the introduction stage, usual marketing strategy is to strengthen the supply chain
relationships to make the product easily accessible by target customers. - Valid
(ii) In the introduction stage, competitors will purchase the product to carry out reverse
engineering and understand how the product works, so that they can develop their own
similar, but different product. - Valid
(iii) In the introduction phase, the firm will seek to avoid this competition by maintaining its
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selling price at the end of the introduction stage. - Invalid
(iv) In the growth stage, if the product cannot be differentiated in other ways, the firm may
need further reductions in selling price to maintain growth. - Valid
(v) In the maturity stage, firms are tempted to engage in costly promotional price wars to win
away market share from competitors. - Valid
(vi) In the decline stage, failing sales may induce firms to slash marketing expenditure. Brand
loyalty will be exploited to create profits. - Invalid

Strategies during Life Cycle
4
Netcom Ltd. manufactures and sells a number of products. All of its products have a life cycle of
less than one year. Netcom Ltd. uses a four stage life cycle model (Introduction, Growth, Matu-
rity and Decline).
Netcom Ltd. has recently developed an innovative product. It was decided that it would be
appropriate to adopt a market skimming pricing policy for the launch of the product.
However, Netcom Ltd. expects that other companies will try to join the market very soon.
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Life Cycle Costing
This product is currently in the Introduction stage of its life cycle and is generating significant
unit profits. However, there are concerns that these current unit profits will not continue during
the other stages of the product’s life cycle.
Required
EXPLAIN, with reasons, the changes, if any, to the unit selling price and the unit production cost
that could occur when the products move from the previous stage into each of the following
stages of its life cycle:
(i) Growth
(ii) Maturity

Changes in Selling Price and Cost during
Life Cycle
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5
P & G International Ltd. (PGIL) has developed a new product “K” which is about to be launched
into the market and anticipates to sell 80,000 of these units at a sales price of `300 over the
product’s life cycle of four years. Data pertaining to product “K” are as follows:
Costs of Design and Development of Moulds, ` 8,25,000

Dies, and Other Tools
Manufacturing Costs `125 per unit
Selling Costs `12,500 per year + `100 per unit
Administration Costs `50,000 per year
Warranty Expenses 5 Replacement Parts per 25 units at `10 per
part ; 1 Visit per 500 units (Cost ` 500 per visit)
Required
i. Compute the product “K”’s ‘Life Cycle Cost’.
ii. Suppose PGIL can increase sales volume by 25% through 10% reduction in selling price.
Should PGIL choose the lower price?

Life Cycle Profitability
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Concept & Practice
Life Cycle Costing
6
Y-Connections, China based firm, has just developed ultra-thin tablet S-5 with few features like
the ability to open two apps at the same time. This tablet cost ` 5,00,000 to develop; it has
undergone extensive research and is ready for production. Currently, the firm is deciding on
plant capacity, which could cost either ` 35,00,000 or ` 52,00,000. The additional outlay would
allow the plant to increase capacity from 500 units to 750 units. The relevant data for the life
cycle of the tablet at different capacity level are as under:
Expected Sales 500 units 750 units

Sale Price `79,600 per unit `69,600 per unit
Variable Selling Costs 10% of Selling Price 10% of Selling Price
Salvage Value - Plant ` 6,25,000 ` 9,00,000
Profit Volume Ratio 40%
Required:
Advise Y – Connections, regarding the optimal plant capacity to install. The tablet’s life cycle is
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two years. Ignore time value of money.

Life Cycle Profitability Variable manufacturing cost
7
A public company responsible for the supply of domestic gas has been approached by several
prospective customers in a rural area adjacent to a high-pressure main. As a condition of its
license to operate as a utility, the company is obliged to respond positively to current needs
provided the financial viability of the company is not put at risk. New customers are charged `
250 each for connection to the system.
Once a meter is installed, a standing charge of ` 10 per quarter is billed. Charges for gas are
levied at ` 400 per 1,000 metered units.
A postal survey of the area containing, according to the rating authority, 5,000 domestic units,
elicited a 40% response rate. 95% of those who responded confirmed that they wished to
become gas users and expressed their willingness to pay the connection charge.
Although it is recognized that a small percentage of those willing to pay for connection may
not actually choose to use gas, it is expected that the average household will burn 50 metered
units per month. There will be some seasonal differences.
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Life Cycle Costing
The company’s marginal cost of capital is 17% pa and supplies of bulk gas cost the company `
0.065 per metered unit.
Determine what the maximum capital project cost can be to allow the company to provide the
service required if wastage of 15% has to be allowed.

Life Cycle Investment
8
Blue Mountains Ltd. (BML) has developed a new product ‘K-2’which is about to be launched
into the market. Company has spent ` 30,00,000 on R&D of product ‘K-2’. It has also bought a
machine to produce the product ‘K-2’ costing ` 11,25,000 with a capacity of producing 1,100
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units per week. Machine has no residual value.

The company has decided to charge price that will change with the cumulative numbers of
units sold:
Cumulative Sales (units) Selling Price ` per unit
0 to 2,200 750
2,201 to 7,700 600
7,701 to 15,950 525
15,951 to 59,950 450
59,951 and above 300
Based on these selling prices, it is expected that sales demand will be as shown below:
Weeks Sales Demand per week (units)
1-10 220
11-20 550
21-30 825
31-70 1,100
71-80 880
81-90 660
91-100 440
101-110 220
Thereafter NIL
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Concept & Practice
Life Cycle Costing
Unit variable costs are expected to be as follows:
` per unit
First 2,200 units 375
Next 13,750 units 300
Thereafter 225
BML uses just-in-time production system. Following is the total contribution statement of the
product ‘K-2’ for its Introduction and Growth phase:
Introduction Growth
Weeks 1 - 10 11 - 30
Number of units Produced and Sold 2,200 5,500 8,250
Selling Price per unit (Rs.) 750 600 525
Variable Cost per unit (Rs.) 375 300 300
Contribution per unit (Rs.) 375 300 225
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Total Contribution (Rs.) 8,25,000 16,50,000 18,56,250
Required
(i) Prepare the total contribution statement for each of the remaining two phases of the
product’s life cycle.
(ii) Discuss Pricing Strategy of the product ‘K-2’.
(iii) Find possible reasons for the changes in cost during the life cycle of the product ‘K-2’.

Profitability during Life Cycle Unique Variety
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Supply Chain Management
Chapter 19
1. SUPPLY CHAIN MANAGEMENT

2. EIGHT PROCESSES IN GLOBAL SUPPLY CHAIN
FORUM FRAMEWORK
3. TYPES OF SUPPLY CHAIN- PUSH AND PULL
a. Push Model
b. Pull Model
4. UPSTREAM AND DOWNSTREAM FLOW
5. MANAGEMENT OF UPSTREAM SUPPLIER CHAIN
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a. Relationship with Suppliers

b. Use of Information Technology
6. DOWNSTREAM SUPPLY CHAIN MANAGEMENT
a. Relationship Marketing
b. Customers Relationship Management
c. use of Information Technology in Downstream Supply
Chain Management
d. Brand Strategy
7. KEY BUSINESS PROCESSES
a. Procurement Process
b. Manufacturing Flow Management Process
c. Product Development and Commercialization
d. Physical Distribution
8. SERVICE LEVEL AGREEMENTS (SLA)
9. BENEFITS OF SUPPLY CHAIN
10. GAIN SHARING ARRANGEMENTS
11. OUTSOURCING
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Concept & Practice
1. SUPPLY CHAIN MANAGEMENT

A complete chain of serving the customers or consumer whether linked or interdependent
is the composition of supply chain. It comprises of vendors that supply raw material,
producers who convert the material into products, warehouses that store, distribution
centers that deliver to the retailers and retailers who sell the product to the ultimate user.
Supply chains encourage value-chains because, without them, no producer has the ability
to give customers what they want, when and where they want, at the price they want.
Deficiencies in supply chain reduces the ability of the producers to compete with each
other.
The term supply chain can be referred to as the entire network of organisations working
together to design, produce, deliver and service products. In other words all activities
associated with the flow and transformation of goods from raw material to end user- is
called supply chain. The transformation of product from node to node includes activities
such as
• Production Planning
• Purchasing
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• Material Management
• Distribution
• Customer Service
• Forecasting
The Global Supply Chain Forum (GSCF) defines Supply chain management as the“integration
of key business processes from end user through original suppliers that provides products,
services, and information that add value for customers and other stakeholders”.
2. EIGHT PROCESSES IN GLOBAL SUPPLY CHAIN FORUM

FRAMEWORK
The following eight supply chain management processes are included in the GSCF
framework:
• Customer Relationship Management, to manage and analyse customer’s interaction
and data throughout the life cycle with the main motive of improving business
relations.
• Supplier Relationship Management, provides the structure for how relationships
with suppliers are developed and maintained.
• Customer Service Management, provides the key points of contact for administering
product and service agreements.
• Demand Management, provides the structure for optimising the customer’s
requirements with supply chain capabilities.
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• Order Fulfilment, includes all activities necessary to define customer requirements,

design the logistics network, and fill customer orders.
• Manufacturing Flow Management, includes all activities necessary to move products
through the plants and to obtain, implement and manage manufacturing flexibility in
the supply chain.
• Product Development and Commercialization, provides the structure for developing
and bringing to market new products jointly with customers and suppliers.
• Returns Management, includes all activities related to returns, reverse logistics,
gatekeeping, and avoidance.
3. TYPES OF SUPPLY CHAIN- PUSH AND PULL

During the traditional chain suppliers were at one end. Suppliers give their products to
manufacturer or distributers who further send it to retailers. Although customers are the
source of the profits, they are at the end of the chain in the ‘push’ model.
Under Push model stocks are produced on the basis of anticipated demand. Demand
forecasting can be done via a variety of sophisticated techniques may be from operations
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research area or data mining.
A. PUSH MODEL
Supplier Manufacturer Distributer Retailer Customer
Supply to Production based Inventory based Stock based Purchase what

Forecast on Forecast on Forecast on Forecast is available
Under Pull model stocks are produced in response to the actual demand. This new
business model is less products centric and more directly focused on the individual
consumer – a more marketing - oriented approach.
B. PULL MODEL
Supplier Manufacturer Distributer Retailer Customer
Supply to Produce to Automatically Automatically Customer

Order Order Replenish Replenish Orders
Warehouse Stock
Electronic connections are used in the pull model to bring out the needs of customers.
• Electronic supply chain connectivity gives end customers the opportunity to
give direction to suppliers, for example about the precise specifications of the
products they want.
• Ultimately, customers have a direct voice in the functioning of the supply chain.
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Concept & Practice
Supply chain created through E-Commerce brings benefit to both customer and
manufacturer. Thus, facilitating the companies to fulfil the customer needs, carry
fewer inventories, and send products to market more quickly.
4. UPSTREAM AND DOWNSTREAM FLOW

A supply chain begins right from the supplier and finally ends on end customer or consumer.
In the total chain there are flows of material, information and capital or finance. When
the flow relates to supplier it is termed as upstream flow. If the flow is with consumers
or customers it is named as downstream flow. For instance, upstream and downstream
include flows as demonstrated in the below tabular format:
Upstream (Supplier) Downstream (Customer)
Material Returns, Repairs, After-Sales Service Products, Parts
Information Orders, Point of Sale Data Capacity, Delivery Schedules
Capital / Finance Payments Invoices, Pricing, Credit Terms
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5. MANAGEMENT OF UPSTREAM SUPPLY CHAIN
Management of transactions with suppliers are termed as upstream supply chain
management.
A. RELATIONSHIP WITH SUPPLIERS

Supplier Relationship Management (SRM) is undergoing a major transition. In today’s
global economy there are so many factors to consider when choosing and managing
a supplier. Supplier capabilities of innovation, quality, reliability and costs/price
reductions and agility to reduce risk factors all have witnessed significant changes
when aligned with key suppliers. Greater value can be achieved for both businesses,
something that would be difficult to achieve if operating independently.
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Supplier Strategy:
To possess a commendable influence on the whole upstream flow, organization has to
build up a set of strategies which in turn results in control over suppliers. This strategy
is likely to take account of matters such as the following:
• Sources
Location and availability of source. The bargaining power of buying organization
depends on that whether the suppliers’ businesses larger or smaller than the
buying organization. In the era of globalization companies choose suppliers from
different parts of world.
• Number of Suppliers
In the event the buying company wants to avail huge discount bulk purchase
from single supplier is advisable. However, if requirement is to avoid the risk of
failed deliveries organization may prefer several or multiple suppliers.
• Cost, Quality, and Speed of Delivery
These factors are closely interrelated and the strategy will probably need to make
compromises to achieve the right balance.
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• Make or Buy and Outsourcing

Depending upon the application of various strategic cost management
techniques, decision on to produce or to outsource.
B. USE OF INFORMATION TECHNOLOGY

The main activities of upstream supply chain are procurement and logistics. In modern
business environment upstream supply chain management use E-Procurement
process. E-Procurement is the electronic methods beginning from identification of the
organization’s requirements and end on payment. E-Procurement includes E-Sourcing,
E-Purchasing and E-Payment.
• E-Sourcing
In E-Sourcing organization provide electronic invitation to tenders and request
them to submit their quotations. Especially organization which may opt to choose
tenders from different countries. ESourcing is the best possible way to find out
the best supplier among others. This process reduces the cost, time and effort
associated with the selection of supplier than it is required in traditional method.
• E-Purchasing
In recent years, organizations are shifting from centralized purchasing to
decentralization. Usage of technology has resulted in lesser time, lower cost &
better result in product selection and ordering.
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Concept & Practice
Features of an E-Purchasing system include:

• Electronic catalogues for core/standard items.
• Recurring requisitions/shopping lists for regularly purchased items. The standard
shopping lists form the basis of regular orders and the lists can have items added
or deleted for each specific order.
• Electronic purchase orders dispatched automatically through an extranet to
suppliers.
• Detailed management information reporting capabilities.
• E-Payment
After purchasing from the best possible supplier, payment also takes place through
electronic mode i.e. invoicing and fund transfer. E-Payment results in faster payment
with zero error which is expected in manual form.
E-Procurement is beneficial for organization as it results in lower cost, lesser time,
quick ordering, selection of best supplier, control over inventory, better purchase and
sales, greater financial transparency etc. but even a small problem in technology can
crash the whole system in few moments.
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6. DOWNSTREAM SUPPLY CHAIN MANAGEMENT
Management of transactions with consumers or customers are termed as downstream
supply chain management.
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A. RELATIONSHIP MARKETING
Marketing plays a vital role to successfully handle the downstream supply chain
management. The Relationship marketing helps the organization to keep existing
customer and to attract new customers through helpful staff, quality service / product,
appropriate prices and proper customer care etc.
Six Markets Model identifies the six key “market domain” where organizations may
consider directing their marketing activities.
Internal Markets
Internal Markets are the crucial requirement for the success of relationship marketing.
Internal markets include internal departments and staff. Staff have the ability to
determine customer oriented corporate culture.
Referral Markets
Referral Markets include two main categories: existing customers who recommend
their suppliers to others and referral sources such as a consultancy firm that may refer
work to a law firm.
Influence Markets
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Influence Markets represent entities and individuals, which have the ability to influence
the marketing environment of a firm may include financial analysts, shareholders, the
business press, the government, and consumer groups. A good relationship needs to
be developed by the firms with critical sources of influencers relevant to their markets.
Recruitment Markets
Recruitment Markets are focal point for relationship marketing. Firms have to manage
its relationships with recruitment markets such as commercial recruitment agencies,
universities and institutes in order to have access to potential employees who possess
the required skills for the job position.
Supplier Markets
Supplier Markets refer to traditional suppliers as well as organizations with which the
firm has some form of strategic alliance to gain benefits such as better quality, faster
reach-to-market, original and creative products, and lower levels of inventory.
Customer Markets
Customer Markets represent all existing and prospective customers as well as
intermediaries. They can be either consumers or intermediaries. In today’s environment,
the way firms provide services affects the market and helps in gaining customers.
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Concept & Practice
Internal
Markets
Supplier Referral
Markets Markets
Customer
Markets
Recruitment Inuence
Markets Markets
The six markets model suggests that a firm must regulate its actions towards developing
appropriate relationships with each of the market areas as the management of
relationships in each of the six markets is critical for the attainment of customer
retention objective.
Gordon (1998) states that there are six dimensions that illustrate how relationship
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marketing differs from the historical definition. These are that:
• Relationship marketing seeks to create new value for customers and then share it
with these customers.
• Relationship marketing recognises the key role that customers have both as
purchasers and in defining the value they wish to receive.
• Relationship marketing businesses are visualised to design and align process.
• Relationship marketing represents continuous cooperative effort between buyers
and sellers.
• Relationship marketing recognises the value of customer’s purchasing lifetimes
(i.e. Customer Lifetime Value).
• Relationship marketing even searches for the chain of relations that can be drawn
within the organisation. Customer’s wants and values are created between the
organisation and its main stakeholders, including suppliers, distribution channels,
intermediaries, and shareholders.
The growing interest in relationship marketing suggests a shift in the nature of
marketplace transactions from discrete to relational exchanges, from exchanges
between parties with no past history and no future to interactions between parties
with a history and plans for future interaction.
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Concept & Practice
B. CUSTOMERS RELATIONSHIP MANAGEMENT

To manage and analyse customer’s interaction and data throughout the life cycle
with the main motive of improving business relations the strategies and technologies
used is Customer Relationship Management (CRM). Relation includes relations with
customers, assisting in customer retention and driving sales growth. Customers under
different channels are compiled through CRM. The staff dealing with customers get a
detailed information about customer’s personal information, purchase history, buying
preferences and concerns.
Organizations must ensure customers are satisfied with their products and services
for higher customer retention. Remember one satisfied customer brings ten new
customers with him where as one dissatisfied customer takes away ten customers
along with him. In simpler words, CRM is knowing the needs of the customers and
providing them with best possible solution.
Analysis of Customers and their Behaviour
Analysis of customers is necessary based on geographical location or purchasing
characteristics. For industrial customer expectation of benefits - quality, discount,
serviceability, size of the should be taken into consideration. During such analysing
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process, management should keep in mind the physiological need, safety need, social
need, status/ ego need and self-fulfilment need of existing and future customers.
Customers Account Profitability (CAP)
Most firms today understand the source of their revenues but unfortunately, do not
understand the source of profits. Often, attempts to measure profitability center on
either product costs alone or on profitability at the business unit or enterprise level.
These attempts can be severely misleading. What firms fail to do is measure profit at
the most meaningful and controllable level, the customer level. Understanding the
underlying components of cost and addressing specific causes of poor profitability
associated with specific customers will significantly improve bottom-line performance.
Undertaking a customer account profitability improvement initiative is a five-step
process:
Analyse the Calculate the Re-engineer/
Calculate the
customer annual Identify and eliminate the
annual costs
base and split revenues retain quality unprotable
of serving the
it into the earned from customers segments
segment
segments the customer
Customer Profitability Analysis is best conducted with a technique known as Activity

Based Costing or ABC analysis. The net profit coming from each customer which
can be calculated by revenue less costs done by this tool. These costs are not only
manufacturing and distribution costs but also sales costs, marketing costs, services
cost and any other related costs which have to be undertaken to service the customer.
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Concept & Practice
Platinum customers
Gold customers
Iron customers
Lead customers
Prot tires Marketing

Investment
Pyramid
After finalisation of cost customers are divided into different profit tiers. This principle
is best observed in the banking industry with credit card as a product. Customers are
basically classified into four types
• Platinum Customers – Most Profitable
• Gold Customers – Profitable
• Iron Customers – Low Profit but Desirable
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• Lead Customers – Unprofitable and Undesirable
A credit card company would always give the best service as well financial and other
benefits to the top two customers. It will at the same time try to attract iron customers
and try to convert these iron customers to platinum or gold customers. Finally, these
companies will have systems in place so as to avoid lead customers completely.
It is found that with customer profitability analysis, the firm can correctly classify
customers and also find out which of the customers it needs to hold on to and acquire
more of the same type, and which customers it needs to let go of. Several times,
firms find out that there are customers which they should have left altogether as the
profitability from these customers is minimum and expenses are more.
Cost calculation is one of the major problem in CPA. Calculating cost per customer
becomes difficult especially in a service environment where manpower as well as time
also has a cost factor associated with it. Time spent with each customer is different and
therefore the cost is different. Furthermore, there are several non-customer related
costs too. If these costs are ignored, then right figures would be difficult to check. The
customers will be shown more profitable than they are.
Customers Lifetime Value (CLV)
Customer Life time value is the present value of net profit that we derive from a
customer over the entire lifetime of relationship with that particular customer. It is
the net present value of the projected future cash flows from a lifetime of customer
relationship. It is an essential tool used in marketing to focus on more profitable
customers and stop servicing non-profitable customers.
First of all, we need to ascertain the profits generated from each customer. ABC model
SCM
helps in associating direct costs and revenues to a particular customer over a period
of time to ascertain the profit margins from that particular customer. To ascertain the
lifetime value, judgements with regards to the duration of relationships have to be
made. These require detailed analysis of the strength of relationships, the likelihood,
frequency and amount of repeated or additional purchases, competitive products,
customer loyalty etc. Thus, profit margins are then discounted at the firm’s cost of
capital or any other rate that may be determined by the organisation to arrive at the
CLV.
Customer’s Selection, Acquisition, Retention and Extension
Customer Selection – Type of customer which the company needs to target has to be
selected.
• Who are we targeting?
• What is their value?
• Where do we reach them?
Customer Acquisition – A relationship needs to be developed with in new customers.
• Methods of acquiring customers include traditional off-line techniques (e.g.
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advertising, direct mail, etc.) and online techniques (e.g. search engine marketing,
online PR, online partnerships, interactive adverts, opt-in e-mail, viral marketing,
etc.).
Customer Retention - Keeping existing customers.
• Emphasis on understanding customer needs to ensure better customer
satisfaction.
• Ensure ongoing service quality by focussing on tangibles, reliability,
responsiveness, assurance and empathy.
• E-techniques for retaining customers are personalisation, mass customisation,
extranets, optin e-mail and online communities.
Customer Extension - The products bought by the customers need to be increased.
• “Re-sell” similar products to previous sales
• “Cross-sell” closely related products
• “Up-sell” more expensive products
C. USE OF INFORMATION TECHNOLOGY IN DOWNSTREAM SUPPLY

CHAIN MANAGEMENT
In managing downstream supply chain organizations link their sales system to the
purchasing system of its customer through Electronic Data Change. Using E-Business,
they sale products.
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Concept & Practice
Intelligence gathering is used to monitor the online customer transactions. E-mail is

the way through which organization keeps touch with customers. Use of IT results in
quick action, reduction in associated cost and saving in time.
D. BRAND STRATEGY
Specially branding of product makes a huge difference in its appeal to customers.
Branding can be usage of logo or specific colour or any other means which makes the
product or service distinctively visible among others.
7. KEY BUSINESS PROCESSES
A. PROCUREMENT PROCESS
To enable the flow of manufacturing management process and development of
new products, organisation have to make strategic plans along with its suppliers. In
Global firms, sourcing may be managed on a global basis. The desired outcome is a
relationship where both parties benefit and a reduction in the time required for the
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product’s design and development.
Development of rapid communication systems, such as Electronic Data Interchange
(EDI) and Internet Linkage, to convey possible requirements faster may be developed
by purchasing departments.
To obtain products and materials from outside suppliers, various activities involving
resource planning, supply sourcing, negotiation, order placement, inbound
transportation, storage, handling, and quality assurance, etc. have to be done many of
which include the responsibility to coordinate with suppliers on matters of scheduling,
supply continuity (inventory), hedging, and research into new sources or programs. In
the recent times, Procurement has become a core source of derive value.
B. MANUFACTURING FLOW MANAGEMENT PROCESS

Based on the past tends the manufacturing process produces and supplies products to
the distribution channels. Flexibility in Manufacturing processes in order to respond to
market changes is a must. Orders are processes operating on a just-in-time (JIT) basis
in minimum lot sizes. Thus, shorter cycle times, would mean improved responsiveness
and efficiency in meeting customer demand. This process manages activities related
to planning, scheduling, and supporting manufacturing operations, such as work-in-
process storage, handling, transportation, and time phasing of components, inventory
at manufacturing sites, etc.
SCM
C. PRODUCT DEVELOPMENT AND COMMERCIALIZATION

Here, customers and suppliers must be integrated into the product development
process in order to reduce the time to market.
For the firms to have a competitive edge, as product life cycles get shorter, the
appropriate products and services should be developed and successfully launched at
even shorter time schedules.
According to Lambert and Cooper (2000), managers of the product development and
commercialization process must:
1. Closely coordinate with customer relationship management so that they are able
to identify customer-articulated needs;
2. select materials and suppliers in aggregate with procurement; and
3. Enhance production technology in the manufacturing flow to manufacture and
integrate into the best supply chain flow for the given combination of product
and markets.
Mixing the suppliers for the new product development process was shown to have
a major impact on product target cost, quality, delivery, and market share. Tapping
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into suppliers as a source of innovation requires an extensive process characterized by

development of technology sharing, but also involves managing intellectual property
issues.
D. PHYSICAL DISTRIBUTION
This concerns the movement of a finished product or service to customers. In physical
distribution, the customer is the final destination of a marketing channel, and the
availability of the product or service is a vital part of each channel participant’s
marketing effort. It is also through the physical distribution process that the time
and space of customer service become an integral part of marketing. Thus, it links
a marketing channel with its customers (i.e., it links manufacturers, wholesalers, and
retailers).
8. SERVICE LEVEL AGREEMENTS (SLA)

An agreement between the customer and service provider is termed as a service-level
agreement. This can be a legally binding formal or an informal “contract”. The agreement
may be between separate organisation or within different teams of the organisation. SLAs
commonly include many components, from a definition of services to the termination of
agreement. To ensure that SLAs are consistently met, agreements are often designed with
specific lines of differentiation and the parties involved are required to meet regularly to
create an open forum for communication. Providers rewards and penalties are specified.
There is always place left for revisiting in most SLA.
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Concept & Practice
9. BENEFITS OF SUPPLY CHAIN

Benefits of supply chain are enormous on any business. Highly controlled supply chain
fetches tangible benefits such as inventory reduction, personnel reduction, productivity
improvement; order management improvement, financial cycle improvement etc. Further
it results in information visibility, new/ improved processes, customer responsiveness,
standardization- flexibility & globalization of business performance.
Illustration 1. Apple’s Supply Chain Model

Supply Chain Planning at Apple Inc is the classic example of New Product Development Process.
It’s the integration of R&D, Marketing and various function under supply chain management.
Apple Inc accelerates the new product introduction by acquiring the licensing and 3rd party
businesses. Apple Inc has to make the pre-payments to some suppliers to secure the strategic
raw materials.
R&D Concept Testing
• Develop new technologies • Conduct market research
• Acquire licensing of intellectual property • Conduct product testing
• Acquire third party business • Assemble cost data
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• Identify potential quality defects
Pre-Launch Launch
• Manage production ramp issues • Resolve backlogs
• Provide software for new products • Make demand forecast upto 150 days
• Manage material purchase commitments
• Provide proper inventory levels
• Determine launch quantity
• Raise orders, make pre payments to suppliers
Quaterly Review
• Review inventory level
• Adjust demand forecast
• Check product life cycle status
• Update new product development status
• Monitor current sales levels
• Monitor component cost trends
Apple Inc purchases raw materials from various sources then get them shipped to an assem-
bling plant in China. From there, assembler will ship products directly to consumers (via UPS/
Fedex) for those who buy from the Apple’s Online Store. For other distribution channels, such as
retail stores, direct sales and other distributors, Apple Inc will keep products at Elk Grove, Cali-
fornia (where central warehouse and call center are located) and supply products from there.
At the end of product’s life, customer can send products back to the nearest Apple Stores or
dedicated recycling facilities.
SCM
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Concept & Practice
Sourcing Manufacturing Warehousing Distribution Return

Intermediate
United
Warehouses Online
States
via Store
UPS/Fedex
Warranty
China Warehouses Retail Return,
Assembly Facility in Store Trade in
inChina Elk Grove, Program,
Other Asian California Direct Recycle/
Countries Sales Reuse
Force Program
Europe
Wholesalers
Retailers,
Network
Carriers
Apple Supply Chain has very high risks as enumerated below:

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• Some re-sellers may also distribute products from the competing manufacturers.
• Inventories can become obsolete or exceed the anticipated demand.
• Some components are currently obtained from the single or limited sources.
• Some custom components are not common to the rest of the industries.
• Ability to obtain components in sufficient quantities is important.
Apple being a marketing company now-a- days having inventory turnover ratio [cost of goods
sold of digital content/ downloadable products are excluded] of 59 which is quite impressive.
Apple have about 156 key vendors across the globe. In effective supply chain management
Apple synchronizes data between the central warehouse in California and its own 246 stores +
customers. The success of its supply chain operations depends on how well they manage the
supplier relationship. This includes early supplier involvement in new product development,
close communication, and supplier performance improvement/evaluation.
Illustration 2. Supply Chain Collaboration Between Wal-Mart and Procter & Gamble
Before Wal-Mart and Procter & Gamble started collaborating back in the ‘80s, retailers shared
very little information with manufacturers. But then the two giants built a software system
that hooked P&G up to Wal-Mart’s distribution centers. When P&G’s products run low at the
distribution centers, the system sends an automatic alert to P&G to ship more. In some cases,
the system communicates down to the individual Wal-Mart store, allowing P&G monitor the
shelves through real-time satellite link-ups that send messages to the factory whenever a P&G
item swoops past a scanner at the register. Within the last couple of years, the relationship
has expanded to include radio-frequency identification (RFID) technologies to gain even more
insight into ridding inefficiencies in the supply chain.
352 |SCM
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With this kind of minute-to-minute information, P&G knows when to make, ship and display
more products at the Wal-Mart stores. There’s no need to keep products piled up in warehouses
awaiting Wal-Mart’s call. Invoicing and payments happen automatically too. The system saves
P&G so much in time, reduced inventory and lower order-processing costs that it can afford to
give Wal- Mart “low, everyday prices” without putting itself out of business.
10. GAIN SHARING ARRANGEMENTS

Gain sharing is an approach to the review and adjustment of an existing contract, or series of
contracts, where the adjustment provides benefits to both parties. A fundamental form of
gainsharing is where a supplier agrees to perform its side of the contract with no guarantee
of receiving a payment. Instead, any payment received is based upon the benefits that
emerge to the customer as a result of the successful completion of the supplier’s side of
the bargain. This is clearly a risky stance for the supplier, because it could spend a fortune
and walk away with nothing. Alternatively, if the benefits to the customer are substantial,
the supplier could find itself rewarded with a large return. In this situation, the supplier
could almost be described as taking an equity stake in the customer rather than entering
into a contract with it. There must be no rewards for the suppliers to achieve a higher
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return through adversarial behaviour or by hiding behind the contract. Gain-sharing deals
are, on the face of it, a win-win situation for suppliers and their customers.
Illustration 3. Chiang International Airport - Gain Sharing with Suppliers

Cost Savings initiatives and Gain Sharing arrangements at Chiang International-
• Supplier will deliver 3% minimum cost savings on controllable portion of costs.
• Cost savings generated in first year as a result of Supplier idea will be retained by Supplier.
• Cost savings generated in year second will be shared between Chiang International and
Supplier at a ratio of 40%:60%.
• Cost savings generated in year three will be passed along to Chiang International.
• Any cost savings generated by an idea proposed exclusively by Chiang International that
does not require capital investment by Supplier will be immediately passed along to
Chiang International.
11. OUTSOURCING
Outsourcing (also sometimes referred to as “contracting out”) is a business practice used
by companies to reduce costs or improve efficiency by shifting tasks, operations, jobs or
processes to another party for a span of time.
The contract given to third party can be done at the premises or outside. Outsourcing is a
costsaving measure, and practising this can have a significant impact on manufacturing.
Outsourcing is not limited to manufacturing. Giving services to customer such as those in
SCM
a call center, and computer programming jobs are also outsourced by companies seeking
ways to reduce costs.
A part of product may even be purchased from outside this would be within the purview
of outsourcing, such as components for computer equipment. The component can
be purchased for a lower cost than it would be for the company to manufacture that
component themselves, and the component may be of higher quality. Outsourcing is
often an integral part of downsizing or reengineering.
Advantages of Outsourcing
• Outsourcing helps in cost savings. The lower cost of operation and labour, and
Reduction in overhead costs makes it attractive to outsource.
• It frees an organization from investments in technology, infrastructure and people
that make up the bulk of a back-end process capital expenditure.
• It gives businesses flexibility in staffing, manpower management, helps in cost savings.
Disadvantages of Outsourcing
• One of the biggest disadvantages is the risk of losing sensitive data and the loss of
confidentiality.
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• Control of operations and deliverables of activities outsourced.

• Inexperienced worker or improper process can lead to quality problems.
Illustration 4. Outsourcing - Parexel

The Challenge
Parexel needed a recruitment solution that would not only source and screen potential candi-
dates, but also develop and build talent pipelines, understand the labor market, deliver top
candidates during periods of heavy hiring, scale up and down quickly, and build a strong
connection between the hiring manager and recruiting consultants.
The solution
Parexel selected ‘IBM Talent Acquisition & Optimization’ and ‘IBM Kenexa Brass Ring on Cloud’ to
attract top talent and meet its organizational hiring needs.
The benefits
• Hired at 90 percent over forecast in the program’s first year.
• Delivered a multi-regional solution, including North America and 17 countries in Europe.
• Lowered time-to-fill by 40 percent.
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Concept & Practice
Illustration 5. Supply Chain Management

Sun Electronics manufactures and sells various electronic goods like mobile phones, laptops,
televisions, refrigerator etc. The company sells these goods through the 30 stores situated in
different parts of the country. The store managers place a request to the centralised team situ-
ated in Mumbai on a monthly basis. One store can send only one requisition per month.
The requirements of the stores are forwarded to the production planning team which is
responsible for scheduling the manufacturing of these products. Once the goods are manu-
factured, the goods are sent to a central warehouse in Mumbai and are dispatched to different
stores according to the store requirements. The time taken from placing a request from store
to the delivery of product to the store takes about 30-40 days on an average. In the process the
company procures parts from more than 100 vendors. The company has faced quality related
issues with many vendors leading to delay in production.
The average holding period of inventory in Sun Electronics is very high at 45 days as against an
industry average of 15 days. Since the order to delivery time at a store is very high, the compa-
ny has traditionally allowed high inventory holding to reduce the stock outs at store level. The
company is under severe pressure to improve its working capital cycle.
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A high amount of inventory held at each store also means that the products become obsolete
quickly. In case of products like mobile phones, new and upgraded versions are available in the
market as early as six months from the date of initial launch of a particular model. A significant
portion of inventory of mobile phones becomes obsolete every year. The company generally
resorts to a discounted sale to liquidate such obsolete models.
The management at Sun Electronics has identified e-commerce as an opportunity for faster
growth, both in terms of revenues and profitability. The company is considering launch of its
own e-commerce website to sell all products which are currently being sold in physical stores.
Depending upon the success of online sales, the company might choose to optimize and close
certain physical stores in the next couple of years.
The management of the company is cognizant of the fact that existing inventory procurement
and management system will not fit in the new e-commerce business. E-commerce works on
a inventory light model and quick as well as on time delivery of products of the customers. The
fact that customers could be from a location other than those where Sun Electronics has phys-
ical presence makes the matter complex.
Required
The company is considering implementation of a supply chain management system. Will
a supply chain management system be of use to Sun Electronics in light of the e-commerce
venture? You are required to EXPLAIN the concept of Supply Chain Management and EVALUATE
the applicability of in the current case.
SCM
Answer
Issue
Sun electronics manufactures and sells various electronic products through its physical stores.
The existing manufacturing system does not take into consider the demand of products in the
market. Store managers are allowed to submit only one order per month. A high level of inven-
tory can be seen at Sun Electronics as compared to the industry average. The store manag-
ers tend to keep high level of inventories as a safeguard against stock-outs. Whereas, keeping
inventory to meet customer requirement is good, high level of inventories due to inefficient
processes is not advisable.
The company also has a longer working cycle because of a long order to deliver time and excess
holding of inventory. A significant amount of working capital is blocked due to this practice.
Technology changes rapidly and the company is expected to roll out latest products in the
market. A product like mobile gets outdated very soon and the company has to resort to
discounted sales. This results in financial losses to the company.
The company has identified an opportunity in e-commerce. E-commerce businesses require
leaner models and faster response time. The production must be based on the demand from
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the customer and not on an ad-hoc basis. In the following paragraphs, the importance of supply
chain management (SCM) and its applicability in the current case is discussed.
Supply Chain Management (SCM)

Supply Chain Management can be defined as the management of flow of products, services
and information, which begins from the origin of products and ends at the product’s consump-
tion at consumer’s end. SCM also involves movement and storage of raw material, work-in-
progress and finished goods. In other words, supply chain management involves management
of all activities associated with moving goods from the raw materials stage to the end user. An
important objective of SCM is to correlate the production and distribution of goods and servic-
es with demand of the product.
The following are the various activities which an organisation carries out to meet the customer
requirements (Primary activities under value chain model) -
• Inbound Logistics covering procurement and related activities.
• Operations covering conversion of raw materials into finished products
• Outbound Logistics covering movement of products from plants to end users
• Marketing and Sales
• Service
Supply Chain Management looks each of the above activities as integrated and interrelated to
each other. None of the activities can be looked in silos. In the case of Sun Electronics, there is
a restriction on number of orders which a store manager can place. This would lead to excess
ordering because of the fear of stock-outs.
356 |SCM
Concept & Practice
The customer demand is completely ignored and hence the production is not in sync with the
market demand. This could lead to excess production, higher inventory holding and longer
working capital cycles.
The facts presented in the case indicate the following problems at Sun Electronics:
• Production planning is not based on customer demand & is done on an ad-hoc basis.
• Inventory Holding period is very high (45 days against an industry average of 15 days).
• The working capital cycle is longer.
• The time take to fulfil an order from the store is very high.
• The production is dispatched to a central warehouse for further deliveries to the stores.
This could be an inefficient process.
• Liquidation of products at discount for products with low shelf life.
SCM Process and applicability to Sun Electronics

The SCM process is explained below:
• Plan - The first step in SCM process is to develop a plan to address the requirements of the
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customer. Sun Electronics must shift its focus from ad hoc and predetermined production
planning to understanding the requirements of customers. Production must be planned
based on the demand of products. The focus must be on producing what the customer
wants.
• Develop (procure) - In this step, the materials required for production is sourced from var-
ious suppliers. A good relationship with supplier is required to ensure that the parts/ma-
terials are received as and when required by the production team. It is also important that
the vendors supply quality material which is not the case in Sun Electronics. The company
must select suppliers which are dependable and can deliver quality products in the stipu-
lated time. The company must focus in reducing the lead time required for sourcing mate-
rials which will reduce the inventory holding period.
• Make - The third step is making or manufacturing the products required by the customer.
This is quite different from the existing practice in Sun Electronics where store mangers are
allowed to place only one order. This would mean that the company is not considering the
ever changing demands and tastes of the customers.
• Deliver - The fourth stage is to deliver the products manufactured for the customers. This
stage is concerned with logistics. The time required to deliver to the store in case of Sun
Electronics is very high. The company must evaluate if the centralised warehouse is caus-
ing delay in delivery of products to the stores.
Logistics is one of the important component of the entire supply chain process. Right from
procurement of material, movement of raw material in the plants and final delivery of
products of customers, logistics play a critical role. An excellent system must be in place to
ensure that the movement of materials and final product are uninterrupted.
SCM
Warehousing also plays an important role in today’s business environment. The company
has a centralised warehouse to meet the needs of all its stores. This would not be the most
efficient way. The company must evaluate creation of additional storage facility which
would ensure timely delivery of goods to the stores. Newer products can reach the market
faster.
Benefits of SCM to Sun Electronics

SCM looks at the entire value chain process as an integrated process. There is a seamless flow
of information and products between suppliers and customers. The customer’s requirements
would be captured to plan the production. The suppliers would be intimated to supply the
materials according the the production plan. An effective logistics system ensures that move-
ment of materials is seamless. Sun Electronics can also consider implementing an integrated
ERP which would also interact with vendors on real time basis.
The following benefits of SCM can be envisaged for Sun Electronics -
• Better Customer Service as customer is supplied with what he/she wants in the minimum
time.
• Better delivery mechanism for goods.
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• Improves productivity across various functions and departments.

• Minimises cost (both direct and indirect).
• Reduces the inventory holding time and improves the working capital cycle.
• Enhances inventory management and assists in implementation of JIT systems.
• Assists companies in minimising wastes and reduce costs.
• Improves supplier relationship.
E-Commerce and SCM

The SCM is the backbone of E-commerce industry. Customers buying products online want
deliveries to be faster. Another distinct feature of e-commerce is that buyers could be located
in any corner of the country and not just restricted to the cities where Sun Limited has phys-
ical presence. This definitely means that the company must have an effective Supply Chain
Management in place which could meet the customer’s requirement.
The existing practice of one order per month from each store would not work in the e-com-
merce space. Orders can come at anytime and from anywhere. Supply Chain Management
would be required for success of e-commerce business.
Customer Orders
The company must have an effective mechanism to capture customer orders and feed it into
the production planning on a real time basis. An integrated ERP system would be required for
this purpose. Any delay in intimating the production team would mean delay in production
and delivery which would not be taken positively by the customers. The existing system of one
order per month from a store would not fit the purpose. A real time flow of information would
mean lower inventory holding.
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Concept & Practice
Procurement
The material requirements must be communicated to suppliers seamlessly. The company must
identify those vendors who can delivery quality materials in the required time frame. A delay
in supplies would delay the production process. A company cannot afford this in e-commerce
business. Automatic exchange of information using EDI (Electronic Data Interchange) or Inte-
grated ERP systems would ensure that the vendors receive material requirements in a timely
manner.
Production
As discussed earlier, the production must be in accordance with the customer order. This
requires a shift in approach of the production team. Business environments have shifted from
“Customer will buy what we produce” to “We have to produce what the customers require”. The
company would ideally not produce products to store them and sell later.
Logistics
Logistics would be the backbone of entire e-commerce set up. Right from sourcing of materi-
als to delivery of products at the customer’s door step, logistics would play an important role.
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If the company has an in-house logistics facility, the logistics team must be trained with the
requirement of the new business. If the company has outsourced the logistics, vendors must
be briefed about the requirements of the e-commerce. The company might have to tie up with
new logistic vendors to avoid any delay in deliveries.
SCM
Standard Costing
Chapter 20
Standard Costing
1. DIRECT MATERIAL VARIANCES

2. DIRECT LABOUR VARIANCES
3. VARIABLE PRODUCTION OVERHEAD VARIANCES
4. FIXED PRODUCTION OVERHEAD VARIANCES
5. SALES VARIANCES (TURNOVER OR VALUE)
6. SALES MARGIN VARIANCES (ABSORPTION COSTING)
7. SALES CONTRIBUTION VARIANCES (MARGINAL
joylawrenciandas50@gmail.com,8420517209 COSTING)
8. INTERPRETATION OF VARIANCES
A. Material Price Variance
B. Material Usage Variance
C. Labour Rate Variance
D. Labour Efficiency Variance
E. Fixed Overhead Variance
D Block
F. Variable Overhead Variance

G. Sales Price Variance
H. Sales Volume Variance
9. BEHAVIOURAL ISSUES AND ETHICS
10. PLANNING, OPERATING AND TRADITIONAL
VARIANCES
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Concept & Practice
Standard Costing
1. DIRECT MATERIAL VARIANCES
Note :
SQ = Standard Quantity = Expected Consumption for Actual Output
AQ = Actual Quantity of Material Consumed
D Block
RSQ = Revised Standard Quantity = Actual Quantity Rewritten in Standard Proportion
SP = Standard Price per Unit
AP = Actual Price per Unit
(*) = Standard Cost refers to ‘Standard Cost of Standard Quantity for Actual Output’
(#) = Direct Material Total Variance (also known as material cost variance)
Material Purchase Price Variance

Single Plan
[(SP – AP) × PQ]
Note :
PQ = Purchase Quantity
SP = Standard Price
AP = Actual Price
SCM
Standard Costing
2. DIRECT LABOUR VARIANCES

Direct Labour Total Variance
[Standard Cost – Actual Cost]

[(SH × SR) – (AH × AR)]
Direct Labour Direct Labour Direct Labour

Rate Variance Idle Time Variance Efficiency Variance
[(SR – AR) × AH] [Standard Rate per Hour × [(SH – APH) × SR]
SR × AH – AR × AH Actual Idle Hours] SH × SR – APH × SR
Direct Labour Mix Variance Direct Labour Yield Variance

Or Gang Variance Or Sub-Efficiency Variance
[(RSH – APH) × SR] [(TSH – TAPH) × Standard WA rate/hour]

TAPH
= × TSC – APH × SR
TSH
Note :
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SH = Standard Hours = Expected time (Time allowed) for Actual Output

AH = Actual Hours
APH = Actual Productive Hours
RSH = Revised Standard Hours = Actual Hours (worked) rewritten in Standard Proportion
SR = Standard Rate per Labour Hour
AR = Actual Rate per Labour Hour Paid
Idle Time is a period for which a workstation is available for production but is not used due
to e.g. shortage of tooling, material or operators. During Idle Time, Direct Labour Wages are
being paid but no output is being produced. The cost of this can be identified separately in an
Idle Time Variance, so that it is not ‘hidden’ in an adverse Labour Efficiency Variance.
Some organizations face Idle Time on regular basis. In this situation the Standard Labour Rate
may include an allowance for the cost of the expected idle time. Only the impact of any unex-
pected or abnormal Idle Time would be included in the Idle Time Variance.
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Standard Costing
3. VARIABLE PRODUCTION OVERHEAD VARIANCES

Variable Overhead Total Variance
(Standard Variable Overheads for Actual Production – Actual Variable Overheads)
Variable Overhead Variable Overhead

Expenditure (Spending) Variance Efficiency Variance
(SR – AR) × AH (SH – AH) × SR
4. FIXED PRODUCTION OVERHEAD VARIANCES
D Block
SCM
Standard Costing
Note
Fixed Overheads Ratios :
1. AQ SH
= =
Volume Ratio or Activity Ratio
BQ BH
2. AH
Capacity Ratio
BH
3. SH
Efficiency Ratio
AH
4. Volume Ratio = Capacity Ratio × Efficiency Ratio
5. SALES VARIANCES (TURNOVER OR VALUE)
D Block
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Concept & Practice
Standard Costing
Note :
BO = Budgeted Sales Output
AO = Actual Sales Output
RSO = Revised Standard Sales Output
= Actual Output Sold Rewritten in Budgeted Proportion
SP = Standard Selling Price per Unit
AP = Actual Selling Price per Unit
6. SALES MARGIN VARIANCES (ABSORPTION COSTING)
D Block
SCM
Standard Costing
Note :
SM = Standard Margin / Ut
= Standard Price per Unit – Standard Cost per Unit
AM = Actual Margin / Ut
= Actual Sales Price per Unit – Standard Cost per Unit
7. SALES CONTRIBUTION VARIANCES (MARGINAL COSTING)
D Block
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Concept & Practice
Standard Costing
Note :
SC = Standard Contribution / ut
= Standard Price per Unit – Standard Cost (variable) per Unit
AC = Actual Contribution / ut
= Actual Sales Price per Unit – Standard Cost (variable) per Unit
• Sales Price Variance is equal to Sales Margin/ Contribution Price Variance. This is be-
cause, for the actual quantity sold, standard cost remaining constant, change in selling
price will have equal impact or turnover and profit/ contribution.
• Sales Margin Volume Variance = (Sales Volume Variance × Budgeted Net Profit Ratio)
• Sales Contribution Volume Variance = (Sales Volume Variance × Budgeted PV Ratio)
A Relation: Sales Margin Volume Variance in terms of Profit & Contribution

Sales Margin (Profit) Volume Variance Standard Margin Per Unit × (Actual Output − Budg-
= eted Output)
= [Standard Contribution Per Unit − Standard Fixed
Overheads Per Unit] × (Actual Output − Budgeted
Output)
= [Standard Contribution Per Unit × (Actual Output
− Budgeted Output)] − [Standard Fixed Overheads
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Per Unit × (Actual Output − Budgeted Output)]
= Sales Contribution Volume Variance − Fixed Over-
head Volume Variance Or
Sales Contribution Volume Variance Sales Margin Volume Variance + Fixed Overhead
Volume Variance
Note: Production units equals to Sales units for both actual & budget.
SCM
Standard Costing
Linking of Market Share and Size Variance with BCG matrix

QUESTION MARKS
High STARS
Low Market Share
and High Market Share
High Market Growth and
Don’t know what to do High Market Growth
with opportunities; Doing well great
decide whether to opportunities.
Market Growth
increase investment.
CASH COWS
DOGS
High Market Share
Low Market Share
and
and
Low Market Growth
Low Market Growth
Doing well in no growth
Low
Weak in market, difficult
to make prot.
market with limited
opportunities.
Low Market Share High
Further continuation of business is advisable only when market growth or size variance
is favourable i.e. when industry sales is growing. Under this situation, even if the market
share variance is adverse i.e. competitor’s have penetrated into the company’s market, the
company can rectify such adversity by doing some investments.
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8. INTERPRETATION OF VARIANCES
There can be a number of potential causes leading to variances in the operational costs
A. MATERIAL PRICE VARIANCE

• Might be caused due to the use of a different supplier.
• Order size can result in variance.
• Any form of unexpected increase in buying costs such as higher delivery charges.
• Efficiency or inefficiency associated with the buying procedure adopted.
• Lack of appropriate inventory control can result in emergency purchase of
material resulting in adverse variance.
B. MATERIAL USAGE VARIANCE

• Purchase of inferior quality material.
• Implementation of better quality control.
368 |SCM
Concept & Practice
Standard Costing
• Increased efficiency in production can help in bringing down wastage rate.

• Changes made in the material mix.
• Careless way of handling material by production department.
• Change in method of production/ design.
• Pilferage of material from the production department.
• Poor inspection.
C. LABOUR RATE VARIANCE

• Unexpected increase in the pay rate of labour.
• Level of experience of the labour can impact the direct cost of labour.
• Payment of bonuses added to the direct labour costs.
• Change in the composition of the workforce can impact direct labour costs.
D. LABOUR EFFICIENCY VARIANCE

• Improvement in work or productivity efficiency.
• Workforce mix can have an impact upon labour efficiency levels.
• Industrial action in relation to workforce.
• Poor supervision of the workforce.
• Learning curve effect upon the labour efficiency levels.
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• Resource shortages causing an unexpected delay and lowering of labour
efficiency levels.
• Using inferior quality of material.
• Introduction of new machinery resulting in improvement of labour productivity
levels.
E. FIXED OVERHEAD VARIANCE

• Fixed Overhead Expenditure Variance (adverse) are caused by spending in excess
of the budget.
• Fixed Overhead Volume Variance is caused by changes in production volume.
F. VARIABLE OVERHEAD VARIANCE

• Variable Overhead Expenditure Variance are often caused by changes in machine
running costs.
• Variable Overhead Efficiency Variances- Causes are similar to those for a direct
labour efficiency variance.
SCM
Standard Costing
G. SALES PRICE VARIANCE

• Higher discounts given to customers in order to encourage bulk purchases.
• The effect of low price offers during a marketing campaign.
• Poor performance by sales personnel.
• Market conditions or economic conditions forcing changes in prices across the
industry.
H. SALES VOLUME VARIANCE

• Successful or unsuccessful direct selling efforts.
• Successful or unsuccessful marketing efforts (for example, the effects of an
advertising campaign).
• Unexpected changes in customer preferences and buying patterns.
• Failure to satisfy demand due to production difficulties.
• Higher demand due to a cut in selling prices, or lower demand due to an increase
in sales prices.
9. BEHAVIOURAL ISSUES AND ETHICS

Variance analysis may encourage short-termism due to their inherent tendency towards
short-term, quantified objectives and results.
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A negative perception of an organization’s variance analysis process can also encourage

other suboptimal behaviour among employees such as attempts to include budget slacks.
The behavioural issues connected with variance analysis could be managed by participating
employees during budget setting so that they do not assess the procedure as biased.
It is also vital for an organization’s performance measurement system to be based on a
extensive range of quantitative and qualitative measures so as to encourage management
to adopt a long-term view that is aligned with an organization’s strategic direction.
Ethics
Variance analysis for evaluating performance can have strong ethical consequences. For
example, standard costing methods have been proposed for medicine as a means for
improving
performance1. Interpretation of a favourable variance may be difficult because it either
reflects insufficient treatment or compliance to guidelines. Most hospitals in various
countries are reimbursed as specified by the diagnostic related groups (DRG). Each DRG
has specified standard “length of stay”. If a patient leaves the hospital early, the hospital is
financial impacted favourably but a patient staying longer than the specified time costs
the hospital money.
370 |SCM
Concept & Practice
Standard Costing
1
To obtain an output of 100 units of a product, 800 kg of material is required at a budgeted price
of ₹ 5 per kg. During the month, the actual output was 500 units. The actual material consump-
tion was 4,400 kgs. Out of the above purchases, 150 kgs had been purchased on emergency
request of production manager @ ` 5.50 per kg and the rest were purchased @ ` 5.30 per kg.
You are required to calculate various material cost variances and Interprete.
Material Variance Effect of emergency purchase
2
The standard set for a chemical mixture of a firm are given below. The standard loss in produc-
tion is 10 %. During a period, the actual consumption and price for a good output of 182 kgs are
also given. Calculate the variances.
Particulars A B
Standard Mix (%) 40 60
Standard Price (`/kg) 20 30
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Actual quantity (kg) 90 110
Actual price (`/kg) 18 34
Material Variance Processing Loss
SCM
Standard Costing
3
Jhakkas Tiles Ltd makes plastic tiles of standard size of 6” × 6” × 1/8”. A standard mix of the
compound required to produce an output of 20,000 square feet of tiles of 1/8” thick is as below:
A B C
Direct Material
Quantity (kg) 600 400 500
Price (`/kg) 0.90 0.65 0.40
During December, eight mixes were processed and actual materials consumed were:
A B C
Direct Material
Quantity (kg) 5,000 2,900 4,400
Price (`/kg) 0.85 0.60 0.45
Actual Production for December was 6,20,000 tiles.
Find all material variances.
Material Variance Output Calculation

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4
Bhandari brass foundry making castings which are transferred to the machine shop of the
company at standard price uses a standard costing system. Basic standards in regard to materi-
als, stocks which are kept at standard price are as follows:
Particulars Copper Zinc
Standard Mixture 70 % 30 %
Standard Price (` /ton) 2,400 650
Standard loss in melt is 5 %. The input figures in respect of a costing period are as follows:
Particulars Copper Zinc
Opening Stock (tons) 100 60
Closing Stock (tons) 110 50
Purchases (tons) 300 100
Purchase Value (`) 7,32,500 62,500
372 |SCM
Concept & Practice
Standard Costing
Materials melted were 400 tons and the castings produced were 375 tons.
Calculate all Material or Ingredient variances under Partial Plan & Single Plan
Material Variance Single Plan and Partial Plan
5
A Company produces a product X. using raw materials A and B. The standard mix of A and B is
1:1 and the standard loss is 10% of input
You are required to compute the missing information indicated by “?” based on the data given
below:
A B Total
Standard Price of Raw Material (` / kg) 24 30 –
Actual input (kg.) ? 70 –
Actual Output (kg.) – – ?
Actual price (` / kg.) 30 ? –
Standard input quantity (kg.) ? ? –
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Yield Variance (sub usage) – – 270 (A)
Mix Variance ? ? ?
Usage Variance ? ? ?
Price Variance ? ? ?
Cost Variance 0 ? 1300 (A)
Material Variance Missing Figures
SCM
Standard Costing
6
To produce 1,000 units of Product X, a standard material input of 1200 units at a standard price
of ` 6 per unit is required. The standard allows for rejection of 25% of input. It is estimated that
one third of the total rejects can be reworked at an additional standard cost of ` 2 per unit and
the scrapped units can be sold at ` 0.50 per unit.
During the period ended, 19,500 units of X was produced. 24,000 units of material were issued
to production, actual rate being ` 8 per unit. 7,000 units were rejected on initial inspection and
out of these 2,500 units were reworked at a cost of ` 5,100. The remainder was sold as scrap at
` 0.60 per unit.
Calculate Quality Cost Variance, Material Cost Variance, Material Price Variance, Material Usage
Variance, Rework Cost Variance and Scrap Realisation Variance.
Material Variance Quality Cost Variances
7
From the following data, Calculate (i) Rate of pay variance (ii) Labour efficiency variance and
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(iii) Labour cost variance:

PARTICULARS STANDARD ACTUAL
Number of men employed 100 90
Output in units 5,000 4,800
Number of working days in a month 20 18
Average wages per man per month ` 200 ` 198
Labour Variance Mandays Calculation
374 |SCM
Concept & Practice
Standard Costing
8
Compute the missing data indicated by the question marks from the following information:
Particulars Product X Product Y
Standard wages rate per hour ₹ 40 ₹ 50
Actual wages paid ₹ 45,000 ₹ 66,240
Standard Labour hours ? 1,400
Actual Labour hours 900 ?
Labour Cost Variance (LCV) ? ?
Labour Rate Variance (LRV) ? ₹ 2,760(F)
Labour Efficiency Variance (LEV) ? ?
Labour Gang (Mix) Variance ₹ 2,000(F) ?
Labour Variance Missing Figures

CA Final Old Nov’18
9
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The following information is given regarding a gang of workers:
Kalakari Mehnati Manmaani
No. of workers in standard gang 20 10 10
Standard rate per hour 625 400 350
No. of workers in the actual gang 26 8 6
Actual rate of pay per hour 600 425 325
A week consists of 40 hours and the standard output for the week is 1,000 units. Two hours are
lost due to idle time. Actual production was 960 units in the week.
Find Labour variances.
Labour Variance Mix and Yield
SCM
Standard Costing
10
Given the following information, compute labour variances:

Skilled Semi-skilled Unskilled
No. in standard gang 16 6 3
Standard Rate per hr 3 2 1
Actual no. in gang 14 9 2
Actual rate per hr 4 3 2
In a 40 hr week, the gang as a whole produced 900 standard hours.
Labour Variance Standard Hour Produced
11
On 1st April, Zed Company began the manufacture of a new electronic gadget. The company
installed a standard costing system to account for the manufacturing costs.
The standard costs for a unit of the product are as under:
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Direct material 3 kg at ` 5 per kg ` 15.00

Direct labour 0.5 hr at ` 20 per hour ` 10.00
Manufacturing overhead 75 % of direct labour cost ` 7.50
The following data was obtained from Zed Company’s records for April:
Particulars Debit (`) Credit (`)
Sales -- 1,25,000
Sundry Creditors (for purchase of D/M ) -- 68,250
Direct material price variance 3,250 --
Direct material usage variance 2,500 --
Direct labour rate variance 1,900 --
Direct labour efficiency variance -- 2,000
The actual production in April, was 4,000 units of the gadget and the actual sales for the month
was 2,500 units. The amount shown above for direct material price variance applies to materials
purchased during the period.
376 |SCM
Concept & Practice
Standard Costing
Required:
(i) Standard direct labour hours allowed for the actual output achieved, Actual direct labour
hours worked, Actual direct labour rate
(ii) Standard quantity of direct materials allowed (in Kgs), Actual quantity of direct materials
used (in Kgs), Actual quantity of direct materials purchased (in Kgs), Actual direct materials
price per kg
Material and Labour Variance Missing Figures
12
Mr. Mansukh Lal provides the following information relating to 1,000 units of Product SUKH
during the month of April:
Standard price of raw material ` 3 per kg

Actual total direct material cost ` 10,000
Standard direct labour hours 1,600 hours
Actual direct labour hours 1,800 hours
Total standard direct labour cost ` 8,000
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Standard variable overhead rate ` 1 per hr
Total standard variable overhead ` 1,600
Actual total variable overhead ` 1,620
The material usage variance is ` 600 A. The overall cost variance per unit of SUKH is ` 0.07
Adverse as compared to the total standard cost per unit of SUKH of ` 21.
1. For Materials: Find standard cost, standard quantity, actual quantity and material price var-
iance.
2. For Labour: Find actual cost, rate variance and efficiency variance
3. For Variable overhead: Find expenditure variance and efficiency variance
Material, Labour and Variable Overhead Missing Figures and Combined

Variance Sum
SCM
Standard Costing
13
Assuming the expenses to be fixed, calculate all variances from the following data:
Budgeted Actual
Working days per month 20 22
Man hours per day 8,000 8,400
Output (units / man hr) 1 1.2
Standard OH Rate per Man Hr 2 --
Fixed Expenses (`) -- 3,25,000
Fixed Overhead Variances Output Calculations
14
From the following information compute fixed overhead variance

Budget Actual
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Days 50 54
Total working Hrs. 5,000 5,500
Idle Hrs. – 400
Units 5,000 5,100
Fixed Overheads 1,00,000 1,15,000
Fixed Overhead Variances Idle Time Effect
378 |SCM
Concept & Practice
Standard Costing
15
Compute Overhead Variances.

Particulars Budgeted Actual
Production (units) 1500 1800
Fixed cost (`) 45000 --
Variable overhead (`) 60000 --
Factory overhead (`) 105000 112700
Hrs 6000 7000
Total Overhead Variances - Three Variances Total Overhead Cost and

Analysis Expenditure
16
Fix me Ltd uses the three variances method to analyse the manufacturing overhead variances.
Manufacturing overhead variances for the fiscal year just were computed as below:
Efficiency ` 36,000 Favourable
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Volume ` 80,000 Favourable
Spending ` 86,000 Adverse
The manufacturing overhead application rate was ` 160 per machine hour of which ` 60 per
machine hour was the variable component. The year - end balance in the Manufacturing Over-
head Control Account was ` 16,50,000 and the standard machine hours for the year were 11,300.
From the above data compute:
(i) Budgeted Machine Hours and Actual Machine Hours
(ii) Applied Manufacturing Overhead
Total Overhead Variances - Three Variances Missing Figures

Analysis
SCM
Standard Costing
17
A company is engaged in manufacturing of several products. The following data have been
obtained from the record of a machine shop for an average month:
Budgeted:
No. Of working days 15
Working hours per day 8
No. of direct workers 60
Efficiency one standard hour per clock hour
Downtime 10 %
Overhead Fixed ` 55,300
Variable ` 70,720
Actual for a month:
Overhead Fixed ` 58,800
Variable ` 50,870
Net operator hours worked 5,500
Standard hours produced 6,550
One special holiday was given in the month
Required:
(a) Calculate efficiency, activity, calendar and standard capacity usages ratio.
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(b) Calculate all the relevant fixed overhead variances.

(c) Calculate variable overheads expenditure and efficiency variance.
Fixed, Variable and Total Overhead Vari- Ratios and Standard capacity
ances usage ratio
18
Following is the standard cost card of a component:
Material 2 units @ ` 15 ` 30
Labour 3 hours @ ` 20 ` 60
Total Overheads 3 hours @ ` 10 ` 30
380 |SCM
Concept & Practice
Standard Costing
During a particular month 10,000 units of the component were produced and the same was
found to be at 60 % capacity of the budget. While preparing the expenses and variance report
for the month, the following information has been derived:
Actual Expenses `
Labour 6,50,000
Variable overheads 2,00,000
Fixed overheads 3,00,000
Variances:
Material Price Variance 70,000 (A)
Material Cost Variance 50,000 (A)
Labour Rate Variance 50,000 (F)
Fixed Overhead Expenditure Variance 50,000 (A)
Required:
(a) Actual material cost incurred and standard cost of materials actually consumed
(b) Labour efficiency variance
(c) Fixed OH Volume, Efficiency and Capacity Variance
(d) Variable OH Expenditure and Efficiency Variance.
All Cost Variances Missing Figures
19 D Block
Ravi, Richard, Rahim and Roop Singh are regional salesmen distributing the product of Super
Perfumes Ltd. The selling price of the product is ` 400 per unit. The sales quota and the standard
selling expenses for the year are:
Standard Selling
Salesmen Sales Quota (`)
Expenses (`)
Ravi 7,50,000 2,25,000
Richard 9,00,000 2,47,500
Rahim 11,50,000 2,87,500
Roop Singh 6,00,000 2,25,000
SCM
Standard Costing
Actual data for the year were as follows: -

Ravi Richard Rahim Roop Singh
Days on field work 200 175 225 250
Kilometres covered 20,000 18,000 18,000 30,000
Sales 8,00,000 10,00,000 10,50,000 5,20,000

Salary 80,000 80,000 80,000 80,000
Free samples 9,000 7,500 5,375 8,000
Postage and stationery 8,000 9,000 10,000 6,000
Other expenses 9,000 5,000 4,000 10,000
The salesmen are allowed conveyance allowance of ` 1.50 per kilometre and a daily allowance
of ` 80 per day for the days spent on field work. Ravi gets a commission of 6 percent on sales
and others are given a commission of 5 percent on sales. Corporate sales office expenses are
chargeable at the rate of ` 30 per unit sold in the case of Ravi and Richard and ` 40 per unit in
the case of Rahim and Roop Singh.
Prepare a schedule showing the selling cost variances by salesmen.
Selling Cost Variances Salesmen wise

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20
A single product company has prepared the following cost sheet based on 8,000 units of output
per month.
Direct Material 1.5 kg @ ` 24 per kg ` 36
Direct Labour 3 hrs @ ` 4 per hr ` 12
Factory OH ` 12
The flexible budget for factory overheads is as under:
Output (units) 6,000 7,500 9,000 10,500
Factory OH (`) 81,600 92,400 1,03,200 1,14,000
The actual results for the month of October are given below:
Direct materials purchased and consumed 11,224 kgs
Cost of direct material ` 2,66,570
Direct Labour hours worked 22,400 hrs
Direct wages paid ` 96,320
382 |SCM
Concept & Practice
Standard Costing
Factory overheads amounted to ` 96,440 of which the variable overhead is ` 2.60 per direct
labour hour worked. The actual output is 7,620 units. Opening and closing WIP are given below:
Opening WIP 300 units
Materials 100% complete
Labour and overheads 60% complete
Closing WIP 200 units
Materials 50% complete
Labour and overheads 40% complete
Analyse the variances.
All Cost Variances WIP Effect
21
File and Smile Associates undertake to prepare income tax returns for individuals for a fee. Their
advice to their clients is to pay the proper tax and relax. In order to arrive at the proper scale of
fees and assess their own performance, they have a good system.
They use the weighted average method and actual costs for financial reporting purposes.
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However, for internal reporting, they use a standard cost system. The standards, based on
equivalent performance, have been established as follows:
Labour per return 5 hrs. @ ` 40 per hr
Overhead per return 5 hrs @ ` 20 per hr
For March 2009 performance, budgeted overhead is ` 98,000 for the standard labour hours
allowed.
The following additional information pertains to the month of March 2009:
March 1 Returns in process (25 % complete) 200 Nos.
Returns started in March 825 Nos.
March 31 Returns in Process (80 % complete) 125 Nos.
Cost data:
March 1 Returns in Process
Elements of Cost:
Labour ` 12,000
Overheads ` 5,000
SCM
Standard Costing
March 1 to 31 Labour 4,000 hrs ` 1,78,000

Overheads ` 90,000
You are required to compute:

a. For each cost element, equivalent units of performance & the actual cost per equivalent
unit.
b. Actual cost of returns in process on March 31.
c. The total labour, labour rate and labour efficiency variances as well as total overhead vol-
ume and overhead budget variance.
22
Goodwill Ltd. manufactures readymade shirts of a specific quantity in lots to each special order
from its overseas customers.
The standard costs for one dozen of shirts are:
Direct Material 24 metres @ ` 11 ` 264

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Direct Labour 3 hours @ ` 49 ` 147

Overheads 3 hours @ ` 40 ` 120
During July, it worked on three order, for which the month’s job cost records show
Lot No. Units Materials Used Hrs Worked
45 (UK) 1,700 Doz 40,440 Metres 5,130
46 (US) 1,200 Doz 28,825 Metres 2,890
47 (CAN) 1,000 Doz 24,100 Metres 2,980
Additional information :
1. The company bought 95,000 meters of materials during July at a cost of ` 10,64,000.The
material price variance is recorded when materials are purchased. All inventories are carried
at standard cost.
2. Direct labour during July amt. to ` 5,50,000. The employees were paid at ` 50 per hr.
3. Overheads during the month amounted to ` 4,56,000.
4. A total of ` 57,60,000 was budgeted for overheads for the year 2008-09, based on estimated
384 |SCM
Concept & Practice
Standard Costing
production of the plant’s normal capacity of 48,000 dozen shirts annually. Overhead at the
level of production is 40% fixed & 60% variable. Overhead is applied on the basis of direct
labour hrs.
5. There was no WIP at the beginning of July. During July, lot nos. 45 and 47 were completed.
All materials were issued for lot no. 46 which was 80% complete as regards conversion.
Required:
a. Computation of standard cost of production of the shirts per dozen & total for each lot.
b. Find the variation in quantity of material used & labour hrs worked for each lot & in total.
c. Calculate the material price variance; labour rate variance; variable overheads efficiency
variance and fixed overheads volume & Expenditure variance.
23
Super Computers manufactures and sells three related PC Models:

1. PC – Sold mostly to college students
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2. Portable PC – Smaller version of PC positioned as home computer
3. Super PC – Sold mostly to business executives.
Budget for 2018:
SP per unit (`) VC per unit (`) Contribution per unit (`) Sales units
PC 24,000 14,000 10,000 7,000
Portable PC 16,000 10,000 6,000 1,000
Super PC 1,00,000 60,000 40,000 2,000
Actual for 2018:
SP per unit (`) VC per unit (`) Contribution per unit (`) Sales units
PC 22,000 10,000 12,000 8,250
Portable PC 13,000 8,000 5,000 1,650
Super PC 70,000 50,000 20,000 1,100
Super computer derived its total unit sales budget for 2018 from the internal management
estimate of a 20% market share and an industry sales forecast by computer manufacturers
SCM
Standard Costing
association of 50,000 units. At the end of the year the association reported actual industry sales
of 68,750 units.
(a) Compute the individual product and total sales volume variance
(b) Compute the total sales quantity variance
(c) Compute the market size and market share variances
(d) Compute individual product and total sales mix variances
Sales Margin Variances Calculating Actual Sales

Margin
24
Salewell Ltd. sells a range of products. Each territory is alloted to a salesman and salesman are
given the discretion of increasing or reducing the catalogue prices within a certain range in
their respective territories, if the circumstances so warrant. This they do, by levying a surcharge
or by offering discount. For each quarter, sales quota are fixed for each salesman and a 5%
commission is given on actual orders booked, in addition to a fixed monthly salary. The quan-
tum of commission earned serves as an indication of the effort made by the salesmen. The new
Cost Accountant, who has joined the company recently, has devised a management informa-
tion system for quarterly appraisal and the following are the figures called out from his records :
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Salesman A (`) B (`) C (`) D (`)

Commission earned 2,380 1,650 2,985 2,110
Standard cost of quota sales 29,400 26,000 28,400 24,000
Selling price variance 600U 6,000U 2,300 U 2,700 U
Sales volume variance 800 U 1,000 U 14,000 U 500 U
Profit mix variance 900 U 1,400 U 4,200 U 1,800 U
Sales quantity variance 200 U 1,000 U 8,000 U 200 F
You are required to compute the sales quota given to each salesman and their actual contribu-
tion made and interpret.
Sales Margin Variances Computation of Sales Margin

Quantity Variance
386 |SCM
Concept & Practice
Standard Costing
25
X Ltd. manufactures product X, the standard production cost of which is as given below
Direct material 5 kgs at ` 2/- per kgs

Direct Labour 2 hrs at ` 3/- per hr.
Variable overheads 2 hrs at ` 0.50 per hr.
Fixed overheads 2 hrs at ` 1/- per hr.
The budget for the current year was based on production and sale of 5,000 units to be sold
at ` 30 per unit. As against this, the company sold 6,000 units at ` 28/- per unit. During the
year, the company manufactured 8,000 units and further, it had 2,000 incomplete units which
are estimated to be 80%, 60% and 60% complete as regards material, labour and overheads
respectively. The company had opening stock of 500 units.
During the year, the company incurred expenses as detailed below:
Direct material 50,000 kgs purchased at ` 1.8

Direct labour 9,000 hrs at ` 3.5 per hr.
Variable overheads ` 4,000
Fixed overheads ` 12,000
You are required to calculate cost and profit variances and show profit reconciliation
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Profit Reconciliation Statement Effect of WIP and FG
Inventories
26
Despite the increase in the sale price of its sole product to the extent of 20%, a company finds
that it has incurred a loss during the year 2018 - 2019 to the extent of ` 4 lacs as against a profit
of ` 5 lacs made in 2017 – 2018. This adverse situation is attributed mainly to the increase in
prices of materials and overheads, the increase over the previous year being on the average, 15
% and 10 % respectively. The following figures are extracted from the books of the company:
PARTICULARS (` in lacs) 31.3.2018 31.3.2019

Material 80.00 91.10
Variable Overhead 20.00 24.00
Fixed Overhead 15.00 18.50
SCM
Standard Costing
PARTICULARS (` in lacs) 31.3.2018 31.3.2019

Cost of Sales 115.00 133.60
Profit 5.00 (4.00)
Sales 120.00 129.60
Analyse the variances over the year in order to bring out the reasons for the fall in profits.
Profit Reconciliation Statement Variances based on Ratios
27
Prepare a statement showing how much each factor has contributed to the variation in profit.
Items
2018 2019
(` in lakhs) (` in lakhs)
Direct Materials 300 324
Direct Wages 120 137
Variable Overhead 60 69
Fixed Overhead 80 150
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Profit 40 90
Sales 600 770
2018 2019
Raw material consumed (Kgs) 1,20,000 1,35,000
Direct Labour Hours 24,00,000 26,00,000
Sales price increased by 10 %.
Profit Reconciliation Statement Variances based on Ratios
388 |SCM
Concept & Practice
Standard Costing
28
Standard Cost Sheet per unit of output is as under:
Direct Material A 3 kg @ ` 4 per kg ` 12

Direct Material B 2 kg @ ` 2 per kg `4
Labour 4 hour @ ` 5 per hour ` 20
Variable overhead 4 hour @ ` 6 per hour ` 24
Fixed overhead 4 hour @ ` 7.5 per hour ` 30
Total Cost ` 90
Budgeted Fixed Overhead for the period: ` 90,000

Budgeted and Actual Sales: ` 3,00,000
During the period, actual production was 2,000 units and the following actual data are given:
Material A: 7,000 kg @ ` 5 35,000

Material B: 5,000 kg @ ` 3 15,000
Payment Hour: 9,000 hrs @ ` 6 54,000
Idle Hour: 500 hrs
Variable Overhead 59,500
Fixed Overhead 1,00,000
Total Cost 2,63,500
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Calculate:
1. All Material Variances
2. All Labour Variances
3. All OH Variances
4. Prepare reconciliation statement as per Absorption Costing technique
5. Prepare reconciliation statement as per Marginal Costing technique
Variances under Marginal Costing Reconciliation in Marginal

Approach Costing
SCM
Standard Costing
29
The following figures are available. Find out the missing figures:
Budgeted Profit ` 15,000

Less: Adverse Variances
Contribution price variance 10,600
Direct Materials variance 1,000
Fixed Overhead variance 600 (12,200)
Add: Favourable Variances
Contribution quantity variance 1,800
Direct wages variance 600
Variable overhead variance 1,800 4,200
Actual Profit 7,000
There is no inventory. Units produced are same as units sold for both actual and budget.
Other information:
Standard selling price ` 18 per unit

Standard variable cost ` 15 per unit
Standard contribution ` 3 per unit
Actual selling price ` 17 per unit
Budgeted sales 10,000 units
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Standard material cost p.u. (5 kg @ 20p / kg) `1

Material usage variance ` 400 (Adverse)
Actual labour hours at actual rate of labour ` 63,000
Actual labour hours at standard rate ` 61,950

Variable overhead standard rate per hour `2
Standard hours of production 4 hrs per unit
Variable overhead at standard rate for actual production ` 84,800
Variable overhead expenditure variance ` 400 (Adverse)
Budgeted fixed overhead ` 15,000
Find out the following:

(i) Actual sales units; Actual Sales (`); Actual quantity of raw materials used; Actual labour
hours
(ii) Labour efficiency variance and Variable overhead efficiency variance
390 |SCM
Concept & Practice
Standard Costing
(iii) Actual variable overhead (`) and Actual fixed overheads (`)
(iv) Operating profit variance.
Variances under Marginal Costing Missing Figures

Approach
30
The standard cost card for a unit of product manufactured by a company is as under:
Direct Materials 20 kg @ ` 1.20 ` 24

Direct Wages 6 hrs @ ` 6.00 ` 36
Overheads 6 hrs @ ` 2.00 ` 12
Profit margin is 20 % of the selling price. Budgeted sales are ` 54,000 per month. Actual data
relating to April 2009:
Sales ` 46,750
Direct Materials used ` 15,000
Direct Wages paid ` 21,175
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Analysis of variances Favourable (`) Adverse (`)
Direct materials Price 600
Usage 1200
Direct Wages Rate 3025
Efficiency 1650
Overheads Expenditure 200
Volume 600
You are required from the data given to calculate the –
(i) Actual output; Actual profit; Actual price per kg of material; Actual rate per direct labour
hour
(ii) Amount of overheads absorbed
(iii) Budgeted output
(iv) Overheads capacity variance and Overheads efficiency variance
(v) Sales price variance and Sales volume profit variance
(vi) Profit Reconciliation statement.
SCM
Standard Costing
All Variances and Profit Reconciliation Missing Figures
31
The following information is available in respect of Y Ltd. for a week:

(a) 400 kg of raw material were actually used in producing product ‘EXE’. The purchase cost
thereof being ` 24,800. The standard price per kg of raw material is ` 60. The expected
output is 12 units of product EXE from each kg of raw material. Raw material price variance
and usage variance as computed by cost accountant are ` 800 (adverse) and ` 600 (ad-
verse) respectively.
(b) The week is of 40 hours. The standard time to produce one unit of EXE is 30 minutes. The
standard wage rate is ` 5 per labour hour. The company employs 60 workers who have
been paid hourly wage rate as under:
No. of workers 6 8 46
Hourly wage rate (`) 4.80 5.20 5.00
(c) Budgeted overheads for a four – weekly period is ` 81,600. The actual fixed overheads
spent during the said week are ` 19,800.
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(d) Entire output of EXE has been sold at its standard selling price of ` 15 per unit.
1. Compute the variances relating to labour and overheads.
2. Prepare a statement showing total standard costs, standard profit and actual profit for the
week.
All Variances and Profit Reconciliation Calculations of Actual Output

and Budgeted Output
392 |SCM
Concept & Practice
Standard Costing
32
A company following standard marginal costing system has the following interim trading state-
ment for the quarter ending 30th June, 2018, which reveals a loss of ₹ 17,000, detailed below:
₹
Sales 4,99,200
Closing Stock (at prime cost) 18,000
Direct Material 1,68,000
Direct Labour 1,05,000
Variable Overhead 42,000
Fixed Overhead 1,20,000
Fixed Administration Overhead 40,000
Variable Distribution Overhead 19,200
Fixed Selling Overhead 40,000
Loss 17,000
Additional information is as follows:
(i) Sales for the quarter were 1,200 units. Production was 1,400 units, of which 100 units were
scrapped after complete manufacture. The factory capacity is estimated at 2000 units.
(ii) Because of low production, labour efficiency is estimated to be 20% below normal level.
Required
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Analyse the above and report to the management giving the reasons for the loss.
Profit Reconciliation Marginal Costing - Effects of

Stock and Scrap
SCM
Standard Costing
33
Trident Toys Ltd. manufactures a single product and the standard cost system is followed.
Standard cost per unit is worked out as follows :
₹
Materials (10Kgs, @ ₹ 4 Per Kg) 40
Labour (8Hours@ ₹ 8 Per hour) 64
Variable overheads (8 hours@ ₹ 3 Per hour) 24
Fixed overheads (8hours@ ₹ 3 per hour) 24
Standard Profit 56
Overheads are allocated on the basis of direct labour hours. In the month of April 2018, there
was no difference between the budgeted and actual selling price and there were no opening
or closing stock during the period.
The other details for the month of April 2018 are as under:
Budgeted Actual
Production and Sales 2000 Units 1800 Units
Direct Material 20000 Kgs. @ ₹ 4 Per Kg 20000Kgs. @ ₹ 4Per Kg
Direct Labour 16000Hrs. @ ₹ 8 Per Kg 14800Hrs. @ ₹ 8Per Hr
Variable Overheads ₹ 48000 ₹ 44400
Fixed Overheads ₹ 48000 ₹ 48000
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Required:
1. Reconcile the budgeted and actual profit with the help of variances according to each of
the following method:
(a) The Conventional method
(b) The relevant cost method assuming that
(i) Materials are scarce and are restricted to supply of 20000Kgs for the Period.
(ii) Labour hours are limited and available hours are only16000 hours for the period.
(iii) There are no scarce inputs.
2. Comment on efficiency and responsibility of the Sales Manager for not using scarce
resources.
Profit Reconciliation Relevant Cost Approach

CA Final New May’18
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Concept & Practice
Standard Costing
34
A company making a single standard product produces accounts for costing period as follows:
` `
Direct Materials 3,960 Direct Wages 5,960
Variable Overheads 9,700 Fixed Overheads 5,200
Profit 4,880 Sales 29,700
The original budget was for 1,000 units per period but during this period only 960 units were
produced and sold. Standard direct wage rate is ` 6 per unit and standard variable overhead
rate is ` 10 per unit. Cost variances during this period were:
Variance Gains (`) Losses (`)
Material Price -- 40
Material Usage -- 80
Wage rate 100 --
Labour efficiency -- 300
Variable overhead price 400 --
Variable overhead efficiency -- 500
Fixed overhead cost -- 200
Selling price 900 --
Required:
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1. Prepare for the period the original budget and flexible budget showing standard cost per
unit.
2. Prepare a statement showing the reconciliation of originally budgeted profit and actual
profit.
Profit Reconciliation Flexible Budget
SCM
Standard Costing
35
C preserves produces Jams, Marmalade and Preservers. All the products are produced in a simi-
lar fashion; the fruits are cooked at low temperature in a vacuum process and then blended
with glucose syrup with added citric acid and pectin to help setting.
Margins are tight and the firm operates a system of standard costing. For each batch of Jam the
standard processing loss is 3%.
The standard cost data for a batch of raspberry jam are:
Quantity Price/ Rate
Fruits extract 400 kgs 16.00
Glucose syrup 700 kgs 10.00
Pectin 99 kgs 33.20
Citric acid 1 kg 200.00
Labour 18 hrs 32.50
The climate proved disastrous for the raspberry crop. As a consequence, normal prices in the
trade were ` 19 per kg for fruits extract although good buying could achieve some savings.
The impact of exchange rates for imported sugar plus the minimum price fixed for sugarcane,
caused the price of syrup to increase by 20%. Actual output is 1,164 kgs of raspberry jam.
The retail results for the batch were –
Quantity Price/ Rate
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Fruits extract 428 kgs 18.00

Glucose syrup 742 kgs 12.00
Pectin 125 kgs 32.80
Citric acid 1 kg 95.00
Labour 20 hrs 30.00
(a) Calculate the ingredients planning variances that are deemed uncontrollable.
(b) Calculate the ingredients operating variances that are deemed controllable.
(c) Calculate the mixture and yield variances.
(d) Calculate the labour and the total variances for the batch.
Planning, Operating and Traditional Controllable and

Variances Uncontrollable Variances
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Standard Costing
36
D Ltd. Manufactures and sells musical instruments, & uses a standard cost system. The budget
for production and sale of one particular drum for April was 600 units at a selling price of ` 72
each. When the sales director reviewed the results for April in the light of the market conditions
that had been experienced during the month, he believed that D Ltd. should have sold 600
units of this drum at a price of ` 82 each. The actual sales achieved 600 units at ` 86 p. u. Calcu-
late
(a) Selling price planning variance
(b) Selling price operating variance
Planning, Operating and Traditional Effect on Selling Variance

Variances
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SCM
Chapter 21
1. RESPONSIBILITY ACCOUNTING
A. Functional Organizational Structure – Centralised
System
B. Divisional Organizational Structure – Decentralised
System
2. LINKING OF FINANCIAL AND NON-FINANCIAL
MEASURES OF PERFORMANCE
3. BALANCED SCORECARD
A. Financial Perspective: “How Do We Look To Sharehold-
joylawrenciandas50@gmail.com,8420517209 ers?”
B. Customer Perspective: “How Do Customer View Us?”
C. Internal Business Perspective: “At What Must We Excel?”
D. Learning and Growth Perspective: “How Do We Contin-
ue To Improve And Create Value?”
E. Benefits of the Balanced Score Card
F. Limitations of Balanced Score Card
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G. Steps in Developing BSC

H. Types of Information Required for BSC
I. Strategy Mapping with BSC
4. BENCHMARKING SCHEMES
A. Meaning
B. Types of Benchmarking :
C. Goals of Benchmarking
D. Process of Benchmarking
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Concept & Practice
1. RESPONSIBILITY ACCOUNTING
Responsibility accounting is the collection, summarization, and reporting of financial
information where individual manager is held accountable for certain costs, revenue,
or assets of the firm. The information is about the decision centers throughout the
organization. It can also be called profitability accounting or activity accounting.
Responsibility accounting is apt where top management has delegated authority to make
decisions. The idea behind responsibility accounting is that each manager’s performance
should be judged by how well he or she manages those items under his or her control.
Performance measurement is directly linked to the organisational structure of a business.
A distinction can be made between two categories of organisational structure for
performance appraisal:
• Functional organisation structures.
• Divisionalised organisation structures.
A. FUNCTIONAL ORGANIZATIONAL STRUCTURE – CENTRALISED

SYSTEM
CEO - Product mix, Pricing, Output decisions
Production Market Finance Purchase R&D

A functional organizational structure forms when a business departmentalizes,
according to the basic business functions such as production and operations,
marketing and finance. Small and medium-sized businesses frequently implement
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this organizational structure, which often includes a production and operations
department, a finance department, and a marketing department. In a functional
organizational structure pricing, product mix and output decisions will be made
by central management. Consequently, the functional managers in a centralized
organization will have far less independence than divisional managers.
B. DIVISIONAL ORGANIZATIONAL STRUCTURE – DECENTRALISED

SYSTEM
CEO
Product X Manager Product Y Manager Product Z Manager
Production Market Purchase

An organization with a division organizational structure has various divisions
operating autonomously as business under a broad corporate framework according
to geographical areas, markets, or products and services.
SCM
Generally, this type of organizational structure leads to a decentralization of the

decision-making process. Using this structure, division heads are free to set selling
prices, choose which market to sell in, make product mix and output decisions, and
select suppliers.
The formation of separate divisions may lead to the delegation of different degrees of
authority; for example, in some organizations a divisional manager may, in addition
to having authority to make decisions on sources of supply and choice of markets,
also have responsibility for making capital investment decisions. Performance
measurement systems depend on the degree of decentralization involved.
There are four recognized levels of decentralization as follows:
a. Cost or Expense Centres
Cost or Expense Centres are responsibility centres where the manager of such
a centre or division is responsible for the costs associated with that centre and
hence the main focus is cost minimisation. This level of decentralisation occurs
normally in functional organisation types.
b. Revenue Centres
Revenue Centres are responsibility centres where the manager is totally concerned
with raising revenue with no responsibility for costs. The key measures used in
appraising performance would be monitoring sales variances from budget.
c. Profit Centres
Profit Centres are responsibility centres where the manager of such a centre or
division has responsibility for both revenue and costs for the assets assigned to
the division. Thus, performance is measured in terms of the difference between
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the revenues and costs that relate to a profit centre.

d. Investment Centres
Investment Centres are responsibility centres where the manager has
responsibility for not just the revenues and costs relating to the centre, but also
the assets that generate these costs and revenues and the investment decisions
relating to disposal and acquisition of assets.
2. LINKING OF FINANCIAL AND NON-FINANCIAL MEASURES OF

PERFORMANCE
A. ‘Balanced Scorecard’ – Kaplan and Norton’s
B. ‘The Performance Pyramid’ – Cross and Lynch’s
C. ‘Building Block Model’ – Fitzgerald and Moon’s
D. ‘The Performance Prism’ – Andy Neely and Chris Adams’s
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Concept & Practice
LINKING CSFs TO KPIS AND CORPORATE STRATEGY

It is easy to understand why Critical Success Factors (CSF) are often misunderstood as a
synonymous or similar term to Key Performance Indicators (KPI). In reality, these two terms
are actually very different and understanding the difference between these two terms is a
vital step in implementing Business Performance Measurement.
Critical Success Factors are elements tied to the strategy of business and they represent
objectives that businesses are trying to achieve, as a corporation, as a department, or as
a business unit. They are derived from the strategic goals, and are in essence, an attempt
to go one level deeper into the high-level strategic goals, and lay them out as a list of
categorized objectives that will collectively drive the company’s strategy forward.
According to Rockart (1979), the following sources should be considered when identifying
CSFs:
• Industry Structure
• Competitive Strategy
• Environmental Factors
• Temporary Influences
To put it very simply, Critical Success Factors represent the ‘what’ – what are the things the
company needs to do in order to achieve its goals.
Key Performance Indicators, on the other hand, are a consequence of critical success
factors – they represent the ‘how’. Having outlined ‘what’ businesses want to achieve, a
company must subsequently define sets of measures and associated targets in such a way
that achieving those targets will translate into successful completion of a CSF.
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CSF of IT Department
For an IT Department, a Critical Success Factor could be restoring normal service, and in
order to achieve that, a logical KPI would be the Average Turnaround Time, with a target
of 4 hours. The Average Turnaround Time and its target of 4 hours is the KPI that repre-
sents ‘how’ the IT department achieved its Critical Success Factor.
Ideally, each critical success factor should have a KPI associated with it. A single Critical
Factor can also have more than one KPI, if need be. The KPI targets are more formally called
thresholds, and the thresholds must be ascertained with a great deal of industry analysis,
as well as internal analysis. KPI targets should be Specific (S), Measurable (M), Achievable
(A), Relevant (R) and Time Constrained (T).
In order to truly achieve effective measurement of business performance, the KPIs must be
selected and designed in a way that ensures that the CSF is delivered if the KPI meets the
threshold, and the CSFs in turn must be designed and constructed in a way that ensures
that the company’s strategic vision is delivered if the CSFs are met.
The objectives, CSFs, and KPIs together represent a chain of links that together deliver a
company’s strategic goal, by breaking down that strategic vision in to a set of quantifiable
targets, such as the Average Turnaround Time with a minimum of 4 hours in the case of the
IT Department.
SCM
The CSFs should also be reviewed and evaluated with respect to the company’s high-level
strategic goals. Having KPIs set up without a well governed feedback and monitoring
process can result in a company aimlessly chasing targets which don’t ultimately deliver
the company’s strategy.
Setting up KPIs is a step in the right direction, but the benefit of KPIs is only truly realized
when they are implemented in the right way, and understanding their linked relationship
with CSFs and objectives is paramount to this effect.
CSF KPI
1. Linked to strategy – defines 1. Linked to CSF – Achieving it will achieve the
business objective CSF
2. Sources by Rockart 2. One CSF should have a KPI, KPIs should be
• Industry Structure S – Specific
• Competitive Strategy M – Measurable
• Environmental Facts A – Acheivale
• Temporary influence R – Realistic / Relevant
T – Time bound
3. Represent “What” 3. Represent “How”
3. BALANCED SCORECARD
In today’s business environment information becomes a vital element and to gain
competitive advantage over the peers, it cannot be denied. In this era of information age
competition, a company cannot survive just by injecting huge capital investment in new
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technology for physical assets only or by excellent management of financial assets and
liabilities. In this information age both manufacturing and service organisation needs new
capabilities for competitive success. Merely investing in and managing physical, tangible
assets is not enough but an organisation must be able to mobilise and exploit its intangible
or invisible assets which in turn becomes a decisive factor.
Intangible assets enable an organisation to:

• Maintain and further development in customer relationships to retain loyalty of
existing customers and to serve new market/ customer segments effectively and
efficiently.
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Concept & Practice
• Introduce products and services as per the desire of targeted customer and market
segments.
• Produce customised high-quality products and services economically with short
gestation periods.
• Mobilise employee skills and motivation for better and consistent deliberation in
process capabilities, quality, and response times.
• Deploy information technology, data bases and effective management information
systems.
FOUR PERSPECTIVES OF BALANCED SCORE CARD

The balanced scorecard is a method which displays organisation’s performance into four
dimensions namely financial, customer, internal and innovation.
The four dimensions acknowledge the interest of shareholders, customers and employees
taking into account of both long-term and short-term goals.
Kaplan and Norton classified performance measures into four business ‘perspectives’:
(i) Financial perspective
(ii) Customer perspective
(iii) Internal business perspective
(iv) Learning and growth perspective
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A. FINANCIAL PERSPECTIVE: “HOW DO WE LOOK TO SHAREHOLD-
ERS?”
In this step manager of a division or a unit, links its business objectives to the corporate
strategy of the company as a whole.
Financial performance measures indicate whether the company’s strategy
implementation and execution are contributing to its revenue and earnings.
Corporate strategy and strategic initiatives are examined from the financial perspective
to see feasibility of these initiatives of being met.
The financial objectives chosen at the onset of the balanced scorecard implementation
should serve two purposes:
• To provide definite performance that was expected at the time of strategies
selection.
• To provide a focus for objectives and appropriate measures in each of the other
three perspectives.
SCM
B. CUSTOMER PERSPECTIVE: “HOW DO CUSTOMER VIEW US?”

In this stage, companies identify customers and market segments in which they
compete and also the means by which they provide value to these customers and
markets.
Managers identify the lead indicators which make a particular business unit or product
different from that of others.
Lead indicator may vary from customer to customer or market segment. If for example,
a customer values on-time delivery then on-time delivery becomes a lead indicator.
Examples of lead indicators may include any number of customer considerations,
including:
• On-time delivery
• On-site service
• After sales support
• Defects per order
• Cost of the product
• Free shipments etc.
By delivering quality as per the customer demand and need, business units can
improve outcome measures such as customer satisfaction, retention, acquisition and
loyalty.
C. INTERNAL BUSINESS PERSPECTIVE: “AT WHAT MUST WE EXCEL?”

In this stage companies identify processes and activities which are necessary to achieve
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the objectives as identified at financial perspectives and customer perspective stage.

These objectives may be achieved by reassessing the value chain and making
necessary changes to the existing operating activities.
If maintaining net earnings is the financial objective of a company and after sales
service can increase customer retention, then internal business perspective needs to
improve after sales services to satisfy customer requirements to maintain net earnings.
This objective may be achieved by providing for example toll free customer help lines,
setting up service centres in all major cities.
D. LEARNING AND GROWTH PERSPECTIVE: “HOW DO WE CONTINUE

TO IMPROVE AND CREATE VALUE?”
In the learning and growth perspective, Companies determine the activities and
infrastructure that the company must build to create long term growth, which
are necessary to achieve the objectives set in the previous three perspectives.
Organisational learning and growth comes from three principle sources:
• People i.e. employee capabilities
• Systems i.e. information system capabilities and
404 |SCM
Concept & Practice
• Organisational procedures i.e. motivation, empowerment and alignment.

Since, the balanced scorecard is intended to improve long-term performance,
managers may invest in resources needed in the short-run but this should not affect
business unit’s performance.
E. BENEFITS OF THE BALANCED SCORE CARD

The ultimate result of using the Balanced Scorecard approach should be an improved
long term financial performance. Since the scorecard gives equal importance to the
relevant non –financial measures, it should discourage the short termism that leads
to cuts in spending on new product development, human resource development etc
which are ultimately detrimental for the future prospects of the company.
The responsibility to devise and implement a Balanced Scorecard should be that of
the managers working with the business. Since every company is different, it shall
need to work out for itself the various financial and non – financial measures, which
need to be focused upon for its own development. Since the Balanced Scorecard is
recommended as a management tool used both for internal and external reporting
purposes, it is again the manager’s responsibility to decide as to what information
needs to be disclosed and how any problems of confidentiality can best be overcome.
F. LIMITATIONS OF BALANCED SCORE CARD

The following are some reasons why Balanced Scorecards sometimes fail to provide
the desired results :
• Managers mistakenly think that since they already use non – financial measures,
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they already have a Balanced Scorecard.
• Senior executives misguidedly delegate the responsibility of the Scorecard
implementation to middle level managers.
• Company’s try to copy measures and strategies used by the best companies
rather than developing their own measures suited for the environment under
which they function.
• There are times when Balanced Scorecards are thought to be meant for reporting
purposes only. This notion does not allow a Business to use the Scorecard to
manage Business in a new and more effective way.
It may be noted that the above-mentioned difficulties refer to the internal use of the
Scorecard, unless it is used internally successfully, it should not be used as a basis for
external reporting.
SCM
G. STEPS IN DEVELOPING BSC

The steps in the process of developing a BSC are:
- Identify the key outcomes to the success of the organization.
- Identify the process that leads to these outcomes.
- Develop key performance indicators for these processes.
- Develop reliable data capture and measurement systems.
- Develop a mechanism for reporting these to the relevant managers and staff.
- Enact improvement programs to ensure that performance improves.
H. TYPES OF INFORMATION REQUIRED FOR BSC

BSC emphasizes that financial and non-financial measures must be part of the
information system for employees at all levels of the organization. BSC can be used to
improve strategic performance in several ways:
• The process of developing activity measures will make individuals and divisions
more aware of how their work fits in with the strategy of the business.
• Individuals and divisions should receive regular reports of their performance
against BSC measures relevant to their area of work. This will help them moderate
their own performance.
• Senior management should receive regular information on the organization’s
overall accomplishments against BSC measures to ensure that strategy is being
followed.
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• Outside stakeholders may also have access to BSC measures help them form a
more full impression of the organization’s value.
The large volume of data gathering manipulation and reporting caused by BSC should
be put into computerised form. The manner of information display is usually in readily
understandable graphs. It is now generally accepted that performance measures
should be an integral part of modern internal reporting system. The performance
indicators should:
- be linked with corporate strategy
- mirror both internal and external concerns
- include financial and non-financial dimensions
- be both leading and lagging indicators of performance.
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Concept & Practice
I. STRATEGY MAPPING WITH BSC

The Strategy Map shows the objectives needed to execute the strategy. The balanced
score card is a part of system that translates strategy into action. Strategy maps can be
created for not-for-profit and public service entities, as well as for-profit enterprises.
Example of Strategy Mapping
Completed Generic Strategy Map
Maximise Organisational
Value
Financial
What we want to accomplish

Revenue Growth Productivity Asset Utilisation
Strategy Strategy
Add/Retain High Increase Revenue Product Cost
Customer
Value Customers per Customer per Customer
New Solutions Scalability

Current Migrated New Strategies
Offerings Focus
(eg Web)
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Industrial
Customer Innovation & Internal Effective Perception;

Management Commercialisation Operations Governance & Public
How we plant to accomplish
Leadership Supermacy Excellence Control Relations

Learning and Growth
1. Human Capital 2. Information Capital 3. Organisational Capital

(Staff Competencies) (Technology Infrastructure) (Climate for Action)
SCM
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Concept & Practice
4. BENCHMARKING SCHEMES
A. MEANING
Benchmarking, technique for continuous improvement was originated in Japan
during the early 1960s due to Japanese curiosity and fondness for achieving the best
of best. Various forms of benchmarking have been used in industry for years. After
1980s with the advent of worldwide competition in key industries benchmarking
come of age. Xerox, Motorola, Ford and other leading companies pioneered a much
broader forms of benchmarking. These companies found benchmarking a valuable
means of improving their competitiveness and effectiveness. It became an integral
part of their continuous process improvement programme.
Benchmarking is a technique for continuous improvement in performance. It involves
comparing a firm’s products, services or activities against other best performing
organisations, either internal or external to the firm. The objective is to find out how
the product, service or activity can be improved and ensure that the improvements
are implemented. It attempts to identify an activity such as customer order processing
needs to be improved and finding a non-rival organisation that is considered to
represent world class best practice and studying how it performs the activity. It is a
performance measure that provides the driving force to establish high performance
and means to accomplish these goals. It is thus a component of a wider improvement
process such as business process reengineering or quality improvement.
B. TYPES OF BENCHMARKING :
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Competitive Strategic Global Process

Benchmarking Benchmarking Benchmarking Benchmarking
Functional Internal External

Benchmarking Benchmarking Benchmarking
e. Competitive Benchmarking: It involves the comparison of competitors products,

processes and business results with own. Benchmarking partners are drawn
from the same sector. However, to protect confidentiality it is common for the
companies to undertake this type of benchmarking through trade associations
or third parties.
f. Strategic Benchmarking: It is similar to the process benchmarking in nature but
differs in its scope and depth. It involves a systematic process by which a company
seek to improve their overall performance by examining the long term strategies
.It involves comparing high level aspects such as developing new products and
services, core competencies etc.
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Concept & Practice
g. Global Benchmarking: It is a benchmarking through which distinction in

international culture, business processes and trade practices across companies are
bridged and their ramification for business process improvement are understood
and utilised. Globalisation and advances in information technology leads to use
this type of benchmarking.
h. Process Benchmarking: It involves the comparison of an organisation critical
business processes and operations against best practice organisation that
performs similar work or deliver similar services. For example, how do best
practice organisations process customers’ orders.
i. Functional Benchmarking: This type of benchmarking is used when organisations
look to benchmark with partners drawn from different business sectors or areas
of activity to find ways of improving similar functions or work processes. This sort
of benchmarking can lead to innovation and dramatic improvements.
j. Internal Benchmarking involves seeking partners from within the same
organisation, for example, from business units located in different areas. The
main advantages of internal benchmarking are that access to sensitive data and
information are easier; standardised data is often readily available; and, usually less
time and resources are needed. There may be fewer barriers to implementation
as practices may be relatively easy to transfer across the same organisation.
However, real innovation may be lacking and best in class performance is more
likely to be found through external benchmarking.
k. External Benchmarking involves seeking help of outside organisations that
are known to be best in class. External benchmarking provides opportunities of
learning from those who are at the leading edge, although it must be remembered
that not every best practice solution can be transferred to others. In addition,
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this type of benchmarking may take up more time and resource to ensure the
comparability of data and information, the credibility of the findings and the
development of sound recommendations.
The benchmarking can be categorised into:
(i) Intra-Group Benchmarking: In intra group benchmarking the groups of
companies in the same industry agree that similar units within the cooperating
companies will pool data on their process. The processes are benchmarked against
each other at or operational level. ‘Improvement task forces’ are established to
identify and transfer best practice to all members of the group.
(ii) Inter-Industry Benchmarking: In inter-industry benchmarking a non-
competing business with similar process is identified and asked to participate in
a benchmarking exercise. For example, a publisher of school book may approach
a publisher of university level books to establish a benchmarking relationship.
Although two publishers are not in direct competition but there are obviously
many similarities in their business with respect to sources of supply, distribution
channels. Each will be able to benefit from the experience of other and establish
‘best practices’ in their common business processes.
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C. GOALS OF BENCHMARKING
Benchmarking can deliver significant performance improvements and returns based
on efficiency, cost savings and new revenues. Benchmarking projects typically target
cycle times, productivity, customer service, quality and production costs. They also
can be part of an effort to shift the culture of a company to be more customer oriented
and results focussed.
D. PROCESS OF BENCHMARKING
The process of benchmarking requires a Company to identify the areas i.e. processes,
activity etc. which are central to its business and then selects the top-performing
companies in those areas. By analyzing how that excellence is achieved, the company
learns lessons to apply to its own processes.
The benchmarking process is comprised of following stages. These stages are:
Planning Collection of Data Analysing the
and Information Findings
Recommendations Monitoring and
Reviewing
a. Planning
(i) Determination of benchmarking goal statement: This requires
identification of areas to be benchmarked. In practice, one should start with
the identification of those areas which have to be really good to be really
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successful. One should start with the areas which account for most of the
expenditure or which tie up the most of cash. One should remember that one
cannot benchmark own performance until one have reliable and efficient
systems of measurement in its own organisation. This applies irrespective
of whether our benchmarking partners are internal or external, in parallel
or in totally different business sectors. For identification of areas to be
benchmarked the following criteria are used:
• What would make the most significant improvements in our relation-
ships with our customers.
• What would make the most significant improvements to our bottomline.
Benchmarks important for customer satisfaction may include:
• Consistency of product or service.
• Process cycle time.
• Delivery performance.
• Responsiveness to customer requirements.
• Adaptability to special needs.
410 |SCM
Concept & Practice
Benchmarks important for direct impact on the bottomline may include:

• Waste and reject levels.
• Inventory levels.
• Work-in-Progress.
• Cost of sales.
• Sales per employee.
(ii) Identification of best performance: Once the benchmarked goal statement
are defined, the next step is seeking the best of the breed or best of the best.
Since practically to arrive at the best is both expensive and time consuming
therefore it is better to identify company which has recorded performance
success in a similar area.
(iii) Establishment of the benchmarking or process improvement team:
Ideally this should include the persons who are most knowledgeable about
the internal operations and will be directly affected by changes due to
benchmarking.
(iv) Defining the relevant benchmarking measurement: Relevant measures
will not include the measures used by the organisation today but they will
be refined measures that comprehend the true performance differences.
Developing good measurement is key to successful benchmarking.
b. Collection of Data and Information
The data gathering for benchmarking could be done through national/
international clearing houses, mail surveys, suppliers, company visits, telephone,
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interviews etc. In recent years national and international clearing houses have
been set up.
The collection of data and information involves following steps:
• Compile information and data on performance. They may include mapping
processes.
• Select and contact partners.
• Develop with partners, a mutual understanding about the procedures to be
followed and, if necessary, prepare a Benchmarking Protocol.
• Prepare questions and agree terminology and performance measures to be
used.
• Distribute schedule of questions to each partner.
• Undertake information and data collection by chosen method for example,
interviews, sitevisits, telephone, fax and e-mail.
• Collect the findings to enable analysis.
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c. Analysing the Findings

The analysing of finding of above step requires following:
• Review the findings and produce tables, charts and graphs to support the
analysis.
• Identify gaps in performance between our organisation and better
performers.
• Seek explanations for the gaps in performance. The performance gaps can
be positive, negative or zero.
• Ensure that comparisons are meaningful and credible.
• Communicate the findings to those who are affected.
• Identify realistic opportunities for improvements. The negative performance
gap indicates an undesirable competitive position and provide a basis
for performance improvement. If there is no gap it may indicate a neutral
position relative to the performance being benchmarked. The zero position
should be analysed for identifying means to transform its performance to a
level of superiority or positive gap.
d. Recommendations
Making recommendation: This requires:
• Deciding the feasibility of making the improvements in the light of the
conditions that apply within own organisation.
• Agreement on the improvements that are likely to be feasible.
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• Producing a report on the Benchmarking in which the recommendations are

included.
• Obtaining the support of key stakeholder groups for making the changes
needed.
• Developing action plan(s) for implementation.
Implementing recommendations:
• Implement the action plans.
• Monitor performance.
• Reward and communicate successes.
• Keep key stakeholders informed of progress.
e. Monitoring and Reviewing
This involves:
• Evaluating the benchmarking process undertaken and the results of the
improvements against objectives and success criteria plus overall efficiency
and effectiveness.
412 |SCM
Concept & Practice
• Documenting the lessons learnt and make them available to others.

• Periodically re-considering the benchmarks for continuous improvement.
E. PRE-REQUISITES FOR SUCCESSFUL BENCHMARKING

Irrespective of the type and scope of benchmarking, it will be important to ensure
that:
• Senior mangers support benchmarking and are committed to continuous
improvements;
• The objectives are clearly defined at the outset;
• The scope of the work is appropriate in the light of the objectives, resources, time
available and the experience level of those involved;
• Sufficient resources are available to complete projects within the required time
scale;
• Benchmarking teams have a clear picture of their organisation’s performance
before approaching others for comparisons;
• Benchmarking teams have the right skills and competencies;
• Stakeholders, particularly staff and their representatives, are kept informed of the
reasons for benchmarking.
F. DIFFICULTIES IN IMPLEMENTATION OF BENCHMARKING

• Benchmarking is a time consuming and at time difficult. It has significant
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requirement of staff time and company resources.
• Benchmarking implementation requires the direct involvement of the senior
manager etc. The drive to be best in the industry or world cannot be delegated.
• It is likely that there is resistance from employees.
• Companies can become preoccupied with the measures. The goal becomes not
to improve process but to match the best practices at any cost.
• The key element in benchmarking is the adaptation of a best practice to tailor it
to a company’s needs and culture. Without that step, a company merely adopts
another company’s process. This approach condemns benchmarking to fail.
• Companies often waste time in benchmarking non-critical functions.
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G. BENCHMARKING CODE OF CONDUCT

Benchmarking - the process of identifying and learning from the best practices
anywhere in the world - is a powerful tool for continuous improvement. To contribute
to efficient, effective, and ethical benchmarking, individuals agree for themselves
and their organization to be abide by the following principles for benchmarking with
other organizations:
The following is a suggested Benchmarking code of conduct:
a. Principle of Legality: Avoid discussions or actions that might lead to or imply an
interest in restraint of trade: market or customer allocation schemes, price fixing,
dealing arrangements, bid rigging, bribery or misappropriation. Do not discuss
costs with competitors if costs are an element of pricing.
b. Principles of Exchange: Be willing to provide the same level of information that
you request, in any benchmarking exchange.
c. Principle of Confidentiality: Treat benchmarking interchange as something
confidential to the individuals and organizations involved. Information obtained
must not be communicated outside the partnering organizations without prior
consent of participating benchmarking partners. An organization’s participation
in a study should not be communicated externally without their permission.
d. Principle of Use: Use information obtained through benchmarking partnering
only for the purpose of improvement of operations within the partnering
companies themselves. External use or communication of a benchmarking
partner’s name with their data of observed practices requires permissions of that
partner. Do not, as a consultant or client, extend one company’s benchmarking
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study findings to another without the first company’s permission.

e. Principle of First Party Contact: Initiate contacts, whenever possible, though
a benchmarking contact designated by the partner company. Obtain mutual
agreement with the contact on any hand off of communication or responsibility
to other parties.
f. Principle of Third Party Contact: Obtain an individual’s permission before
providing their name in response to a contact request.
g. Principle of Preparation: Demonstrate commitment to the efficiency and
effectiveness of the benchmarking process with adequate preparation at each
process step; particularly, at initial partnering contact.
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Concept & Practice
1
Nicefit manufactures readymade garments by a simple process of cutting the clothes in various
shapes and then sewing the corresponding pieces together to form the finished product.
The sewing Department and the cutting department report to the production manager who
along with Engineering Manager reports to the Director-Manufacturing. The Sales Manager,
Publicity Manager and the Credit Manger report to the Director-Marketing, who along with
Direct-Manufacturing reports to the Managing Director of the company.
The Accounts Department reports the following for the last quarter of 2019:
Budgeted Actual
(`) (`)
Bad debt Losses 5,000 3,000
Cloth used 31,000 36,000
Advertising 4,000 4,000
Audit fees 7,500 7,500
Credit reports 1,200 1,050
Sales representative Travelling expenses 9,000 10,200
Sales commission 7,000 7,000
Cutting Labour 6,000 6,600
Thread 500 450
Sewing Labour 17,000 18,400
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Credit Deptt. Salaries 8,000 8,000
Cutting utilities 800 700
Sewing utilities 900 950
Director Marketing salaries & Admn. Exp. 20,000 21,400
Production engineering expenses 13,000 12,200
Sales management office expenses 16,000 15,700
Production Manger office expenses 18,000 17,000
Direct Mfg. Salaries & Admn. Expenses 21,000 20,100
Using the above data, prepare Responsibility Accounting reports for the Director- marketing,
the Director-manufacturing and the Production manager.
Responsibility Accounting Statement of

Functional Managers
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2
Sterling Works Ltd. has at the factory three production Departments, Machine Shop, Fabrica-
tion and Assembly which are the responsibility of the shop Superintendent. The shop super-
intendent along with Materials Manager, Planning Superintendent and Maintenance Engineer
report to the Works Manager at the factory. The office administration, sales and publicity come
under the sales Manager who along with the Works Manager report to the Managing Director
of the Company. The following data relating to a month’s performance are culled out from the
books of the company:
Variance from
Particulars Budget (`)
Budget (`)
Sales Commission 800 50 A
Raw Material & Components
- Machine Shop 900 20 A
Publicity Expenses 1,100 100 A
Printing & Stationery 3,200 200 F
Travelling Expenses 4,000 200 A
Wages - Machine Shop 800 10 F
- Fabrication 600 20 A
- Assembly 720 10 A
Material - Assembly 760 40 A
- Fabrication 460 10 A
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Utilities - Machine shop 320 10 A

- Assembly 470 60 F
- Fabrication 560 30 F
- Maintenance 400 20 A
- Stores 210 40 F
- Planning 180 20 A
Shop Superintendent’s Office
- Salaries & Expenses 1,100 22F
Depreciation - Factory 3,880 40A
Works Manager’s Office
- Salaries & Administration 3,810 40 A
General Office Salaries & Administration 4,270 30 A
Managing Director’s Salary & Administration 2,800 20 F
Required
Treating the Machine shop, Fabrication and Assembly as Cost Centres, prepare Cost Sheets for
each centre with the help of this addition information:
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Concept & Practice
The shop superintendent devotes his time amongst Machine shop, fabrication and Assembly
in the ratio 4 : 3 : 4. Other Factory Overheads are absorbed on the basis of Direct Labour in
each Cost centre. Office, Administration, Selling and Distribution Overheads are borne equally
among the Cost Centres.
Responsibility Accounting Statement of Responsibility Cost Sheet

Functional Managers
3
Classify the following measures under appropriate categories in a balanced score card for a
banking company which excels in its home loan products:
(a) A new product related to life insurance is being considered for a tie up with the successful
housing loan disbursements. E.g. every housing loan applicant to be advised to take a life
policy or compelled to take a fire insurance policy.
(b) How different sectors of housing loans with different interest rates have been sanctioned,
their volumes of growth in the past 4 quarters.
(c) How many days are taken to service a loan, how many loans have taken longer, what addi-
tional loans are to be released soon, etc.
(d) The company plans to capture additional market share.
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(e) Maintaining low cost of their products supported by low prices.
(f) The company intends to become a low price leader.
(g) An internal strategy linked with reward and recognition to employees.
(h) Maintain consistent loan disbursement.
(i) Promote entrepreneurial culture.
(j) Improve efficiency of employees to service the loan.
(You are not required to copy these statements into your answer books)
Balanced Score Card Identification of perspectives

for different measures
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4
ABC Ltd. has supermarkets located in most towns and cities. Over the last few years, profits have
fallen. ABC Ltd. has recognized that customer care has been paid insufficient attention. ABC Ltd.
has now realized the importance of the customer experience at its supermarkets.
ABC Ltd. has introduced a loyalty card scheme that rewards customers with discount vouchers
based on their spend and buying patterns at supermarkets in an attempt to earn the loyalty of
its customers.
The management of ABC Ltd. is considering the introduction of a Balanced Scorecard approach
to manage the performance of its stores.
Required:
Recommend an objective and a suitable performance measure for each of three nonfinancial
perspectives of a Balanced Scorecard that ABC Ltd. could use to support its new strategy of
improving the customer experience. You should state three perspectives, an objective and a
performance measure for each one of the three perspectives.
Balanced Score Card Case Study on Super Market

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Answer
Non- Financial
Objective Performance Measure
Perspective
Customer Increase the customer loyalty. Percentage of customers using
Perspective Or Retaining the existing cus- loyalty cards.
tomers. Or
No. of discount vouchers
redeemed.
Internal Business For customers to pay for goods Time spent by customers in queu-
Perspectives in a reasonable time. ing to pay for products at a check
Or out.
Paying proper attention to the Or
customers and their product Time spent by customers care
enquiries. executives in handling customers
Or queries.
Provide necessary support to the Or
existing loyal customers. No. of times home delivery made.
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Concept & Practice
Learning and To have qualified staffs able to No. of staff training days
Growth Perspectives meet the needs of the customers Or
Or Adding new products for new No. of schemes launched
segments
5
“Hard Rock Coconut” is an exclusive resort located in a famous island of Pacific Ocean that
vows to isolate its guests from the hustle and bustle of everyday life. Its leading principle is
“all contemporary amenity wrapped in old world charisma”. Each of the resort’s 18 villas has
a separate theme like Castle, Majestic, Ambassador, Royal Chateau, Coconut, Lemon, Balinese
etc. and guest often ask for a specific villa when they make reservations. Villas are ideal for fami-
lies or friend travelling together and these villas feature luxurious accommodations spanning
two floors. Since it is located within a 300 acre estate on white sand beach, the resort offer its
guests a wide variety of outdoor activities such as horseback riding, hiking, diving, snorkelling,
sailing, golf and so on. Guest could also while away the day relaxing in the pool and availing
themselves of the resort’s world-famous spa “Hard Coco Spa”. The dining room, which only has
three tables for the public, is acceptable proud of its 4-star rating.
You are required to develop a balanced scorecard for “Hard Rock Coconut”. It is sufficient to
give two measure in each of the four perspectives.
Balanced Score Card Case Study on Resort
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SCM
Chapter 22
1. BUDGETARY CONTROL RATIO

2. FIXED BUDGET
3. FLEXIBLE BUDGET
4. FUNCTIONAL BUDGET
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Concept & Practice
1
A company is engaged in manufacturing of several products. The following data have been
obtained from the record of a machine shop for an average month:
Budgeted:
No. of working days 24
Working hours per day 8
No. of direct workers 150
Efficiency One standard hour per clock hour
Downtime 10%
Actual for August 2010:
Net operator hours worked 20,500
Standard hours produced 22,550
There was a special holiday in August
Required:
Calculate Efficiency, Activity, Standard capacity usage ratio, and Calendar Ratio.
Budgetary Control Ratios Standard Hours and Standard

Capacity usage
November, 2010
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2
The following are the details of the budgeted and the actual cost in a factory for six months from
January to June 2019. From the figures given below you are required to prepare the production
cost budget for the period from January to June 2020:
Particulars Budget Actual
Production (units) 20,000 18,000
Qty of materials used 2,000 MT 1,900 MT
Labour Hours used 8,00,000 hrs 7,99,920 hrs
Materials Cost (`) 40,00,000 39,90,000
Labour Cost (` per hour) 20 22
Variable Overhead (`) 2,40,000 2,16,000
Fixed Overhead (`) 4,00,000 4,20,000
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In the first half of 2020, production is budgeted for 25,000 units. Material cost per metric tonne
will increase from last year’s actual by ` 300 but is proposed to maintain the consumption effi-
ciency of 2020 as budgeted. Labour efficiency will be lower by another 1 % and labour rates will
be ` 22 per hour. Variable and Fixed overheads will go up by 20 % over 2019 actual.
Fixed Budget Labour Efficiency Ratio

November, 2008
3
A company prepared the following budget for a year:

Fixed Fixed
Variable Variable Sales
Item R/M Labour Factory Selling Profit
Factory OH Selling OH Price
joylawrenciandas50@gmail.com,8420517209 OH OH
Percent 40% 20% 10% 10% 5% 12% 3% 100%
After evaluating the half – yearly performance, it was observed that the company would be
able to achieve only 80% of the original budgeted sales. The revised budgeted sales as envis-
aged above was estimated at ` 1,080 lakhs after taking into account a reduction in the selling
price by 10%.
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Prepare a statement showing the break – up of the original and revised budget for the year.
The Co. has received an export order. The estimated prime cost and special export expenses for
fulfilling the export order are ` 12 lac and ` 40,000 respectively.
Find the lowest quotation.
Fixed Budget Revised Budget and Lowest

Quotation - Relevant Cost
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Concept & Practice
4
V Ltd. manufactures a single product. The selling price of the product is ` 150 per unit. The
following are the result obtained by the company during the last two quarters:
Particulars Quarter 1 Quarter 2
Sales (units) 5,100 4,800
Production (units) 5,500 4,500
Direct Materials – A (`) 66,000 54,000
Direct Materials – B (`) 55,000 45,000
Manufacturing wages (`) 1,56,750 1,38,000
Factory Overheads (`) 86,000 83,000
Selling Overheads (`) 79,000 73,000
The company estimates its sales for the next quarter to range between 5,500 units and 6,500
units, the most likely volume being 6,000 units. The manufacturing programme will match with
the sales quantity such that no increase in inventory of finished goods is contemplated in the
next quarter. The following price and cost changes will, however, apply to the next quarter:
1. The price of direct material B will increase by 10%. There will be no change in the price of
direct material A.
2. The wage rates will go up by 8%. If the production volume increases beyond 5,500 units
overtime premium of 50% is payable on the increased volume due to overtime working to
be done by the variable labour complement.
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3. The fixed factory and selling expenses will increase by 20% and 25% respectively.
4. A discount in the selling price of 2% is allowed on all sales made at 6,500 units level of
output. The selling price, however, will remain unaltered, if the volume of output is below
6,500 units.
5. While operating at a volume of output of 6,500 units in the next quarter, the company
intends to quote for an additional volume of 2,000 units to be supplied to a Government
department for its captive consumption. The working capital requirement of this order is
estimated at 80% of the sales value of the Government order. The company desires a return
of 20% on the capital employed in respect of this order.
Required:
a. Prepare a flexible budget for the next quarter at 5,500, 6,000 and 6,500 unit levels and de-
termine the profit at the respective volumes.
b. Calculate the lowest price p.u. to be quoted in respect of the GOVT. order for 2,000 units.
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Flexible Budget
May, 2003
5
JBC Limited, a manufacturing company having a capacity of 60,000 units has prepared a follow-
ing cost sheet:
Direct Material (per unit) ` 12.50

Direct Wages (per unit) ` 5.00
Semi – variable cost ` 30,000 fixed plus 0.50 per unit
Factory overhead (per unit) ` 10.00 (50 % fixed)
Selling and administration overhead (per unit)
` 8.00 (25 % variable)
Selling price (per unit) ` 40
During the year 2018, the sales volume achieved by the company was 50,000 units. The compa-
ny has launched an expansion program as under:
a. The capacity will be increased to 1,00,000 units.
b. The cost of investment on expansion is ` 5 lakhs which is proposed to be financed through
financial institution at 12 per cent per annum.
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c. The depreciation rate on new investment is 10 per cent based on straight line.
d. The additional fixed overheads will amount to ` 2.00 lakhs up to 80,000 units and will in-
crease by ` 80,000 more beyond 80,000 units.
After the expansion, the company has two alternatives for operating the expanded plant as
under:
(i) Sales can be increased up to 80,000 units by spending ` 50,000 on special advertisement
campaign to explore new market.
(ii) Sales can be increased up to 1,00,000 units subject to the following:
(a) Reduction of selling price by ` 4 per unit on all the units sold.
(b) The direct material cost would go down by 4 per cent due to discount on bulk buying.
(c) By increasing the variable selling and administration expenses by 4 per cent.
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Concept & Practice
Required:
(i) Construct a flexible budget at the level 50,000 units, 80,000 units and 1,00,000 units of
production and select best profitable level of operation.
(ii) Calculate break- even point both before and after expansion.
Flexible Budget Break Even Point

May, 2009
6
Nesley Ltd. has prepared the following sales budget for the first five months of 2018:
Month Sales Budget (units)
Jan 20,800
Feb 25,600
Mar 22,200
Apr 20,800
May 18,800
Inventory of finished goods at the end of every month is to be equal to 25 % of sales estimate
for the next month. On 1st January, 2008 there were 5,500 units of product on hand. There is no
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work – in – progress at the end of any month.
Every unit of product requires two types of materials in the following quantities:
Material A: 2 kg
Material B: 5 kg
Materials equal to one half of the requirement of next month’s production are to be in hand at
the end of every month. This requirement was met on 1st January, 2018.
Prepare the following budgets for the quarter ending 31st March 2018:
(a) Production Budget and
(b) Material Purchase Budget.
Functional Budget
SCM
7
A single product company estimated its sales for the next year quarter - wise as under:
QUARTER SALES (UNITS)
I 30,000
II 37,500
III 41,250
IV 45,000
The opening stock of finished goods is 10,000 units and the company expects to maintain the
closing stock of finished goods at 16,250 units at the end of the year. The production pattern
in each quarter is based on 80% of the sales of the current quarter and 20% of the sales of the
next quarter.
The opening stock of raw materials in the beginning of the year is 10,000 kg. and the closing
stock at the end of the year is required to be maintained at 5,000 kg. Each unit of finished
output requires 2 kg. of raw materials.
The company proposes to purchase the entire annual requirement of raw materials in the first
three quarters in the proportion and at the prices given below:
Quarter Purchase of raw material % to annual requirement (kg) Price per kg (`)
I 30 % 2
II 50 % 3
III 20 % 4
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You are required to present the following for the next year, quarter wise:
(i) Production budget (in units).
(ii) Raw material consumption budget (in quantity).
(iii) Raw material purchase budget (in quantity and value).
Functional Budget Production Budget
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Concept & Practice
8
Solo products Ltd. manufactures and sells a single product and has estimated a sales revenue
of ` 126 lakhs this year based on a 20% profit on selling price. Each unit of the product requires
3 Ibs of material P and 1 and 1/2 Ibs of material Q for manufacture as well as a processing time
of 7 hours in the Machine Shop and 2 and 1/2 hours in the Assembly Section. Overheads are
absorbed at a blanket rate of 33-1/3% on Direct Labour. The factory works 5 days of 8 hours a
week in a normal 52 weeks a year. On an average statutory holidays, leave and absenteeism and
idle time amount to 96 hours, 80 hours and 64 hours respectively, in a year.
The other details are as under:
Purchase Price Material P ` 6 per lb

Material Q ` 4 per lb
Comprehensive Labour Rate Machine Shop ` 4 per hour
Assembly Shop ` 3.20 per hour
No. of employees Machine Shop 600
Assembly Shop 180
FINISHED GOODS: Material P Material Q
Opening Stock (20,000 units) 54,000 lbs 33,000 lbs
Closing Stock (Estimated) ? units 30,000 lbs 66,000 lbs
The past performances of factory in last three years are:
Year Machine Shop (hrs) Assembly Shop (hrs)
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1 11,00,000 3,45,000
2 10,30,000 3,20,000
3 10,80,000 3,40,000
You are required to calculate:
(a) The number of units of the product proposed to be sold and the closing finished goods
stock.
(b) Purchases to be made of materials P and Q during the year in Rupees.
(c) Capacity utilization of machine shop and Assembly section, along with your Comments.
Functional Budget Based on Bottle Neck and

Capacity Utilisation
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9
P. Ltd. manufactures two products using one type of material and one grade of labour. Shown
below is an extract from the company’s working papers for the next period’s budget:
PARTICULARS PRODUCT A PRODUCT B
Budgeted Sales (units) 3,600 4,800
Budgeted material consumption per product (Kg) 5 3
Budgeted material cost ` 12 per kg
Standard hours allowed per product 5 4
Budgeted wage rate ` 8 per hour
INFORMATION:
1. Overtime premium is 50% and is payable, if a worker works for more than 40 hours a week.
There are 90 direct workers.
2. The target productivity ratio (or efficiency ratio) for the productive hours worked by the
direct workers in actually manufacturing the products is 80%; in addition the non-produc-
tive down time is budgeted at 20% of the productive hours worked.
3. There are twelve 5 day weeks in the budget period and it is anticipated that sales and pro-
duction will occur evenly throughout the whole period.
4. It is anticipated that stock at the beginning of the period will be:
Product A: 1,020 units; Product B: 2,400 units; Raw material 4,300 kgs.
5. The target closing stock, expressed in terms of anticipated activity during the budget peri-
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od are:
Product A: 15 days sales; Product B: 20 days sales; Raw material: 10 days consumption.
Required:
(a) Material Purchases Budget showing the quantities and values, for the next period.
(b) Wages budget for the direct workers
(c) Would your answer change in (a) above if raw materials stock on closing date is kept ac-
cording to the requirement of stock of finished goods, if yes, then prepare new material
purchase budget.
Functional Budget Wages Budget

November, 2014
428 |SCM
Concept & Practice
10
A company is engaged in the manufacture of specialised sub-assemblies required for certain

electronic equipments. The company envisages that in the forthcoming month, December,
2019, the sales will take a pattern in the ratio of 3:4:2 respectively of sub-assemblies, X, Y and Z.
The following is the schedule of components required for manufacture:
Component Requirements Per Unit
Sub – Assembly SP ` / Unit
A B C D
X 520 1 8 4 2
Y 500 1 2 10 6
Z 350 1 2 4 8
Purchase Price (`/ Unit) 60 20 12 8
The direct labour time and variable overheads required for each of the sub-assemblies are:
Labour Hour Per
Assembly Variable Overheads
Grade I Grade II
per sub assembly (`)
X 8 16 36
Y 6 12 24
Z 4 8 24
Direct Wage Rate per hour `5 `4 --
Fixed overheads amount to ` 7,57,200 for the month and a monthly profit target of ` 12 lacs has
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been set.
Prepare Sales budget in quantity and value for December 2019:
Functional Budget Sales Budget
Answer
Working Note 1: Desired Contribution:
Amount
Particulars
(`)
Fixed Cost
Desired Profit
Desired Contribution
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| 429
Concept & Practice
Working Note 2: Contribution Per Unit:

Particulars X Y Z
Selling Price
Less: Variable Costs per unit
Components cost
A
B
C
D
Labour cost
Grade I
Grade II
Variable OH
Contribution per unit 96 130 62
Working Note 3: Units to be Sold: x = 6300 units y = 8400 units z = 4200 units
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Sales Budget (in Qty and Value)

Particulars X Y Z
Units to be Sold (WN – 3)
Selling Price Per unit
Estimated Sales (`)
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Concept & Practice
11
Bintan-Indo Manufacturers Ltd. (BIML) is specialist in the manufacturing of Industrial Prod-

ucts. They manufacture and market two types of products under the name ‘X’ and ‘Y’. Company
produces two products from three basic raw materials ‘A’, ‘B’, and ‘C’. Company follows a 13-
period reporting cycle for budgeting purpose. Each period is four weeks long and has 20 work-
ing days. Data relating to the purchase of raw materials are presented below:
Purchase Standard Projected Inventory Lead Time
Reorder
Raw Material Price (Per Purchase Lot Status at the end of 5th in Working
Point (Kg)
Kg) (Kg) period (Kg) Days
On Hand On Order
A ` 1.00 90,000 72,000 96,000 90,000 10
B ` 2.00 30,000 45,000 54,000 - 25
C ` 1.00 60,000 60,000 84,000 60,000 20
Past experience has shown that adequate inventory levels for ‘X’ and ‘Y’ can be maintained if 40
percent of the next period’s projected sales are on hand at the end of a reporting period. Other
relevant information is as follows:
Projected
Product Raw Material Specifications Inventory Projected Sales
Levels
At the end of
A B C current (5th) 6th Period 7th Period 8th Period
D Block
period
Kg Kg Kg Units Units Units Units
X 1.25 0.50 - 18,000 45,000 52,500 57,000
Y 2.00 - 1.50 16,800 42,000 27,000 24,000
The sales of ‘X’ and ‘Y’ do not vary significantly from month to month. Consequently, the safety
stock incorporated into the reorder point for each of the raw materials is adequate to compen-
sate for variations in the sales of the finished products.
Raw materials orders are placed the day the quantity on hand falls below the reorder point.
BIML’s suppliers are very trustworthy so that the given lead times are reliable.
The outstanding orders for raw materials ‘A’ and ‘C’ are due to arrive on the 10th and 4th work-
ing day of the 6th period, respectively. Payments for all raw material orders are remitted by the
10th day of the delivery.
Required
Determine the following items for raw materials ‘A’, ‘B’, and ‘C’ for inclusion in the 6th period
report to management:
(i) Projected quantities (in Kg) to be issued to production.
SCM
(ii) Projected quantities (in Kg) ordered and the date (in terms of working days) the order is to
be placed.
(iii) The projected inventory balance (in Kg) at the end of the period.
(iv) The payments for purchases with due date.
Functional Budget Inventory Control Techniques
D Block
432 |SCM
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For CA-CMA – Final

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© SJC Institute LLP

This file belongs only to students registered in this course.

CA Final New CA Final Old CMA Final

2. Application / Sums Solving

1. TOTAL QUALITY MANAGEMENT

1. TOTAL QUALITY MANAGEMENT

2. SIX SIGMA QUALITY

Representation of Six Sigma Process through Normal Distribution

A. NUMERICAL CONCEPT OF SIX SIGMA

B. THE VALUE OF THE DEFECT PERCENTAGE UNDER VARIOUS SIGMA

C. LIMITATIONS OF SIX SIGMA

D. LEAN SIX SIGMA

DMDAV is used under the following circumstances:

A. SIMILARITIES BETWEEN DMADV AND DMAIC

B. DIFFERENCES BETWEEN DMAIC AND DMADV

5. BUSINESS PROCESS REENGINEERING

A. THE FOUR KEY COMPONENTS OF BPR

Fundamental Radical Dramatic End to End

• Fundamental rethinking of business processes requires management to

eliminates the traditional segregation of duties that organisations normally associate

C. MAIN STAGES OF BPR

• Support Services: Innovations in processes aren’t limited to simply production or

7. DEMING’S 14 POINTS METHODOLOGY:

10. Eliminate slogans, exhortations and targets for the workforce.

8. PDCA CYCLE OF MR. DEMING

9. FOUR P’S OF QUALITY CONTROL

10. SIX C’S OF QUALITY CONTROL

11. EIGHT DIMENSIONS OF QUALITY

based on indirect measures.

12. QUALITY CONTROL COSTS - BY JOSEPH JURAN AND PHILIP

A. COSTS ASSOCIATED WITH DELIVERING QUALITY ARE:

Cost of Poor Quality Cost of Good Quality

Internal Failure External Failure Appraisal Prevention

3. Cost of acquiring and operating the process control and measuring

C. STEPS OF APPLICATION OF PAF MODEL

5. Do this study on a regular basis and evaluate your performance

D. THE ICEBERG MODEL

Excessive Overtime Excessive Field Incorrectly

Reference What’s New

(j) Packaging inspection

Reference What’s New

Reference What’s New

Reference What’s New

Direct Materials X 8 sq mt at ` 40 per square metre

Before the implementation of QMP After the implementation

5% of incoming material from suppliers scrapped due to poor Reduced to 3%

Reference What’s New

Reference What’s New

Reference What’s New

Direct materials 33 1/3 %

Reference What’s New

Particulars (` ‘000) Option 1 Option 2 Option 3

Reference What’s New

Reference What’s New

Reference What’s New

(ii) Planned component cost = (3 × ` 18 for material A) + (2 × ` 9 for material B) + ` 15

12. QUALITY CONTROL COSTS - BY JOSEPH JURAN AND PHILIP