Paper 16 Chapters 1 To 5 With Addition Matter

Introduction to Strategic Cost Management
Introduction to Strategic Cost

Management
1
This Study Note Includes

1.1 Concepts of Strategic Cost Management in different stages of Value Chain
1.2 Cost Control and Cost Reduction–Contemporary Techniques
1.3 Value Analysis and Value Engineering -Business Process Re-engineering
1.4 Supply Chain Management
The Institute of Cost Accountants of India 1

Strategic Cost Management (SCM)
Introduction to Strategic Cost Management 1

1.1 Concepts of Strategic Cost Management in different stages of Value Chain

A firm’s strategy aims to match its own capabilities with the available opportunities. In other words, strategy
defines as to how an organization creates value for its customers while distinguishing itself from its competitors.
In general, businesses follow one of two broad strategies, i.e., either Cost Leadership or Product Differentiation.
Low-Cost-Carriers (Airlines) are known to provide quality products or services at low prices by toeing the cost
leadership strategy. Electronic giants such as Apple are known to garner premium prices by following product
differentiation strategy.
Strategic Cost Management (SCM) refers to the cost management that specifically focuses on strategic
issues such as:
(a) the company’s cost, productivity, or efficiency advantage relative to competitors or
(b) the premium prices a company can charge over its costs for distinctive product or service features.
Strategic Cost Management, thus, plays a vital role in formulating beneficial strategies relevant for the firm
by providing information about the sources of competitive advantage.
Strategic Cost Management (SCM) may be stated as the process of identifying, accumulating, measuring,
analysing, interpreting, and reporting cost information useful to both internal and external groups concerned with
the way in which an organization utilises its resources to achieve its strategic objectives. As such, Strategic cost
management needs to be perceived as the application of cost management techniques with a view to enhance the
strategic posture of a firm and reduce the costs. It is a process of combining the decision-making structure with the
cost information, in order to reinforce the business strategy as a whole. It measures and manages costs to align the
same with the company’s business strategy.
Strategic Cost Management may be divided into four stages, viz.
(i) Formulation of Strategies
(ii) Communication of Strategies across the entire organization.
(iii) Implementation of the tactics to execute the strategies.
(iv) Controlling the activities to track the achievement.
In Strategic Cost Management (SCM), primary importance is given to constant improvement in the product or
service to deliver better quality to its target customers. SCM, therefore, encompasses every facet of the value chain
of an organisation.
2 The Institute of Cost Accountants of India

The need for SCM may be summarised as:

(i) It is an updated form of cost analysis, in which the strategic elements are clearer and more formal.
(ii) It helps in identifying the cost relationship between value chain activities and its process of management
to gain competitive advantage.
(iii) It is used to analyse cost information with a view to develop relevant tactics to garner a sustainable
competitive advantage.
(iv) It provides a better understanding of the overall cost structure in the quest for gaining a sustainable
competitive advantage.
(v) It uses cost information specifically to govern the strategic management process – formulation,
communication, implementation and control.
SCM has three important pillars, viz., strategic positioning, cost driver analysis and value chain analysis.
1. Strategic Positioning Analysis: It determines the company’s comparative position in the industry in terms
of performance.
2. Cost Driver Analysis: Cost is driven by different interrelated factors. In strategic cost management, the cost
driver is divided into two categories, i.e., structural cost drivers and executional cost drivers. It examines,
measures and explains the financial impact of the cost driver concerned with the activity.
3. Value Chain Analysis (VCA): VCA is the process in which a firm recognizes and analyses, all the activities
and functions that contribute to the final product. VCA depicts the manner in which customer-value accrues
along the activity chain that results in the final product or service.
In a nutshell, strategic cost management is not just about controlling the costs but also using the information
for strategic decision making. The fundamental objective of strategic cost management is to gain a sustainable
competitive advantage by way of cost leadership and product differentiation.
Value Chain
Developed by Michael Porter in 1985 and used throughout the world, the value chain is a powerful tool for
disaggregating a company into its strategically relevant activities in order to focus on the sources of competitive
advantage, that is, the specific activities that result in lower costs or higher prices.
A company’s value chain is typically part of a larger value system that includes companies either upstream
(suppliers) or downstream (distribution channels), or both. This perspective about how value is created forces
managers to consider and see each activity not just as a cost, but as a step that has to add some increment of value
to the finished product or service.
Manufacturing companies create value by
acquiring raw materials and using them to
produce something useful. Retailers bring
together a range of products and present them in
a way that is convenient to customers, sometimes
supported by services such as trial rooms or
personal shopper advice. And insurance
companies offer policies to customers that are
underwritten by larger re-insurance policies.
Here, they are packaging these larger policies in
a customer-friendly way, and distributing them
to a mass audience.

In other words, the value that is created and captured by a company as reduced by the costs incurred is the profit
margin. Expressed as a formula the equation would read as:
(Value Created and Captured – Cost of Creating that Value) = Profit Margin
The more value an organization creates, the more profitable it is likely to be. As more and more value is provided
to the customers, competitive advantage creeps in. Understanding how a company creates value, and looking for
ways to add more value, are critical elements in developing a competitive strategy.
Thus, the value chain is a set of activities that an organization carries out to create value for its customers. Porter
proposed a general-purpose value chain that companies can use to examine all of their activities, and see how they
are connected. The way in which value chain activities are performed determines costs and affects profits.
Elements in Porter’s Value Chain

Rather than looking at departments or accounting cost types, Porter’s Value Chain focuses on systems, and how
inputs are changed into the outputs purchased by consumers. Using this viewpoint, Porter described a chain of
activities common to all businesses, and he divided them into primary and support activities, as shown below.
Primary Activities: Primary activities relate directly to the physical creation, sale, maintenance and support of
a product or service. They consist of the following:
~~ Inbound Logistics: These are all the processes related to receiving, storing, and distributing the inputs
internally. The supplier relationships are a key factor in creating value here.
~~ Operations: These are the transformation activities that change inputs into outputs that are sold to customers.
Here, operational systems create value.
~~ Outbound Logistics: These activities deliver the product or service to the customer. These are the things
like collection, storage, and distributing the outputs. They may be internal or external to the organization.
~~ M
arketing and Sales: These are the processes that are used to persuade clients to purchase from the firm
instead of its competitors. The benefits being offered, and how well they are communicated to the customers,
are sources of value here.
~~ Service: These are the activities related to maintaining the value of the product or service to customers, once
it has been purchased.
Support Activities: Support activities support the primary functions stated above. Each support, or secondary,
activity can play a role in each primary activity. For example, procurement supports operations with certain
activities, but it also supports marketing and sales with other activities.
~~ Procurement (Purchasing): This is what the organization does to get the resources it needs to operate. This
includes finding vendors and negotiating best prices.
~~ Human Resource Management: This is how well a company recruits, hires, trains, motivates, rewards, and
retains its workers. People are a significant source of value, so businesses can create a clear advantage with
good HR practices.
~~ Technological Development: These activities relate to managing and processing information, as well as
protecting a company’s knowledge base. Minimizing information technology costs, staying current with
technological advances, and maintaining technical excellence are sources of value creation.
~~ Infrastructure: These are a company’s support systems, and the functions that allow it to maintain
daily operations. Accounting, legal, administrative, and general management are examples of necessary
infrastructure that businesses can use to their advantage.

Activities
Primary
Profit Margin
Activities
Support
Human Resource Technological

Procurement Infrastructure
Management Development
Companies use these primary and support activities as “building blocks” to create a valuable product or service.
Value chain analysis (VCA)

Value chain analysis (VCA) is a process where a firm identifies its primary and support activities that add value
to its final product and then analyse these activities to reduce costs or increase differentiation. Value chain analysis
relies on the basic economic principle of advantage - companies are best served by operating in sectors where
they have a relative productive advantage compared to their competitors. Simultaneously, companies should ask
themselves where they can deliver the best value to their customers.
Conducting a value chain analysis prompts a firm to consider how each step adds or subtracts value from its final
product or service. This, in turn, can help it realize some form of competitive advantage, such as:
●● Cost reduction, by making each activity in the value chain more efficient and, therefore, less expensive
●● Product differentiation, by investing more time and resources into activities like research and development,
design, or marketing that can help the product stand out
Typically, increasing the performance of one of the four secondary activities can benefit at least one of the
primary activities.
Five Steps to developing a value chain analysis (Illustrative)
Step 1: Identify all value chain activities

Identify each activity that plays a part in creating your company’s finished product. For example, it is not enough
to write down that you have a product design team. You need to dig deeper and ask:
How many designers are on that team?
How much time does each activity on that team require?
What raw materials are they using?
Once you’ve identified each primary activity in detail, you’ll need to do the same for each support activity. This
step will take a considerable amount of time and, if possible, shouldn’t be a one-person task. Instead, encourage
cross-collaboration internally so each department can outline its logistics, operational costs and services.
Step 2: Calculate the cost of each activity

Remember to calculate cost drivers such as rent, utilities and staff. By having an accurate picture of every
single cost (and what activities increase or decrease costs), it’s easier to see how much revenue you’re actually
generating. Once each activity has been mapped out, you can delineate which parts of your value chain are costing
your business the most money. According to the Financial Times, a value chain analysis on a £2.50 cup of coffee
revealed that only 1p goes to the actual coffee grower. The rest of the £2.49 is made up of additional supplies like:
Milk, Stirrers, Transport, Rent, Staff and Taxes. Using this value chain analysis example, we learn that the most

critical component (coffee) is one of the least expensive parts of the cost breakdown. Rent and staff are the most
expensive. Having this information, the company can choose their next steps wisely.
If they want to reduce rent costs, they can attempt to negotiate their contract. Failing that, they can relocate to
a less expensive location. While that may draw less foot traffic, the low-cost option could potentially boost their
profit margin. If they want to reduce staff costs, they could evaluate how many people are scheduled per shift and
perhaps cut staff hours during less busy times. Alternatively, if they cannot streamline their process or lower costs
in any way, they could try to boost their perceived value. They could do this by creating and promoting unique
items, or sourcing new ingredients (at a similar cost) that increase sales or engagement.
It’s easy to see why detailed, accurate calculations can make or break the effectiveness of your value chain.
Step 3: Look at what your customers perceive as value

Know that customers tie value directly to a product’s price tag, in other words, perception greatly impacts product
margins. Research shows that although branded and non-branded painkillers have the exact same health outcome,
the former is better perceived by consumers. Because customers believe it is more valuable to their health, they’re
willing to pay more for the brand name. To determine what your end customers perceive as valuable, you need
to dig into their psychology. Collecting quantitative and qualitative data can help you identify statistical patterns
in your customer’s buying behaviour. Identifying these qualities will also help your sales reps down the line
with prospecting and qualifying ideal customers. Understanding why and how your customers make purchasing
decisions boils down to understanding their intent and what they perceive as valuable.
As Rory Sutherland’s TED Talk highlights, the same product can mean very different things to different people.
He explains that when it comes to selling a product, there’s no such thing as an objective value. Rather, the value
that people place on products comes from factors such as societal influence and group-think. People often make
decisions based on actions that their friends, family and close social groups take. For example, if people in your
social circles start to buy noise-cancelling headphones to wear at work, you may begin to think of them as valuable,
even if you didn’t want to buy them before. Knowing what your customers, and their social circles, desire opens
up the opportunity to market your product in a way that motivates them to buy it.
Step 4: Look at your competitors’ value chains

The best way to determine value is through market analysis. Although it’s unlikely you will have access to your
competitors’ infrastructure and operational breakdowns, you can use benchmarks as a starting point. This process
is called competitive benchmarking. You can choose to use competitive benchmarking in one of three main ways:
(i) Process benchmarking: Comparing your process structure and operations against how your competitors
carry out tasks.
(ii) Strategic benchmarking: Comparing your high-level business strategy to your competitors’ to determine
what emulates success.
(iii) Performance benchmarking: Comparing outcomes, such as revenue, organic traffic, social media
performance, reviews and ratings and so on.
First, you need to determine your competitive benchmarking goals; then, you can conduct research, make a
comparison and determine value. As SmartInsights’ Dave Chaffey explains, you need a baseline to review the
marketing effectiveness of competitors. For example, the sales and marketing value chain of online companies
can be expansive. By breaking down the rough costs of your competitor’s online sales and marketing efforts, you
can calculate whether your spending is too high. McKinsey recommends using a competitor-insight loop to build
insight into your competitors’ strategic planning and decision-making processes.

The key to making this process successful is to tap into the latest data from a competitor’s frontline workforce,
such as a blog or shared database, and identify value gaps.
Step 5: Decide on a competitive advantage

At this stage, you will have a clear understanding of your internal costs, what changes you can make and how
they stack up to your competitors. If you choose cost advantage, you need to find a way to optimize and cut the cost
of primary and support activities in your value chain. You might choose to outsource talent, replace certain human
activities with automation or look for cheaper delivery services or distribution channels. As more and more people
start working remotely, you may even get rid of office space. Any cost cuts you make in the chain can lower the
cost of your final product. The more you can push your product prices down, the larger your cost advantage will
be compared to competitors.
If you choose competitive differentiation, you must capitalize on increasing the value perception of those products
that your customers and end users are most willing to pay for. You can cater to your customers’ most basic desires
and needs by recognizing their pain points and repositioning your products as the ultimate solution.
For example, your sales team can highlight your product differentiation during the sales pitch or closing stage
in the pipeline by:
●● Mentioning the unique benefits your product has that your competitors’ products don’t
●● Presenting a case study from a customer that reinforces your position and highlighting relevant data or ROI
●● Listing other businesses in the prospect’s industry that have used your product or service and had a positive
experience
Example of Apple
When Steve Jobs began building Macs in the 80s in his garage, he wasn’t doing it for customers—it was for
himself. “We were the group of people who were going to judge whether it was great or not,” he said in an
interview years later. “We weren’t going to go out and do market research.” Just over a decade later, Jobs famously
quipped: “People don’t know what they want until you show it to them.” These admissions give us a unique
understanding of the mindset behind a very successful brand. While Jobs was insistent on making products that
he loved, the company spent massive amounts of money on its internal creative processes—a support activity in
their value chain. These investments were made possible because of tight control over the cost of Apple’s primary
activities such as operations, logistics and support. This is what Apple’s value chain analysis tells us about how the
company became so successful.
Apple’s Primary Activities

1. Inbound logistics: Apple’s supply chain is enormous. Its top 200 suppliers provide the company with 98%
of procurement expenditures for materials, manufacturing and product assembly. To manage the sheer volume
of suppliers and inbound logistics, they must run a tight supply chain management ship. As such, the suppliers
are held to strict quality standards and to streamline this process, the company launched the Apple Procurement
Program, which states:
“Our business environment is competitive and fast-paced. Our suppliers must understand this dynamic and be
agile and flexible in responding to changing business conditions. Above all, Apple values innovation. We appreciate
suppliers who truly understand and share in our challenges, and who help us find the best possible solutions.”
Every year, the list of suppliers is revisited. Suppliers that meet Apple’s standards and provide a more competitive
product are added to the list to ensure optimization of their value chain.
2. Operations: Apple takes advantage of lower labour and raw material costs in Japan and China, overall
manufacturing costs are also cut. Outsourcing helps them keep overall manufacturing costs low.
3. Outbound logistics: Apple’s business model allows for products to be purchased online and from the
company’s stores. Because the company has hundreds of retail stores, it can capitalize on keeping any retail
margins made through Apple sales. Brand name recognition also means that non-Apple outlets stock the products
in large numbers. A Communications Of The ACM article estimates that Apple gives retailers a 25% wholesale
discount. Using this estimate, Apple was left with a gross profit of $80 for the 30GB 5th Gen iPods sold through
non-Apple outlets. For any sale made through Apple’s online or customer-facing stores, they also pocketed a $45
retail margin.
4. Marketing and sales: Apple’s marketing and sales efforts are identifiable for its design, quality and innovation.
In 2015, the company boosted its marketing budget to $1.8 Billion, explaining that an “ongoing investment in
marketing and advertising is critical to the development and sale of innovative products and technologies”. Apple’s
approach to marketing and sales reflects its chosen competitive advantage: ‘highlighting value’. As SeedX Inc
Founder Jacqueline Basulto points out, Apple reflects its perceived value not only in the cost of its products but
also in its advertising.
5. Service: Most products sold by Apple are initially covered by a 1-year warranty and 90 days of support from
staff. Customers can book appointments for technical repairs or general product assistance. They also staff their
stores with trained Apple technicians who offer guided, interacted demos to customers. Allowing store visitors to
engage with products, in turn, helps encourage them to buy.
Apple’s Support Activities

1. Research and development: Apple invests heavily in research and development. In 2019 alone, more than $16
billion was pumped into its R&D program to continue research into products that can maintain Apple’s competitive
advantage. The investment paid off: in 2020, the company released 28 new or refreshed products onto the market.
2. Human Resource Management: Apple was crowned the most admired company for HR in 2019, reflecting
its reputation on hiring and paying well. The company is known for recruiting top candidates and even poaching
talent from other companies to get the best people working for them.
Summing up, conducting a value chain analysis is one of the most powerful processes a business can undertake.
The detail involved in the analysis can uncover where your company spends its money, how well your operations
are working and how you can outmanoeuvre your competitors. In fact, without a detailed value chain analysis, it’s
impossible to see where you can lower costs and how to decide what competitive advantage will work best for your
product. At the same time, a value chain analysis is invaluable in identifying wasteful activities in your product
production. By sizing up your competitors and tightening up your development process, you can take steps to add
value to your product and ultimately—your bottom line.
(Resource: www.pipedrive.com/en/blog/value-chain-analysis_17.01.2022)
Example of Pizza Hut

As another example, let’s look at the value chain of Pizza Hut:
Primary activities
●● Inbound logistics: This includes all of the sourcing activities to procure and standardize all of the produce,
ingredients and materials to bake pizza’s fast, consistently, and delicious – in house. They capitalize on
economies of scale, and use massive global purchase orders to source the best prices on raw products for
their restaurants.
●● Operations: By targeting areas where there is an affinity for Italian food, Pizza Hut operates in a huge
number of countries globally with a licensing model where stores are managed by a local franchise owner.

●● Outbound logistics: There are two models that Pizza Hut capitalizes on, in store dining and their home
delivery service.
●● Marketing and Sales: There is a large investment in marketing to drive additional sales, and compete with
the other fast-food chains.
●● Service: The entire goal of Pizza Hut is to offer value to their customers in affordable and convenient pizza
that everyone can enjoy.
Support activities
●● Infrastructure: Again, this includes every other activity that is required to keep the stores in business, such
as finance, legal, etc.
●● Human Resources: To keep the costs down staff are typically junior, and unskilled.
●● Technological development: The process they have created to have unskilled chefs cooking the pizza is
their biggest asset. Breaking down the complicated method into simple steps that can be repeated again and
again for consistently great pizza.
●● Procurement: The purchasing and activities required to produce the pizza, the raw food, and all of the
buildings, and equipment needed to cook and deliver the pizzas.
Based on these activities, Pizza Hut is leading the market in producing pizza that is both affordable, and can be
delivered to your door in under 30 minutes (in most cities). This convenience is what sets them apart from many
other competing options for meals, like going out to dinner or preparing a meal at home yourself, and they use a
strong campaign and marketing focus to entice customers to use them over similar competitors in the fast-food
delivery industry.
Doing a value chain analysis is a fantastic way of following a process to review all of the ways you can generate
value for your customers. When you review all of these in detail, you’ll find that you come across many different
ways you can satisfy your customers even more. Very soon you be excelling in all the things that really matter to
your customers. That’s when you’ll have real success!
(Resource: blog.udemy.com/value-chain-analysis-example_17.01.2022)
1.2 Cost Control and Cost Reduction – Contemporary Techniques
Cost Control
‘Cost Control’ is defined as the regulation by executive action of the costs of operating an undertaking, particularly
where such action is guided by cost accounting. Thus, cost control is the guidance and regulation through an
executive action and this executive action is exercised in respect of all the expenses incurred in operating an
undertaking. Cost control comprises all procedures and measures by which the cost of carrying out an activity
is kept under check and aims at ensuring that costs do not go beyond the targeted level. Standard costing and
budgetary control are the conventional techniques adopted for cost control.
Cost control is exercised through setting standards of targets and comparing actual performance therewith, with
a view to identify the deviations from standard norms and taking corrective actions in order to ensure that future
performance conforms to standard norms. In
other words, it is a scientific management Setting the Targets
technique to contain the costs of doing Process of
business. Cost control is concerned with the Identifying the Deviations
Cost Control
ways and means of keeping the costs at a
Taking Corrective Actions
lower level, without affecting efficiency and
effectiveness.

Cost control involves the following steps and covers the various facets of the management:
(a) Planning: First step in cost control is to establish plans/targets. The plan/target may be in the form of
budgets, standards, estimates and even past actual may be expressed in physical as well as monetary terms.
These plans/targets serve as yardsticks by which the planned objective can be assessed.
(b) Communication: The plan and the policy laid down by the management are made known to all those
responsible for carrying them out. Communication is established in two directions; directives are issued
by higher level of management to the lower level for compliance and the lower-level executives report
performances to the higher level.
(c) Motivation: The plan is given effect to and performances starts. The performance is evaluated, costs are
ascertained and information about results achieved are collected and reported. The fact that costs are being
complied for measuring performances acts as a motivating force and makes individuals endeavour to better
their performances.
(d) Appraisal and Reporting: The actual performance is compared with the predetermined plan and variances,
i.e., deviations from the plan are analyzed as to their causes. The variances are reported to the proper level
of management.
(e) Decision Making: The variances are reviewed and decisions taken. Corrective actions and remedial
measures or revision of the target, as required, are taken.
Key points for exercising effective Cost Control

(i) Quantity and price standards should be set to, or be estimated for, each physical unit. The factors influencing
variances should not be ignored (inadequate facilities, poor organisation and poor materials).
(ii) To make the standards realistic, all concerned should be associated in determining standard costs.
(iii) The data collected should be kept to a minimum, and proper collection and processing of cost control data
are important.
(iv) The different variances, price, usage, mix and efficiency should be considered, whether they are relating to
materials, labour or overheads.
(v) No amount of detailed analysis of the cost of variances can undo what has already been done; however,
control measures should ensure that such mistakes are not repeated. The only way to prevent excess costs
in practice is for the manager to take action before the event.
(vi) The essentials of effective cost control not only include realistic targets (based on work study data) but also
flexible attitudes regarding the standards set.
It shall always be remembered that cost control implies deriving maximum benefits for the costs incurred. In
other words, the objective of cost control is the performance of the same job at a lower cost or a better performance
for the same cost.
Advantages of cost control

The advantages of cost control are mainly as follows:
(a) Achieving the expected return on capital employed by maximising or optimising profit.
(b) Increasing the productivity of the available resources.
(c) Delivering the product or service to the customers at a reasonable price.
(d) Continued employment and job opportunity for the workers

(e) Economic use of limited resources of production

(f) Increased credit worthiness
(g) Prosperity and economic stability of the industry
Cost Reduction
Cost reduction is defined as the real and permanent reduction in the unit costs of goods manufactured or services
rendered without impairing their suitability for the use intended.
As will be seen from the definition, the reduction in costs should be real and permanent. Reductions due to
windfalls, fortuities receipts, changes in government policy like reduction in taxes or duties, or due to temporary
measures taken for tiding over the financial difficulties do not fall under the purview of cost reduction. At the same
time, a programmer of cost reduction should in no way affect the quality of the products nor should it lower the
standards of performance of the business.
Profit is the result of two variable factors, viz., sales and cost. The wider the gap between these two factors, the
larger is the profit. Thus, profit can be maximised either by increasing sales or by reducing cost. In a competition-
less market or in case of monopoly products, it may perhaps be possible to increase prices to earn more profits
and the need for reducing costs may not be felt. Such conditions cannot, however, exist paramount and when
competition comes into play, it may not be possible to increase the sale price without having its adverse effect on
the sale volume, which, in turn, reduces profit. Besides, an increase in prices of finished products has the ultimate
effect of pushing up the raw material prices, wages of employees and other expenses all of which tend to increase
costs.
In the long run, substitute products may come up in the market, resulting in loss of business. Avenues have,
therefore, to be explored and methods devised to cut down expenditure and thereby reduce the cost of products. In
short, cost reduction would mean
maximization of profits by reducing Reducing the Costs
cost through economies and savings Ways & Means of
in costs of manufacture, Increasing the Productivity
Cost Reduction
administration, selling and
Doing the both at the same time
distribution.
Broadly speaking reduction in cost per unit of production may be affected in two ways viz.,
(a) By reducing expenditure, the volume of output remaining constant, and
(b) By increasing productivity, i.e., by increasing volume of output and the level of expenditure remaining
unchanged.
These aspects of cost reduction are closely linked and they act together; there may be a reduction in the expenditure
and at the same time, an increase in productivity.
Five steps to Strategic Cost reduction

A research study by PWC puts forward the following five steps for strategic cost reduction to ensure that the
business can sustain competitive relevance and maximise its potential.
1. Start with strategy: Have a clear view of cost reduction strategy and ensure it is consistently understood
across the organisation.
2. Align costs to strategy: Look across the whole organisation and differentiate the strategically-critical ‘good-
costs’ from the non-essential ‘bad-costs’.

3. Aim high: Be bold, be brave and be creative – use technology, innovation and new ways of working to
radically optimise the cost base.
4. Set direction and show leadership: Deliver cost optimisation as a strategic, business transformation
Programme.
5. Create a culture of cost optimisation: Ensure that a culture of ownership is embedded and continuous
improvement is incentivised.
There are huge top and bottom-line rewards for getting this right. Your business will be more differentiated and
equipped to deliver on its objectives. You’ll also be less reliant on pricing to compete in the market as resources are
targeted at high earning growth business. Without this clear sense of what costs to keep and what ones to eliminate,
you run the risk of being left behind.
Tools & Techniques

There are several tools and techniques that are adopted in achieving cost reduction. Some of the vital ones which
are normally used are listed below.
(i) Value Analysis
(ii) Business Process Re-engineering.
(iii) Simpliﬁcation & Standardisation
(iv) Benchmarking
(v) Financial Restructuring
(vi) Work Study
(vii) Job Evaluation
(viii) Quality Control
(ix) Inventory Control
(x) Credit Control
Any of these lists would remain inconclusive without mentioning lean management and target costing.
Cost Reduction Practices

Cost reduction efforts shall be continuous and incessant. Furnished here under are few such practices as Case
Studies.
Case Study 1: How EY assisted a Client in Cost Reduction

The client is world leader in the food and beverage industry. As his legacy, the departing executive committed
the company to adding hundreds of basis points to the bottom line. The CFO of the client approached EY in 2011
to help the company establish a strategic cost reduction program. Understanding the culture of the company, the
CFO wanted to start small and expand as milestones were achieved.
Although there are a number of approaches to cost reduction, many companies opt for zero-based budgeting.
Zero-based budgeting removes a budget’s baseline, which means that every cost identified in the budget must be
approved. The client, under discussion, preferred to take a priority-based budgeting approach where marginal
services or costs need to be justified.
EY began to prioritize cost savings by looking at half of the company’s cost base. EY team recommended that the
company first seek savings in non-headcount-related areas, such as travel and entertainment, as well as consultant

fees. The goal was to remove 10% of the costs in these areas in the first year and then 5% to 10% annually thereafter
for the following two years.
Once the company was well on its way to removing costs from these areas, EY team helped the company
renegotiate procurement costs to gain greater efficiencies. After that, EY team set to work determining cost savings
in targeted emerging market locations to expand “efficient growth.”
Priority-based budgeting formed one part of the cost reduction equation for all of EY team’s efforts. Culture
formed another. For every cost savings EY team members identified, they had to then put it through the client’s
cultural lens to confirm that the decision was a good fit for both the company and its employees.
The company had spent years cultivating a youthful and energetic culture for the organization. As such, it needed
to balance shareholder and analyst demands for cost reductions with a culture that formed the company’s identity
and its brand — with employees and in the market.
Working closely with the client in targeted areas of the organization, EY helped the company carve out more than
US$250 million in costs from its bottom line over three years by reducing or eliminating activity in non-headcount
areas. EY expects the company would save another US$50 million by renegotiating contracts and generating
efficiencies in the company’s procurement processes.
In addition to the savings identified, the client’s cost reduction program is also expected to help the departing
executive to reach his legacy goal. Because culture is such an important factor for the client, the company took a
conservative approach to its priority-based decision-making. However, the CFO was willing — and prepared — to
take more aggressive action, should the need arise.
(Resource: When cost cutting alone isn’t enough; Gregg Sutherland; www. ey.com/optimize)
Case Study 2: A Four-pronged Approach to input steel prices and commodity purchases
A research paper by ‘Atkearney’ suggests that there are four ways that the companies can improve their steel and
other commodity purchases.
1. Capture the value of Scrap: Steel scrap, a by-product of the manufacturing process, is typically not well
managed. Depending on the process, upto 30% of input steel is unused and considered waste. This is true
for numerous manufacturing industries from automotive, white goods and electronics to heavy industries.
While manufacturers focus on minimizing waste, they often fail to capture the value of material scrap in the
part price. Companies that account for scrap material value in the component price can reduce their material
costs by 5 to 8 percent.
2. Increase Sourcing Power: Steel is often purchased from an intermediary, such as a steel service center,
resulting in an extended supply chain that includes numerous service centers and different pricing levels.
It is possible to increase negotiating leverage and reduce costs by gaining more visibility and control over
material supply chain – specifically by optimizing the material purchases directly from the large steel mills.
3. Optimize Material Usage: The third component of the strategy is to focus on reducing costs through
technical improvements including reducing complexity, shrinking, part design costs, and segmenting
supplies. To reduce complexity, the focus turns to portfolio rationalization to reduce specifications such as
gauges and grades and then implementing processes to prevent re-proliferation. Reducing part design costs
begin with collaborative reviews with internal and supplier engineering teams to evaluate all parameters that
affect material costs and utilisation. In the context of segmentation, sourcing parts that use the same grade
or gauges to the same supplier allows for nesting parts more effectively. Optimization of material usage can
result in cost reduction from 5 to 8 percent.
4. Include Scrap in Material Supply Chain: Material scrap generated – both internally and externally – shall

form part of material supply chain. The goal is to create a closed loop network whereby the company uses
the scarp dealer for processing and transportation and sells scrap directly to a scrap consuming suppler.
(Resource: www.atkearney.com)
Case Study 3: Ichalkaranji Power-Loomers minimise their Fixed Cost Burden

Ichalkaranji is a moderate industrial town located in the western parts of Maharashtra. The place is well known
for skilled weavers and a prosperous power-loom industry. Hence, the town has acquired the fame as the Manchester
of Maharashtra. The power-loom is considered as a diligent economic model between well-organized mill sector
and outdated handlooms. An important characteristic of the power loom industry in Ichalkaranji is that most of the
looms are owned by the local micro entrepreneurs with an average holding of about four looms.
One power-loom unit, on an average, produces about 80 metres of grey cloth per day from either cotton or
polyester yarn. The cloth is used as the primary material by the textile and garment industries. As the textile
industry is prone to seasonal fluctuations, i.e., surging in sales during festive and marriage seasons and declining
sales in slack seasons; the power-looms also used to suffer from lack of buyers during the slack season. In order
to retain the skilled labour during the slack season, the loom owners used to pay wages to the workers even when
there is no work. As such, the industry is burdened with considerable retaining costs (i.e., idle labour costs) which
tend to remain fixed for the entire slack-period. These of the idle costs used to cripple the earnings of the loom
owners severely.
Grey cloth is one of the primary packing materials for the agriculture-seeds because of the fact that most of the
seeds are packed in cloth bags. One of the renowned seed companies, which was having international presence,
was looking for ways and means of reducing its packing costs. The company came to know about the slack season
cost-burden of the power loom industry of Ichalkaranji. The company has also observed that peak demand for the
seed packing coincides with the slack-season of the power looms.
The seed company came up with a pricing proposal for buying the cloth from the power loom owners during the
slack season on variable cost-plus basis whereby the fixed cost burden of the looms would be reduced substantially.
The loom owners came forward willingly and supplied the cloth to the seed company at fairly cheaper prices. The
end result was a win-win cost reduction both for the loom owners as also the seed company. The loom owners were
able to reduce their slack season idle costs by about eighty per cent and the seed company was able to reduce its
packing material costs by about twenty percent.
(Resource: As narrated by a Senior CMA)
Case Study 4: MEC multiplies its profit through Outsourcing

MEC (name changed) is a medium scale electronic manufacturer located in Central India. Its annual turnover
used to be about five crores of rupees. The components used in the company’s products could be conveniently
divided into A, B and C; A items accounting for ten percent in quantity and seventy percent in value, B items twenty
percent in quantity and twenty percent in value and C items seventy percent in quantity and ten percent in value.
Over a period of time, the company established a niche for quality in its field and started experiencing an upswing.
For the year under consideration the company was flooded with profitable orders worth twenty crores of rupees,
i.e., four times of its existing turnover. After a diligent review, the management felt that its existing capacity can,
at best, be stretched by fifty percent whereby orders to the extent of ` 7.5 crore can be executed.
The management had several sessions of brainstorms. The executives realised that the company is capable of
producing the entire quantity of A & B items needed for the orders; but the challenge was about C items. Assembly
labour was identified as the major limiting factor for the production of C items. The deliberations were extended to
the vendors and a viable solution brought out. The vendors were willing to undertake the work of assembling the
C items, if they were given to them in SKD (Semi Knocked Down) form. The proposition was readily accepted.

At the end MEC was able to execute the orders worth ` 20 crores successfully by outsourcing the assembly
operations relating to C items. The productivity as also the profitability of MEC and its vendors were multiplied by
means of prudent deployment and optimum utilisation of their labour resources.
(Resource: As narrated by a Senior CMA)
Case Study Learnings

The tools and techniques of cost reduction could be many; but the key is successful adaptation and implementation.
Cost behaviour, too, plays a significant role in cost reduction endeavours. The approach, methods, and duration
targets could be different for variable costs as compared to fixed costs. Variable costs may be prone to reduction
even on short term basis whereas as fixed cost reduction may warrant long term strategies. In the ultimate, it is
the total cost that shall be reduced on a permanent basis. Cost Reduction is the first step towards Cost Leadership!
Difference between Cost Control and Cost Reduction

Controlling the costs, with reference to the pre-determined standards or benchmarks, is the main focus of cost
control whereas the primary focus of cost reduction is permanent reduction in costs. In that cost reduction is a
process which actually starts from where cost control ends. The key distinctions, nomenclature wise, between cost
control and cost reduction can be tabulated as follows:
Sl Nomenclature Cost Control Cost Reduction
1 Objective Containing the cost in accordance with Exploring ways and means of improving
the pre-set targets the targets
2 Approach Attaining lowest possible costs under A continuous process of analysis to
the existing circumstances find out new ways & means to achieve
reduction in costs.
3 Nature Preventive function Corrective function
4 Emphasis The emphasis is on the past i.e., on The emphasis is on the present and
predetermined standards the future i.e., on feasible permanent
reductions
5 Assumptions Assumes the existence of certain Assumes the existence of concealed
standards or norms potential savings in the standards or
norms
1.3 Value Analysis and Value Engineering -Business Process Re-engineering
Concept
Value Analysis (VA) is one of the important techniques of cost reduction and control. It is a scientific approach
that ensures all the functions of a product or service are carried out at the minimum cost without compromising
quality, reliability, performance and appearance. Society of American Value Engineers (SAVE) states “Value
analysis is the systematic application of recognised techniques which identify the function of a product or service
to establish a monetary value for the function and to provide the necessary function reliability at the lowest overall
cost.”

Value analysis is a methodical approach to sharpening the efficiency and effectiveness of any process. Value, in
the context of value analysis, refers to economic value, which may reflect:
(i) Use value
(ii) Cost value
(iii) Exchange value, or
(iv) Esteem value.
‘Use Value’ reflects the intrinsic value. It is the measure of properties, qualities and features which make the
product or service useful for the consumer. Use value, therefore, is the price paid by the buyer or the cost incurred
by the manufacturer in order to ensure that the product or service performs its intended function efficiently.
‘Cost Value’ is the sum of all costs incurred in producing the product or rendering a service. Cost value, thus, is
the sum of raw material cost, labour cost, and overheads expended to produce the product or service.
‘Exchange Value’ is the measure of all the properties, qualities and features of the product or service which make
the product or service possible of being traded for another product or service or for money. In a conventional sense,
‘exchange value’ refers to the price that a purchaser is willing to offer for the product or service, the price being
dependent upon the satisfaction level that is derived from the product or service.
‘Esteem Value’ is the measure of properties, features, attractiveness graphic packaging and the like which
increases sales appeal or which attracts customers and create in them a strong desire to own the product. “Esteem
value”, therefore, is the price paid by the buyer or the cost incurred by the manufacturer beyond the use value. It
is the perception value.
Use value may be construed as the fundamental form of economic value. An item without use value can have
neither exchange value nor esteem value. Summing up it may be stated that value is: quality, performance, style,
design and cost in relation to a product or service.
Value Equation
Value analysis aims to simplify products and process, thereby increasing efficiency. Value analysis enables
people to contribute towards value addition by continuous focus on product design and services. Value analysis
provides a structure through initiatives in the direction of cost saving, cost reduction and continuous improvement.
Value Equation: Value = {(Performance + Capability) ÷ Cost}
= Function ÷ Cost
Value addition is not a matter of just
minimizing the cost. It is a 3D technique. Increasing the Function
Value can be increased either by increasing
function or reducing the cost or by doing VALUE ADDITION Reducing the Costs
both simultaneously. The concept is that of
Doing the Both
adding value by enhancing the functional
worth
Any attempt to improve the value of a product must consider two elements. The first element is the utility of the
product, i.e., the use value. The second element relates to the value of ownership, i.e., esteem value.
The concept can, better, be explained by the price discrimination being practiced in relation to a luxury car and
a basic small car. From the use point of view both the cars fulfil the same function, viz. both of them offer safe
economical travel (use value); but the luxury car has a greater esteem value and hence priced at a phenomenal
value.

Another example could be the exorbitantly priced gold-plated ball pen in comparison to a disposable pen. Even
though the use value for both the pens is nearly the same, the factor of esteem value enables a privileged pricing
for gold-plated ball pen.
Focus of Value Analysis

The key focus of the VA approach is, therefore, the management of ‘functionality’ to yield value for the customer.
Let us emphasize this point a little. Not that long ago, consumers of electric kettles were offered a variety of
different types of metal-based boiling device. The value of a kettle is derived through heating water and therefore
its functionality can be determined (temperature, capacity, reliability, safety etc.). Now faced with the same
functionality (to boil water), designers would probably look towards a kettle made of plastic.
Plastic has the same functionality as metal in terms of containing and boiling water. The action to boil water is
conducted by the same part - known as the element. However, the switch from metal to plastic does not impair
this value and functionality with the customer – they still want to boil water - but it does result in a cost saving for
the manufacturing company. If a company that traditionally made metal kettles did not review its design process,
then it would be severely disadvantaged when attempting to compete against the lower cost plastic alternative.
This is a simple example used only to provide an illustration of the VA concept but it does demonstrate the point of
maintaining value whilst reducing costs.
If a company seeks to reduce the costs of producing a product, then it must seek out costs that are unnecessary
or items of the product that provide no functional value to the customer. If you adopt this approach, then the VA
process is concerned with removing a specific type of cost that can be removed without negatively affecting the
function, quality, reliability, maintainability or benefit required by the customer. As such, the target for all VA
activities is to find these costs as opposed to simply re-engineering a product design with no real purpose to the re-
engineering exercise. The VA approach is, thus, formal and systematic because it is directed towards highlighting
and dealing with these ‘recoverable costs’ of production. The objective is to create value for money as opposed to
creating new products that do not provide customer satisfaction but are relatively inexpensive. The rules governing
the application of the VA approach are simple:
●● No cost can be removed if it compromises the quality of the product or its reliability, as this would lower
customer value, create complaints and inevitably lead to the withdrawal of the product or lost sales.
●● Salability is another issue that cannot be compromised, as this is an aspect of the product that makes it
attractive to the market and gives it appeal value.
●● Any activity that reduces the maintainability of the product increases the cost of ownership to the
customer and can lower the value attached to the product.
Phases of Value Analysis
Value Analysis may consist of the following seven phases.
(i) Origination: The phase of origination starts with the identification of a project to undertake value analysis.
After selecting the project, a project team consisting of experts from various fields and departments is
constituted.
(ii) Information: The second phase is that of collecting relevant information. In this phase, the relevant facts
relating to specifications, drawings, methods, materials, etc. are collected. Costs are, also, ascertained for
each of the elements that are being studied.
(iii) Functional Analysis: Then follows the important phase of functional analysis. After familiarisation with
the relevant facts & figures, a functional analysis is carried out to determine the functions and uses of
the product and its components. The cost and importance of each function are identified. A value index

is computed on the basis of cost benefit ratio for each of the functions. A list of the functions is prepared
wherein the functions are arranged in decreasing order of their value.
(iv) Innovation: This is the creative phase concerned with the generation of new alternatives to replace or
remove the existing ones. The objective is to produce ideas and to formulate alternative means and methods
for accomplishing the essential functions and improving the value of the element under consideration.
Creative problem solving techniques are utilized to discover alternatives that will provide essential or
required functions at the lowest possible cost.
(v) Evaluation: During the stage of evaluation, each and every alternative is analysed and the most promising
alternatives are selected. These alternatives are further examined for economic and technical feasibility.
The alternatives finally selected must be capable of performing the desired functions satisfactorily. They
must meet the standards of accuracy, reliability, safety, maintenance and repairs, environmental effects,
and so on.
(vi) Choice: In this phase, the decision makers choose the best of alternatives. The programs and action plans
are then developed to implement the chosen alternative.
(vii) Implementation: The chosen alternative is put to the actual use with the help of the programs and action
plans. The progress of implementation is continuously monitored and followed up to ensure that the desired
results are achieved.
Types of Value Analysis Exercises
VA for Existing Products: One of the best approaches to VA is simply to select an existing product that is sold
in relatively large volumes. This product, or product family, will tend to have a great deal of the basic information,
and documented history, which can be used quickly as opposed to a newly introduced product where such a history
is not available. An existing product unites all the different managers in a business, each with an opinion and list
of complaints concerning the ability to convert the design into a ‘saleable’ product. Therefore, any team that is
created for the purpose of VA will understand their own problems but not necessarily the cause of these problems
across the entire business. These opinions regarding poor performance (and documented evidence of failures) are
vital to the discussions and understanding of how the product attracts costs as it is converted from a drawing to a
finished product. These discussions therefore allow learning to take place and allow all managers to understand the
limitations to the scope of product redesign and re-engineering activities. These issues include:
●● The inability to change existing product designs due to the need to redesign tooling and the expense of such
an initiative.
●● The project team may have a finite duration before the project is concluded and therefore time will dictate
what can be achieved.
●● The high levels of purchased costs may imply a need to engage with suppliers in the VA process. This
initiative will be constrained by a number of issues such as the timing of the project, the availability of
resources from the supplier, the location of the suppliers, and other constraints.
VA for New Products (Value Engineering): For new products, the team will need to modify the VA approach
and will operate in an environment that is less certain and has poor levels of available information upon which to
make decisions. In this case, the analysis and systematic process of review for new products is known as Value
Engineering (VE). The VE approach is similar to that of Value Analysis but requires a much greater level of
investment by the organization in terms of the skilled, experienced and proficient human resources seconded to
the group.
VA for Product Families- Horizontal Deployment: The final form of VA is results when there is scope for
the ‘horizontal deployment’ of the results of a VA exercise with a single product or family of products. Under

conditions where the value analysis project team finds commonalties with many products manufactured by the
company, then it is possible to extend the benefits to all these other products concurrently. In this manner, all
affected products can be changed quickly to bring major commercial benefits and to introduce the improvement on
a ‘factory-wide basis’. This is particularly the case when supplying companies offer improvements that affect all
the products to which their materials or parts are used. The horizontal deployment activity has many advantages
both in terms of financial savings and also the relatively short amount of time required to introduce the required
changes to the product design.
Competitive VA: VA techniques are not simply the prerogative of the business that designed the product. Instead,
VA is often used as a competitive weapon and applied to the analysis of competitor products in order to calculate
the costs of other company’s products. This is often termed ‘strip down’ but is effectively the reverse value analysis.
Here the VA team are applied to understanding the design and conversion costs of a competitor product. The results
of the analysis is to understand how competitor products are made, what weaknesses exist, and at what costs of
production together with an understanding of what innovations have been incorporated by the competitor company.
It is recommended that the best initial approach, for companies with no real experience of VA, is to select a single
product that is currently in production and has a long life ahead. This approach offers the ability to gain experience,
to learn as a team, and to test the tools and techniques with a product that has known characteristics and failings. In
the short term it is most important to develop the skills of VA, including understanding the right questions to ask,
and finally to develop a skeleton but formal process for all VA groups to follow and refine.
The core advantage of using value analysis is its potential for reducing costs, which is a benefit that permeates all
advantages of the system. Because of the fact that value analysis breaks down a product or service into components,
it enables the analysis of each of the components on its own, evaluating its importance and efficiency. A value
analysis correctly implemented and applied enables the entity to identify components that are not worth the cost
they require and that can be eliminated or replaced with an alternative. In this manner, the process for the product
or service being analyzed is refined to be done at less expense.
Value Engineering (VE)

‘VA’ and ‘VE’ are closely related terms so much so that they are, frequently, used interchangeably. Though the
philosophy of understanding the two is the same, the difference lies in the time and stage at which the technique
is applied.
“Value Analysis” is the application of a set of techniques to an existing product with a view to improve its value.
Thus, it is a remedial process. “Value Engineering” is the application of exactly the same set of techniques to a
new product at the design stage to ensure that bad features are not added. Thus, it is a ‘preventive’ measure. In that
sense, ‘VE’ is fundamental and VA is collateral because ‘prevention is better than cure.”
Value Engineering simply answers the question “what else will accomplish the purpose of the product, service, or
process we are studying?”. VE technique is applicable to all type of sectors. Initially, VE technique was introduced
in manufacturing industries. This technique is then expanded to all type of business or economic sector, which
includes construction, service, government, agriculture, education and healthcare.
Case Study (Illustrative)

Aadarsh Instruments, located in Ambala, is a medical instrument manufacturing company considered to apply
Value Engineering in to the Focus Adjustment Knob in one of their model SL 250 for Slit Lamp in microscope. This
microscope has found application in the field of eye inspection. The value engineering analysis may help company
in running its export business of medical microscope. This firm is producing different types of microscopes which
they export to various countries around the globe. All of the products manufactured here are conforming to the
international standards. It is an ISO certified company.

The following are the steps to be used for carrying out the Value Engineering exercise by Aadarsh Instruments in
their model SL 250 for Slit Lamp in Microscope for the Focus Adjustment Knob:
(i) Selection of the Product Plan.
(ii) Gathering Product Information
(iii) Functional Analysis
(iv) Creativity Phase and preparing the work-sheet
(v) Evaluation Sheet
(vi) Cost Analysis
(vii) Result and Conclusion
(viii) Implementation.
The total savings after the implementation of value engineering are as given below:
●● Cost before analysis — `
29.99
●● Total Cost of Nylon Knob — `
18.40
●● Saving per product — `
11.59
●● Percentage saving per product — 38.64%
●● Annual Demand of the product — 8,000
●● Total Annual Saving — `
92,720
●● Value Improvement — `
62.98%
With a critical evaluation of this study, Aadarsh Instruments has been able to increase the value of the product by
substituting another material in place of the one currently in use. The% value improvement is to the tune of 62.98%
and the total annual saving has been ` 92,720. The various advantages have been observed in terms of:
~~ Cost Reduction
~~ Increase in overall production
~~ Reduction in man-power
~~ Reduction in scrap.
Thus, the cost has been brought down by a substantial margin and thereby the value of the product has been
increased.
Business Process Reengineering

Concept
Hammer and Champy (1993) define Business Process Reengineering (BPR) as: “ the fundamental rethinking and
radical redesign of the business processes to achieve dramatic improvements in critical, contemporary measures
of performance, such as cost, quality, service and speed”. BPR refers to a complete redesign of a process with an
emphasis on finding creative new means to accomplish an objective.
BPR involves the radical redesign of core business processes to achieve dramatic improvements in productivity,
cycle times and quality. In Business Process Reengineering, companies start with a blank sheet of paper and rethink
existing processes to deliver more value to the customer. They typically adopt a new value system that places
increased emphasis on customer needs.

Companies reduce organizational layers and eliminate unproductive activities in two key areas. First, they
redesign functional organizations into cross-functional teams. Second, they use technology to improve data
dissemination and decision making.
Rather than searching continually for minute improvement, reengineering involves a radical shift in thinking
about how an objective should be met. Re-engineering prescribes radical, quick and significant change. Admittedly,
it can entail high risks, but it can also bring big rewards. These benefits are most dramatic when new models are
discovered for conducting business.
Characteristics
(i) Several jobs are combined into one
(ii) Very often workers make decisions
(iii) The steps in the process are performed in a logical order
(iv) Work is performed, where it makes most sense
(v) Quality is built in
(vi) Manager provides a single point of contact
(vii) Centralized and decentralized operations are combined.
Seven Principles
(i) Processes should be designed to achieve a desired outcome rather than focusing on existing tasks
(ii) Personnel who use the output from a process should perform the process
(iii) Information processing should be included in the work, which produces the information
(iv) Geographically dispersed resources should be treated, as if they are centralized
(v) Parallel activities should be linked rather than integrated
(vi) Doers should be allowed to be self-managing
(vii) Information should be captured once at source.
Key Benefits
(i) Reduction in Costs and Cycle Times: Business Process Reengineering reduces costs and cycle times
by eliminating unproductive activities and the employees who perform them. Reorganization by teams
decreases the need for management layers, accelerates information flows and eliminates the errors and
rework caused by multiple handoffs.
(ii) Improvement in Quality. Business Process Reengineering improves quality by reducing the fragmentation
of work and establishing clear ownership of processes. Workers gain responsibility for their output and can
measure their performance based on prompt feedback.
Example of Business Process Reengineering:
Example 1: Credit Card Approval

An applicant submits an application. The application is reviewed first to make sure that the form has been
completed properly. If not, it is returned for completion. The complete form goes through a verification
of information. This is done by ordering a report from a credit company and calling references. Once the
information is verified, an evaluation is done. Then, a decision (yes or no) is made. If the decision is negative,
an appropriate

rejection letter is composed. If the decision is positive, an account is opened, and a card is issued and mailed to
the customer. The process, which may take a few weeks due to workload and waiting time for the verifications,
is usually done by several individuals. Business processes are characterized by three elements:
●● The inputs, (data such customer inquiries or materials),
●● The processing of the data or materials (which usually go through several stages and may necessary
stops that turns out to be time and money consuming), and
●● The outcome (the delivery of the expected result).
The problematic part of the process is processing. Business process reengineering mainly intervenes in the
processing part, which is reengineered in order to become less time and money consuming.
Example 2: Ford Motors

One of the best-known examples of organisations that used BPR in an effort to become more efficient is Ford
Motors, a car manufacturer. Ford Motor Company is the world’s second largest manufacturer of cars and trucks
with products sold in more than 200 markets.
With inherent large-scale growth issues, more demanding customers, and mounting cost pressures, Ford
needed to transform from a linear, top-down bureaucratic business model to an Internet ready, nimble
organization that engages and integrates customers, suppliers, and employees. Working with Cisco, Ford
integrated and leveraged their supplier base by designing Covisint, an end-to-end infrastructure that enables
an online, centralized marketplace connecting the automotive industry supply chain. Ford also enhanced the
customer buying experience through redesigned and more user friendly Web sites.
As a result, Ford is enjoying an increase in customer satisfaction, sees huge revenue opportunities for
developing and retaining loyal product advocates, and has taken both complexity and cost out of the supply
chain.
1.4 Supply Chain Management
Supply Chain
Supply Chain refers to the entire gambit of linkages in manufacturing a
Extraction of Raw Materials
product or rendering a service. For example, in relation to a manufacturing
entity, it encompasses all the activities that commence from the extraction of
raw materials till the delivery of the finished product to the ultimate consumer. Vender
Listed below are the generic links of a supply chain:
(i) Extraction of Raw Materials
Manufacturer
(ii) Vender
(iii) Manufacturer
Distributor
(iv) Distributer
(v) Retailer
Retailer
(vi) Consumer
In its simplest form a supply chain is the activities required by the
organisation to deliver goods or services to the consumer. A supply chain is Consumer

a focus on the core activities within the organisation required to convert raw materials or component parts through
to finished products or services.
In its simplest form the stages in a supply chain are as depicted within the Porters Value Chain and this can be
considered a good guide to a supply chain structure, viz.
●● Inbound Logistics
●● Operations
●● Marketing and Sales
●● Outbound Logistics
●● Services
Thus, supply chains are made up of all the links that participate in the design, assembly, and delivery of a
particular product.
●● Vendors supply raw materials
●● Producers convert those raw materials into products
●● Warehouses store that product until it’s needed
●● Distribution centers pick up and deliver that product
●● Retailers, online and in-store, bring that product to you
Supply chains are the reason that the producer can provide customers what they want, when and where they want
it, at the price they need. For example, in the electronics industry, the supply chain is the central nervous system
that governs how products are created. In an HDTV supply chain, a variety of companies play a role in building
the components, assembling the final product, and moving it through the supply chain (see chart below). The goal
of the supply chain is to have the television in stock when you’re ready to purchase it.
Supply Chain Management

Supply chain management encompasses every activity involved in maintaining the supply chain. The goal of
supply chain management is to look holistically at the entire supply chain from supplier through to the consumer,
and review three core areas of people, process and systems in order to maximise value from all activities. Behind
every product one uses – electronics, coffee, clothing, lawn mowers – there lies SCM which it possible to get the
products better, faster, and cheaper.
Each year, these products get bigger and better, yet the prices drop. How is it possible? It’s the end result of SCM
professionals working together – LCD glass panel fabricators in South Korea, semiconductor manufacturers in
Taiwan, television assembly plants in Mexico. These global partners collaborate across time zones and oceans to
decrease costs and increase performance in ways no single company ever could.
In essence, supply chain management integrates supply and demand management within and across companies.
Companies like Dell, Nokia, Proctor & Gamble, Toyota, and Walmart consider SCM to be a key factor in their
overall success.
Not only is supply chain management important to the world’s leading organizations, this fast-paced, global field
offers tremendous employment opportunities. Nearly every size and type of organization needs motivated, well-
prepared individuals to become their supply chain leaders.
Supply Chain Strategy

Without a strategy the supply chain activities cannot be aligned to an overall objective. Think of an organisation

with no functional or operational strategy much like a ship setting sail without letting the crew know the destination,
the crew could be making decisions that could unwittingly impede the ship arriving safely at its end destination.
Supply chain strategy follows the corporate strategy. Once the corporate strategy is defined, this will cascade
into the functional areas of the business where each function will set their strategy that is aligned to the corporate
strategy. The supply chain strategy may be set for example as “We aspire to reduce waste in our supply chain
activities to support the company’s strategy to be a cost leader in our market”.
Once this strategy is determined for the function it will influence daily operational decisions.
●● Procurement may focus on driving cost out of the procurement activities by sourcing suppliers with favourable
terms, negotiating quality improvements that reduce waste activities or stronger contractual terms
●● Operations may look to remove the 7 wastes from their existing processes.
●● Logistics may look to invest in equipment to support removal of waste activities or review their operational
processes.
There are three core areas to consider when developing the supply chain strategy and business case:
●● People – Do you have the right number of staff with the right skill set?
●● Process – Are there waste activities within your current operating processes?
●● Systems – Are your systems enablers to the strategy or are legacy systems holding you back?
Strategies need to be clear, voiced to ALL staff members and have buy in. When in 1961 JFK visited NASA he
asked a janitor what his job was, his reply was: “I’m sending a man to the moon”. This is a clear example of a well
communicated strategy and mission flowing throughout the whole organisation, with complete buy in, regardless of
an individual’s position within the organisation they understand expectations and the part they play in that strategy.
Importance of Supply Chain Management

It is well known that supply chain management is an integral part of most businesses and is essential to company
success and customer satisfaction.
Boosts Customer Service

~~ Right Location: Customers expect products to be available at the right location. (i.e., customer satisfaction
diminishes if an auto repair shop does not have the necessary parts in stock and can’t fix the car for an extra
day or two).
~~ Right Delivery Time: Customers expect products to be delivered on time (i.e., customer satisfaction
diminishes if pizza delivery is two hours late or Christmas presents are delivered on December 26).
~~ Right After Sale Support: Customers expect products to be serviced quickly. (i.e., customer satisfaction
diminishes when a home furnace stops operating in the winter and repairs can’t be made for days)
Reduces Operating Costs

~~ Decreases Purchasing Cost: Retailers depend on supply chains to quickly deliver expensive products to
avoid holding costly inventories in stores any longer than necessary. For example, electronics stores require
fast delivery of 60” flat-panel plasma HDTV’s to avoid high inventory costs.
~~ Decreases Production Cost: Manufacturers depend on supply chains to reliably deliver materials to
assembly plants to avoid material shortages that would shut-down production. For example, an unexpected
parts shipment delay that causes an auto assembly plant shutdown can cost $20,000 per minute and millions
of dollars per day in lost wages.

~~ Decreases Total Supply Chain Cost: Manufacturers and retailers depend on supply chain managers to design
networks that meet customer service goals at the least total cost. Efficient supply chains enable a firm to be
more competitive in the market place. For example, Dell’s revolutionary computer supply chain approach
involved making each computer based on a specific customer order, then shipping the computer directly to
the customer. As a result, Dell was able to avoid having large computer inventories sitting in warehouses and
retail stores which saved millions of dollars. Also, Dell avoided carrying computer inventories that could
become technologically obsolete as computer technology changed rapidly.
Improves Financial Position

~~ Increases Profit Leverage: Firms value supply chain managers because they help control and reduce supply
chain costs. This can result in dramatic increases in firm profits. For instance, U.S. consumers eat 2.7 billion
packages of cereal annually, so decreasing U.S. cereal supply chain costs just one cent per cereal box would
result in $13 million dollars saved industry-wide as 13 billion boxes of cereal flowed through the improved
supply chain over a five-year period.
~~ Decreases Fixed Assets: Firms value supply chain managers because they decrease the use of large fixed
assets such as plants, warehouses and transportation vehicles in the supply chain. If supply chain experts can
redesign the network to properly serve customers from six warehouses rather than ten, the firm will avoid
building four very expensive buildings.
~~ Increases Cash Flow: Firms value supply chain managers because they speed up product flows to customers.
For example, if a firm can make and deliver a product to a customer in 10 days rather than 70 days, it can
invoice the customer 60 days sooner.
Societal Benefits
●● Lesser known, is how supply chain management also plays a critical role in society. SCM knowledge and
capabilities can be used to support medical missions, conduct disaster relief operations, and handle other
types of emergencies. Whether dealing with day-to-day product flows or dealing with an unexpected natural
disaster, supply chain experts roll up their sleeves and get busy. They diagnose problems, creatively work
around disruptions, and figure out how to move essential products to people in need as efficiently as possible.
Case Study 1: Walmart’s Inventory Innovations

Fewer links in the Supply Chain: Even in its early years, Walmart’s supply chain management contributed to
its success. Walmart’s supply chain innovation began with the company removing a few of the chain’s links, right
from the very beginning. Founder Sam
Walton, who owned several Ben Franklin Fewer links in
franchise stores before opening the first the Supply Chain
Walmart in Rogers, Arkansas in 1962,
selectively purchased bulk merchandise
and transported it directly to his stores.
Later, in the 1980s, Walmart began working Top Strategic Vendor
directly with manufacturers to cut costs and Stock Partnerships
more efficiently manage the supply chain.
In the process, Walmart has pioneered the
concept of VMI with an added competitive
advantage.
Strategic Vendor Partnerships: Inventory Cross
Walmart has long practiced strategic Technology Docking

sourcing to find products at the best price from suppliers who are in a position to ensure they can meet demand.
The company then establishes strategic partnerships with most of their vendors, offering them the potential for
long-term and high-volume purchases in exchange for the lowest possible prices.
Furthermore, Walmart streamlined supply chain management by constructing communication and relationship
networks with suppliers to improve material flow with lower inventories. The network of global suppliers,
warehouses, and retail stores has been described as behaving almost like a single firm.
Cross-docking: Cross-docking is a logistics practice that is the centrepiece of Walmart’s strategy to replenish
inventory efficiently. It means the direct transfer of products from inbound or outbound truck trailers without the
need for extra storage, by unloading items from an incoming semi-trailer truck or railroad car and loading these
materials directly into outbound trucks, trailers, or rail cars (and vice versa), with no storage in between.
Suppliers have been delivering products to Walmart’s distribution centers where the product is cross-docked
and then delivered to Walmart stores. Cross-docking keeps inventory and transportation costs down, reduces
transportation time, and eliminates inefficiencies.
Walmart’s truck fleet of drivers continuously deliver goods to distribution centers (located an average 130 miles
from the store), where they are stored, repackaged and distributed without sitting in storage. Goods will cross from
one loading dock to another, usually in 24 hours or less, and company trucks that would otherwise return empty
“backhaul” unsold merchandise.
This strategy has reduced Walmart’s costs significantly, allowing the company to pass those savings on to their
customers with highly competitive pricing.
Advanced Inventory Technology: In its relentless pursuit of low consumer prices, Walmart embraced and
invested in technology to become an innovator in the way stores track inventory and restock their shelves, thus
allowing them to cut costs. In 2015, the company spent a reported $10.5 billion on information technology and has
also invested significantly in improving their eCommerce capability.
Technology plays a key role in Walmart’s supply chain, serving as the foundation of their supply chain strategy.
Walmart has the largest information technology infrastructure of any private company in the world, and it is
this state-of-the-art technology and network design that allows Walmart to accurately forecast demand, track and
predict inventory levels, create highly efficient transportation routes, manage customer relationships, and service
response logistics.
For example, Walmart implemented the first company-wide use of Universal Product Code (barcodes) in 1983,
through which store level information was immediately collected and analyzed. Later, Walmart leveraged this now-
everyday technology into a further innovation: Savings Catcher, which allows consumers to scan product barcodes
on their smartphones to compare best prices.
The company then devised Retail Link, a mammoth database. Through a global satellite system, Retail Link is
connected to analysts who forecast supplier demands to the supplier network, which displays real-time sales data
from cash registers and to Walmart’s distribution centers.
Suppliers and manufacturers within the supply chain synchronize their demand projections under a collaborative
planning, forecasting and replenishment scheme, and every link in the chain is connected through technology that
includes a central database, store-level point-of-sale systems, and a satellite network.
What made Walmart so innovative was that it had been sharing all this information with their partners. Back in
the day, a lot of companies weren’t doing that, but rather using third-party services where they had to pay for the
information.
Walmart’s approach allows for frequent, informal cooperation among stores, distribution centers and suppliers,
and less centralized control. Furthermore, the company’s supply chain, by tracking customer purchases and demand,

allows consumers to effectively pull merchandise to stores through demand, rather than having the company push
goods onto shelves.
In recent years, Walmart has used radio frequency identification tags (RFID), which use numerical codes that can
be scanned from a distance to track pallets of merchandise moving along the supply chain. As inventory must be
handled by both Walmart and its suppliers, Walmart has encouraged its suppliers to use RFID technology as well.
Even more recently, the company has begun using smart tags, read by a handheld scanner, that allow employees
to quickly learn which items need to be replaced so that shelves are consistently stocked and inventory is closely
watched.
According to researchers at the University of Arkansas, there has been a 16% reduction in out-of-stocks since
Walmart introduced RFID technology into its supply chain. The researchers also pointed out that the products using
an electronic product code were replenished three times as fast as items that only used barcode technology.
In addition, Walmart also networked its suppliers through computers. It entered into collaboration with P&G
for maintaining the inventory in its stores and built an automated re-ordering system, which linked all computers
between the P&G factory through a satellite communication system. P&G then delivered the item either to a
Walmart distribution center or directly to the concerned stores.
Top Stock: And it’s not just high-tech innovation that Walmart innovates on: in the recent past, Walmart
announced the trial of a new system to manage its stock, called Top Stock, in which the top shelves are utilized for
more storage, freeing up back rooms. This move is designed to get products on the shelves sooner, creating more
space for fulfilling online delivery orders and allowing more visibility of stock levels for both staff and customers.
The move also means that customers don’t have to wait to find a staff member to track down an item they don’t
see on a shelf.
Competitive Advantages: Walmart’s supply chain management strategy has provided the company with several
sustainable competitive advantages, including lower product costs, reduced inventory carrying costs, improved
in-store variety and selection, and highly competitive pricing for the consumer. This strategy has helped Walmart
become a dominant force in a competitive global market. As technology evolves, Walmart continues to focus on
innovative processes and systems to improve its supply chain and achieve greater efficiency.
(Resource: Walmart’s successful supply chain management; www.tradegecko.com; 30.03.2019)
Case Study 2: Deere & Company

Deere & Company (brand name John Deere) is famed for the manufacture and supply of machinery used in
agriculture, construction, and forestry, as well as diesel engines and lawn care equipment. Despite the ongoing
challenges associated with the pandemic, John Deere delivered a year of solid performance in 2020. The company’s
Net sales and revenues for the year were $35.54 billion, and net income was $2.75 billion. Deere also delivered
solid returns to investors.
Supply Chain Cost Reduction Challenges: Deere and Company has a diverse product range, which includes a
mix of heavy machinery for the consumer market, and industrial equipment, which is made to order. Retail activity
is extremely seasonal, with the majority of sales occurring between March and July.
The company was replenishing dealers’ inventory weekly, using direct shipment and cross-docking operations
from source warehouses located near Deere & Company’s manufacturing facilities. This operation was proving
too costly and too slow. So the company launched an initiative to achieve a 10% supply chain cost reduction within
four years.
The Path to Cost Reduction: The company undertook a supply chain network-redesign program, resulting
in the commissioning of intermediate “merge centers” and optimization of cross-dock terminal locations. Deere

& Company also began consolidating shipments and using break-bulk terminals during the seasonal peak. The
company also increased its use of third-party logistics providers and effectively created a network that could be
optimized tactically at any given point in time.
Supply Chain Cost Management Results: Deere & Company’s supply chain cost-management achievements
included an inventory decrease of $1 billion, a significant reduction in customer delivery lead times (from ten days
to five or less) and annual transportation cost savings of around 5%.
Case Study 3: Intel

One of the world’s largest manufacturers of computer chips, Intel needs little introduction. However, the company
needed to reduce supply chain expenditure significantly after bringing its low-cost “Atom” chip to market. Supply
chain costs of around $5.50 per chip were affordable for units selling for $100; but the price of the new chip was
a fraction of that, at about $20.
The Supply Chain Cost Reduction Challenge: Somehow, Intel had to reduce the supply chain costs for the
Atom chip, but had only one area of leverage—inventory. The chip had to work, so Intel could make no service
trade-offs. With each Atom product being a single component, there was also no way to reduce duty payments. Intel
had already whittled packaging down to a minimum, and with a high value-to-weight ratio, the chips’ distribution
costs could not be pared down any further.
The only option was to try to reduce levels of inventory, which, up to that point, had been kept very high to
support a nine-week order cycle. The only way Intel could find to make supply chain cost reductions was to bring
this cycle time down and therefore to reduce inventory.
The Path to Cost Reduction: Intel decided to try what was considered an unlikely supply chain strategy for
the semiconductor industry: make to order. The company began with a pilot operation using a manufacturer in
Malaysia. Through a process of iteration, they gradually sought out and eliminated supply chain inefficiencies to
reduce order cycle time incrementally. Further improvement initiatives included:
●● Cutting the chip assembly test window from a five-day schedule, to a bi-weekly, 2-day-long process
●● Introducing a formal S&OP planning process
●● Moving to a vendor-managed inventory model wherever it was possible to do so
Supply Chain Cost Management Results: Through its incremental approach to cycle time improvement, Intel
eventually drove the order cycle time for the Atom chip down from nine weeks to just two. As a result, the company
achieved a supply chain cost reduction of more than $4 per unit for the $20 Atom chip—a far more palatable rate
than the original figure of $5.50.
Case Study Learnings

Evidently, Supply Chain Management is an important avenue of cost reduction. What can be seen from these
brief accounts is that for an enterprise to make significant and sustainable cost improvements, substantial change
must take place. At the same time, none of the changes took place overnight. Each of the companies tackled issues
in phases, effectively learning more as they went along. If one wants to see sustainable cost reductions, one will
need to view the big picture from a new perspective and be prepared to step out of the comfort zone and seek long
term distinct solutions.
Resources:
(i) Logistics and Supply Chain Management Practices in India, Samir K. Srivastava, Management Development
Institute, Gurgaon
(ii) www.logisticsbureau.com/23.04.2021

Terms to Master
Strategic Cost Management: Strategic cost management refers to the cost management that specifically focuses
on strategic issues.
Value Chain: Value chain is a set of activities that an organization carries out to create value for its customers.
Cost Control: Cost Control is the regulation by executive action of the costs of operating an undertaking,
particularly where such action is guided by cost accounting.
Cost Reduction: Cost reduction refers to the real and permanent reduction in the unit costs of goods manufactured
or services rendered without impairing their suitability for the use intended.
Value Analysis: Value Analysis (VA) or Value Engineering (VE) is a function-oriented, structured, multi-
disciplinary team approach to solving problems or identifying improvements.
Business Process Reengineering (BPR): BPR refers to a complete redesign of a process with an emphasis on
finding creative new means to accomplish an objective.
Supply Chain: Supply Chain refers to the entire gambit of linkages in manufacturing a product or rendering a
service.
Problems for Practice
Illustration 1.
Ever Forward Ltd is manufacturing and selling two products: Splash and Flash, at selling prices of ` 3/- and ` 4/-
respectively. The following sales strategy has been outlined for the year 2021.
(i) Sales planned for year will be ` 7.20 lakhs in the case of Splash and ` 3.50 lakhs in the case of Flash.
(ii) Break-even is planned at 60% of the total sales of each product.
(iii) Profit for the year to be achieved is planned at ` 69,120 in the case of Splash and ` 17,500 in the case of
Flash. This would be possible by launching a cost reduction programme and reducing the present annual
fixed expenses of ` 1,35,000 allocated as ` 1,08,000 to Splash and ` 27,000 to Flash.
The selling price of Splash and Flash will be reduced by 20% and 12.5% respectively to meet the competition.
You are required to present the proposal in financial terms giving clearly the following information.
(a) Number of units to be sold of Splash and Flash to break-even as well as the total number of units of Splash
and Flash to be sold during the year.
(b) Reduction in fixed expenses product-wise that is envisaged by the cost Reduction Program.
Answer:
Computation of Number of units to be Sold, Breakeven & envisaged Reduction in FC
Serial Item Splash Flash Total

1 Sales (`) 7,20,000 3,50,000 10,70,000
2 Existing SP (`) 3.00 4.00
Proposed Reduction in SP 20% 12.5%
Revised SP (`) 2.40 3.50
3 No. of units to be sold (Sales ÷ Revised SP) 3,00,000 1,00,000 4,00,000

Serial Item Splash Flash Total

4 Break even units (60% of Item 3) 1,80,000 60,000
5 Break even sales (`) 4,32,000 2,10,000 6,42,000
6 Margin of Safety (Sales – Break even sales) (`) 2,88,000 1,40,000 4,28,000
7 Profit Planned (`) 69,120 17,500 86,620
8 P/V Ratio {(7 ÷ 6) × 100} 24% 12.5%
9 FC (Break even sales × P/V Ratio) (`) 1,03,680 26,250 1,29,930
10 Existing FC (`) 1,08,000 27,000 1,35,000
11 Cost Reduction envisaged in FC (10 – 9) (`) 4,320 750 5,070
(Explanatory Note: The problem shows the methodology to set cost reduction targets)
Illustration 2.
The profit for The Forward Look 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
Capital employed 4,00,000
The new Sales Manager who has recently joined the Company estimates for the next year a profit of about 23%
on the capital employed provided the volume of Sales is increased by 10% and simultaneously there is an increase
in Selling Price of 4% and an overall cost reduction in all the elements of cost by 2%.
Verify the contention of the Sales Manager by computing in detail the cost and profit for the next year and state
whether his proposal can be adopted by the management.
Answer:
Computation of Fixed Cost:
(`)
Annual Sales = 5,00,000
Less Profit: ` 4,00,000 × 12.5% = 50,000
Total Cost = 4,50,000
Less Variable Cost:
Direct Material = ` 2,50,000
Direct Labour = ` 1,00,000

Variable Overhead = ` 40,000

3,90,000
Fixed Cost = 60,000
Statement showing Profit obtained upon adopting the Sales Manager’s proposal:
(`)
(i) Revised Sales: ` 5,00,000 × 110% x 104% = 5,72,000
(ii) Variable Cost: ` 3,90,000 × 110% x 98% = 4,20,420
(iii) Contribution = 1,51,580
(iv) Fixed Cost ` 60,000 × 98% = 58,800
(v) Profit = 92,780
Percentage of Profit on Capital Employed = (` 92,780 ÷ 4,00,000) × 100 = 23.195
i.e. > 23%
Recommendation: The Sales Manager’s proposal can be adopted.
(Explanatory Note: The problem shows the impact of achieving cost reduction targets)
Illustration 3.
The anticipated sales of Electronic Corporation Ltd. is ` 4,00,000 and unit selling price is ` 20 each. The per
unit cost of direct material is ` 9, labour is ` 3 and other variable expenses are ` 3 per unit. The company is
earning a net profit of 5% and to improve the profitability, the following proposals were discussed at the Executive
Committee Meeting:
(i) The present administrative setup is on the regional basis and it was felt that centralization will reduce the
fixed cost by ` 12,000.
(ii) The Production Manager has agreed that he will try to work on a cost reduction programme which will
reduce the cost by ` 1 per unit but there will be little impact on the quality which will be negligible to the
customer.
(iii) The Sales Manager opposed the two proposals and suggests that it may be possible to increase the number
of units sold by 20%, provided the selling price is reduced by 5%
(iv) Alternatively, as per Sales Manager, if the selling price is increased by 10%, the sales number of units will
be reduced by 5%.
As the Cost and Management Accountant of the company, evaluate the aforesaid four proposals and also put
forward your suggestions to improve the situation.
Answer:
Step 1: Deriving the Fixed Cost
Particulars Per Unit (`) Total (`)
Sales (20000 Units) 20 4,00,000
Variable Costs

Particulars Per Unit (`) Total (`)

Direct Materials 9 1,80,000
Labour 3 60,000
Other Variable Expenses 3 60,000
Total Variable Cost 15 3,00,000
Contribution 5 1,00,000
Less: Profit @ 5% of 4,00,000 20,000
Total Fixed Cost (Contribution – Profit) 80,000
Step 2: Evaluation of Alternatives
Alternative (i) (ii) (iii) (iv)

Proposal Central Variable cost 20% increase in 10% increase in
administration Reduction by Sales units with Selling price and
(Reduction in ` 1 per unit 5% reduction in 5% reduction in
F.C. by ` 12,000) selling price sales units
Sales(units) 20,000 20,000 24,000 19,000
Selling price per unit (`) 20 20 19 22
Variable cost (`) 15 14 15 15
Contribution / unit 5 6 4 7
Total Contribution (`) 1,00,000 1,20,000 96,000 1,33,000
Less: Fixed cost (`) 68,000 80,000 80,000 80,000
Net Profit (`) 32,000 40,000 16,000 53,000
Existing Profit (`) 20,000 20,000 20,000 20,000
Increase (Decrease) in profit (`) (+) 12,000 (+) 20,000 (-) 4,000 (+) 33,000
Ranking 3 2 Reject 1
Suggestion Accept
Observations:
(i) The proposal of Sales Manager to increase the selling price by 10% (i.e., alternative iii iv) is really
attractive, as it will fetch additional profit worth ` 33,000, and hence recommended forthwith.
(ii) The proposal of Production Manager that he will try to work on a cost reduction programme which will
reduce the cost by ` 1 per unit with little impact on quality (i.e., alternative ii) leads to a profit of ` 20,000,
and hence may be explored further for long run cost reductions.
(iii) The proposal of centralization that reduces the fixed cost by ` 12,000/- will yield an additional profit of
` 12,000 and hence needs further persuasion.

(iv) The proposal of Sales Manager to increase the number of units sold by 20%, provided the selling price is
reduced by 5% (i.e., alternative iii) is not at all acceptable as this will result in a loss of ` 4,000.
Recommendation: As Cost and Management Accountant of the company, I will recommend a combination of
proposals (i) and (iv) which will, together, generate an additional profit of ` 45,000 (12,000 + 33,000).
Descriptive Questions
1. Define Strategic Cost Management (SCM) and discuss its relevance in the contemporary scenario.
2. What are the generic links of Porter’s Value Chain?
3. Demonstrate the significance of Value Chain Analysis with an illustrative example.
4. List out the key points for exercising cost control.
5. Discuss the tools and techniques of cost reduction.
6. Differentiate Cost Control with Cost Reduction.
7. Narrate five steps to Strategic Cost Reduction?
8. Draft a report to your Managing Director emphasizing the importance of value analysis with reference to an
existing problem in your organization.
9. Explain the phases of Value Analysis.
10. Distinguish between Value Analysis and Value Engineering.
11. What is the need for Business Process Reengineering (BPR)?
12. Define Supply Chain. Discuss the generic links of supply chain.
13. What is Cross-Docking?
14. Explain Supply Chain Management with an illustrative case let.
Multiple Choice Questions (MCQs)
QQ1. Which of the following is not a primary activity of Value Chain?

A. Inbound Logistics
B. Operations
C. Service
D. Infrastructure
QQ2. Which of the following is not a secondary activity of Value Chain?

A. Procurement
B. Human Resource Development
C. Service
D. Technology Development
QQ3. Which of the following is not a term normally used in value analysis?
A. Resale value
B. Use value
C. Esteem value
D. Cost value
Reason: The resale value is normally referred to as the ‘exchange value.

QQ4. A company has forecast sales and cost of sales for the coming year as ` 25 lakhs and ` 18 lakhs respectively.
The inventory turnover has been taken as 9 times per year. In case the inventory turnover increases to 12
times and the short-term interest rate on working capital is taken as 10%, what will be the saving in cost?
A. ` 10,000
B. ` 20,000
C. ` 15,000
D. ` 5,000
Reason:
Workings
Level of Inventory when the turnover is 9 times = (18,00,000 ÷ 9) = ` 2,00,000
Level of Inventory when the turnover is 12 times = (18,00,000 ÷12) = ` 1,50,000
Reduction in the level of Inventory = (` 2,00,000 - ` 1,50,000) = ` 50,000
Saving in working capital interest cost = (` 50,000 × 10%) = ` 5,000
[Answer: D; C; A; D]
Question: State whether the following statements are True (T) or False (F).
1. Strategic cost management refers to the cost management that specifically focuses on strategic issues. (T)
2. ‘VA’ and ‘VE’ are closely related terms so much so that they are, frequently, used interchangeably. (T)
3. Cost reduction refers to the real and permanent reduction in the unit costs of goods manufactured or services
rendered without considering their suitability for the use intended. (F)
4. Supply Chain Management is not an avenue of cost reduction. (F)

Quality Cost Management
Quality Cost Management 2

2.1 Managing Quality in Competitive Environment
2.2 Cost of Quality
2.3 Total Quality Management
2.4 Lean Accounting
2.5 Six Sigma

Quality Cost Management 2

2.1 Managing Quality in Competitive Environment
Quality
Quality is that characteristic or a combination of characteristics that distinguishes one article from the other
or goods of one manufacturer from that of competitors or one grade of product from another when both are the
outcome of the same factory.
The main characteristics that determine the quality of an article may include such elements as design, size,
materials, chemical composition, mechanical functioning, electrical properties, workmanship, finish and
appearance. The quality of a product may, thus, be defined as the sum of a number of related characteristics such
as shape, dimension, composition, strength, workmanship, adjustment, finish and colour.
Quality as perception: It will not be wrong when you state that the term quality is a perception which is personal
to an individual. In plain terms, quality is “features” or “worth” or “value”. You will realise how this is true when
you read the following phrases picked-up from literature on quality.
(i) “Quality is not an act. It is a habit”- Aristotle. This is true and applicable to any act of a human being.
(ii) “Quality is conformance to requirements”: This is in line with the concept that quality is decided by the
customer.
(iii) “Quality is zero defects”: No customer wants defects in the products or services he or she pays for. This is
a totally different idea on quality and is true when you make quality a habit.
(iv) “Quality is free” - Phil Crosby. This is the utopian situation. When there are no defects, then there is no
wastage and thus quality becomes free.
(v) “Quality is the degree to which a set of inherent characteristics fulfils requirements”- ISO 9000. This is an
attempt to give universality to the term quality.
Today, there is no single universal definition of quality. Some people view quality as “performance to standards.”
Others view it as “meeting the customer’s needs” or “satisfying the customer.” Let’s look at some of the more
common definitions of quality.
~~ Conformance to Specifications: Conformance to specifications measures how well the product or service
meets the targets and tolerances determined by its designers. For example, the dimensions of a machine
part may be specified by its design engineers as 3 + .05 inches. This would mean that the target dimension
is 3 inches but the dimensions can vary between 2.95 and 3.05 inches. Similarly, the wait for hotel room
service may be specified as 20 minutes, but there may be an acceptable delay of an additional 10 minutes.
Also, consider the amount of light delivered by a 60-watt light bulb. If the bulb delivers 50 watts it does not
conform to specifications. As these examples illustrate, conformance to specification is directly measurable,
though it may not be directly related to the consumer’s idea of quality.

~~ Fitness for Use: Fitness for use focuses on how well the product performs its intended function or use.
For example, a Mercedes Benz and a Jeep Cherokee both meet a fitness for use definition if one considers
transportation as the intended function. However, if the definition becomes more specific and assumes that
the intended use is for transportation on mountain roads and carrying fishing gear, the Jeep Cherokee has a
greater fitness for use. You can also see that fitness for use is a user-based definition in that it is intended to
meet the needs of a specific user group.
~~ Value for Price Paid: Value for price paid is a definition of quality that consumers often use for product or
service usefulness. This is the only definition that combines economics with consumer criteria; it assumes
that the definition of quality is price sensitive. For example, suppose that you wish to sign up for a personal
finance seminar and discover that the same class is being taught at two different colleges at significantly
different tuition rates. If you take the less expensive seminar, you will feel that you have received greater
value for the price.
~~ Support Services: Support services provided are often how the quality of a product or service is judged.
Quality does not apply only to the product or service itself; it also applies to the people, processes, and
organizational environment associated with it. For example, the quality of a university is judged not only by
the quality of staff and course offerings, but also by the efficiency and accuracy of processing paperwork.
~~ Psychological Criteria: Psychological criteria is a subjective definition that focuses on the judgmental
evaluation of what constitutes product or service quality. Different factors contribute to the evaluation, such
as the atmosphere of the environment or the perceived prestige of the product. For example, a hospital patient
may receive average health care, but a very friendly staff may leave the impression of high quality. Similarly,
we commonly associate certain products with excellence because of their reputation; Rolex watches and
Mercedes-Benz automobiles are examples.
Differences Between Manufacturing and Service Organizations

Defining quality in manufacturing organizations is often different from that of services. Manufacturing
organizations produce a tangible product that can be seen, touched, and directly measured. Examples include cars,
CD players, clothes, computers, and food items. Therefore, quality definitions in manufacturing usually focus on
tangible product features.
The most common quality definition in manufacturing is conformance, which is the degree to which a product
characteristic meets preset standards. Other common definitions of quality in manufacturing include performance—
such as acceleration of a vehicle; reliability—that the product will function as expected without failure; features—
the extras that are included beyond the basic characteristics; durability— expected operational life of the product;
and serviceability—how readily a product can be repaired. The relative importance of these definitions is based on
the preferences of each individual customer. It is easy to see how different customers can have different definitions
in mind when they speak of high product quality.
In contrast to manufacturing, service organizations produce a product that is intangible. Usually, the complete
product cannot be seen or touched. Rather, it is experienced. Examples include delivery of health care, experience
of staying at a vacation resort, and learning at a university. The intangible nature of the product makes defining
quality difficult. Also, since a service is experienced, perceptions can be highly subjective. In addition to tangible
factors, quality of services is often defined by perceptual factors. These include responsiveness to customer needs,
courtesy and friendliness of staff, promptness in resolving complaints, and atmosphere. Other definitions of quality
in services include time—the amount of time a customer has to wait for the service; and consistency—the degree to
which the service is the same each time. For these reasons, defining quality in services can be especially challenging.
Dimensions of quality for manufacturing versus service organizations are shown in the Table.

Dimensions of Quality for Manufacturing Versus Service Organizations
Manufacturing organizations Service organizations

Conformance to specifications Tangible factors
Performance Consistency
Reliability Responsiveness to customer needs
Features Courtesy/friendliness
Durability Timeliness/ promptness
Serviceability Atmosphere
Quality Management
Quality management is defined as “coordinated activities to direct and control an organization with regard to
quality” (ISO 9000:2000). The activities are normally integrated into a system.
This is known as the systems approach to managing quality and the same approach needs to be adapted to
business operations. Starting from early 60s and migrating to the 70s, the practices of quality management have
shown an evolution. In the following paragraphs, you will get an overview of the way this evolution started from
the activity or process of “Inspection”.
Inspection: Inspection is defined as “Activities such as measuring, testing and gauging one or more characteristics
of a product or service and comparing with specifications as in design to determine its conformity”. This approach
is the “after the event” approach, meaning the things which have happened and then which you verify by, measuring
or testing and screen out those which do not meet specifications. Organisation is said to be working in a “detection”
mode, having things or events which have happened! The result is that the nonconforming products are cost as they
are a waste of material and as well as that of efforts or needing some rework or being sold as “seconds” at a lower
price, all resulting into a dent in profits. This also creates the culture of “somebody else will check my outcome
and it is that somebody’s responsibility to give the conforming product”. This approach had several limitations and
had to be replaced by another effective way of attaining quality and the concept of Quality Control was the result.
Quality Control: Quality Control may be defined as “Operational techniques and activities that are used to
fulfill requirements for quality”. Organisations realized that “Inspection” alone was a costly affair as all that
was segregated was a waste and a cost to the organisation, thus reducing profitability. The result was the idea of
“control on operations,” as Quality control. This was not necessarily very different from Inspection but had a new
look at inspection. Under a system of quality control, there was a need to find controls for an activity, in the form
of procedures, intermediate stage inspections and recording of performance of a process for giving feedback. The
methods of inspection got sophisticated with addition of tools like sample checks, lot size, etc., for inspections at
identified stages. However, the intention and activity of preventing a non-conforming product reaching a customer
depended solely on the screening inspection at the final stage of production or service delivery. Application of
this concept of course resulted into lesser defects but remained in nature as “detection mode”, which we have
discussed earlier.
Quality Assurance: From the business point of view, eliminating non-conformance was the key to a better level
of quality and assurance of quality. And then the concept of Quality Assurance (QA) was developed. The central
idea is to identify the root cause of nonconformity, take steps to eliminate the cause and thus remove recurrence
of the nonconformity in future deliveries to the customer. QA is defined as “All those planned and systematic
actions necessary to provide an adequate confidence that a product or service will satisfy the given requirements
for quality”.

Quality assurance is a prevention-based system. The system improves product and service quality and increases
productivity by placing emphasis on the design of product or service and relevant processes. The basis is that the
process that makes the product or a service needs to be designed in such a manner that the variation in the process
outcome is minimal in reference to design specifications, thus eliminating non-conformance. This is a proactive
approach as compared to the reactive one in the “detection mode” discussed above.
In this system of operations, quality is created in the design stage and not in the control stage. The premise is
that the design of the products and the processes makes the quality happen and not any verification or inspection as
in the detection mode. Changing from “detection mode” to “prevention-based system” requires the use of a set of
quality management tools and techniques along with a new operating philosophy and approach –even of thinking,
by the top management.
The new philosophy demands a change in the management style to integrate various functions or departments
to work together to discover the root cause of non-conformance or variation and to pursue elimination. Quality
planning and improvements begin when the top management includes prevention, as opposed to detection, in
organizational policies because this philosophy directs the business towards the future.
Integrating various processes of the business into “a whole” was at the basis and thus a true system approach to
business. Such thinking resulted into a new practice which came to be known as the “Total Quality Management”
(TQM). To get an insight into this concept, you need to understand that no-business process can work in isolation.
Interdependence and an interaction between each of the business processes exist, and must be addressed while
operating a business. This is the systems approach.
Quality is a key differentiator in a populated marketplace, driven by dynamic customer choices and competitive
business offerings. Quality products make an important contribution to long-term revenue and profitability,
building your brand value by simply letting your services and products, speak for themselves. So, we must consider
the customer, the attributes of the product and the degree to which the product or service meets the needs of all
stakeholders. Based on these characteristics we can define the quality of a product as “good”, “average”, “excellent”.
Adherence to a recognized quality standard is essential for dealing with certain customers or complying with
legislation. If you sell products in regulated markets, such as health care, food or electrical goods, you must
be able to comply with the health and safety compliance standards designed to protect consumer’s interests. In
today’s business environment, organizations face multiple challenges ranging from a global economic slowdown,
challenging and agile competition, and technology that’s moving at lightening pace. And one of the ways in which
an organization can build a strong, sustainable competitive advantage for itself, is via implementing Total Quality
Management (TQM) practices.
Case 1. A Quality Education

Although it may appear easier to find success with TQM at a boutique-sized endeavour, the philosophy’s principles
hold true in virtually every sector. Educational institutions, for example, have utilized quality management in much
the same way – albeit to tackle decidedly different problems.
The global financial crisis hit higher education harder than many might have expected, and nowhere have the
odds stacked higher than in India. The nation plays home to one of the world’s fastest-growing markets for business
education. Yet over recent years, the relevance of business education in India has come into question. A report by
one recruiter recently asserted just one in four Indian MBAs were adequately prepared for the business world.
At the Ramaiah Institute of Management Studies (RIMS) in Bangalore, recruiters and accreditation bodies
specifically called into question the quality of students’ educations. Although the relatively small school has always

struggled to compete with India’s renowned Xavier Labour Research Institute, the faculty finally began to notice
clear hindrances in the success of graduates. The RIMS board decided it was time for a serious reassessment of
quality management.
The school nominated Chief Academic Advisor Dr Krishnamurthy to head a volunteer team that would audit,
analyse and implement process changes that would improve quality throughout (all in a particularly academic
fashion). The team was tasked with looking at three key dimensions: assurance of learning, research and productivity,
and quality of placements. Each member underwent extensive training to learn about action plans, quality auditing
skills and continuous improvement tools – such as the ‘plan-do-study-act’ cycle.
Once faculty members were trained, the team’s first task was to identify the school’s key stakeholders, processes
and their importance at the institute. Unsurprisingly, the most vital processes were identified as student intake,
research, knowledge dissemination, outcomes evaluation and recruiter acceptance. From there, Krishnamurthy’s
team used a fishbone diagram to help identify potential root causes of the issues plaguing these vital processes. To
illustrate just how bad things were at the school, the team selected control groups and administered domain-based
knowledge tests.
The deficits were disappointing. A RIMS students’ knowledge base was rated at just 36 percent, while students
at Harvard rated 95 percent. Likewise, students’ critical thinking abilities rated nine percent, versus 93 percent at
MIT. Worse yet, the mean salaries of graduating students averaged $36,000, versus $150,000 for students from
Kellogg. Krishnamurthy’s team had their work cut out.
To tackle these issues, Krishnamurthy created an employability team, developed strategic architecture and
designed pilot studies to improve the school’s curriculum and make it more competitive. In order to do so, he
needed absolutely every employee and student on board – and there was some resistance at the onset. Yet the
educator asserted it didn’t actually take long to convince the school’s stakeholders the changes were extremely
beneficial.
“Once students started seeing the results, buy-in became complete and unconditional,” he says. Acceptance
was also achieved by maintaining clearer levels of communication with stakeholders. The school actually started
to provide shareholders with detailed plans and projections. Then, it proceeded with a variety of new methods,
such as incorporating case studies into the curriculum, which increased general test scores by almost 10 percent.
Administrators also introduced a mandate saying students must be certified in English by the British Council –
increasing scores from 42 percent to 51 percent.
By improving those test scores, the perceived quality of RIMS skyrocketed. The number of top 100 businesses
recruiting from the school shot up by 22 percent, while the average salary offers graduates were receiving increased
by $20,000. Placement revenue rose by an impressive $50,000, and RIMS has since skyrocketed up domestic and
international education tables.
(The case study is taken from the website www.europeanceo.com/business-and-management/total-quality-
management-three-case-studies-from-around-the-world on 21.03.2019)
No matter what the business is, total quality management can and will work. Yet this philosophical take on
quality control will only impact firms that are in it for the long haul. Every employee must be in tune with the
company’s ideologies and desires to improve, and customer satisfaction must reign supreme.
2.2 Cost of Quality

The reason quality has gained such prominence is that organizations have gained an understanding of the high
cost of poor quality. Quality affects all aspects of the organization and has dramatic cost implications. The most
obvious consequence occurs when poor quality creates dissatisfied customers and eventually leads to loss of

business. However, quality has many other costs, which can be divided into two categories. The first category
consists of costs necessary for achieving high quality, which are called quality control costs. These are of two
types: prevention costs and appraisal costs. The second category consists of the cost consequences of poor quality,
which are called quality failure costs. These include external failure costs and internal failure costs. The first two
costs are incurred in the hope of preventing the second two.
Prevention Costs: Prevention costs are all costs incurred in the process of preventing poor quality from
occurring. They include quality planning costs, such as the costs of developing and implementing a quality plan.
Also included are the costs of product and process design, from collecting customer information to designing
processes that achieve conformance to specifications. Employee training in quality measurement is included as part
of this cost, as well as the costs of maintaining records of information and data related to quality.
Appraisal Costs: Appraisal costs are incurred in the process of uncovering defects. They include the cost of
quality inspections, product testing, and performing audits to make sure that quality standards are being met. Also
included in this category are the costs of worker time spent measuring quality and the cost of equipment used for
quality appraisal.
Internal Failure Costs: Internal failure costs are associated with discovering poor product quality before the
product reaches the customer site. One type of internal failure cost is rework, which is the cost of correcting the
defective item. Sometimes the item is so defective that it cannot be corrected and must be thrown away. This
is called scrap, and its costs include all the material, labour, and machine cost spent in producing the defective
product.
External Failure Costs: External failure costs are incurred when inferior products are delivered to customers.
They include cost of handling customer complaints, warranty replacements, repairs of returned products and cost
arising from a damaged company reputation.
We may tabulate the above details with suitable examples as below:
Prevention costs Ensuring the failures do not happen

Example:
●● Quality training
●● Quality circles
●● Statistical process control activities
●● System Development for prevention
Quality improvement
Appraisal costs Checking for failures
Example:
●● Testing and inspecting materials
●● Final product testing and inspecting
●● WIP testing and inspecting
●● Package inspection
Depreciation of testing equipment
Internal failure costs Keeping defective products from falling into the hands of customers
Example:
●● Cost of Scrap (net of realization)

●● Cost of Spoilage
●● Cost of Rework
●● Down time due to defect in quality
Retesting
External failure costs Costs of defects discovered by the customers
Example:
●● Cost of field servicing
●● Cost of handling complaints
●● Warranty repairs
●● Lost sales
Warranty replacements
2.3 Total Quality Management

Total Quality Management is a philosophy of continuously improving the quality of all the products and processes
in response to continuous feedback for meeting the customers’ requirements. It aims to do things right the first time,
rather than need to fix problems after they emerge (A company should avoid defects rather than correct them). Its
basic objective is customer satisfaction.
The elements of TQM are:
Total Quality involves everyone and all activities in the company (Mobilizing the whole
organization to achieve quality continuously and economically)
Quality Understanding and meeting the customers’ requirements. (Satisfying the customers first
time every time)
Management Quality can and must be managed (Avoid defects rather than correct them)
TQM is a vision based, customer focused, prevention oriented,

continuous improvement strategy based on scientific approach Customer Focus
adopted by cost conscious people committed to satisfy the customers
first time every time. It aims at Managing an organization so that it Total Employee Commitment
excels in areas important to the customer.
Process Approach
Underlying Principles of TQM
1. Customer Focus: The first of the Total Quality Management Integrated System
principles puts the focus back on the people buying your
product or service. Your customers determine the quality of Strategic and Systematic Approach
your product. If your product fulfills a need and lasts as long or
longer than expected, customers know that they have spent their Continual Improvement
money on a quality product. When you understand what your
customer wants or needs, you have a better chance of figuring Fact-based Decision-making
out how to get the right materials, people, and processes in
place to meet and exceed their expectations.
Communications
2. Total Employee Commitment: You can’t increase

productivity, processes, or sales without the total commitment of all employees. They need to understand
the vision and goals that have been communicated. They must be sufficiently trained and given the proper
resources to complete tasks in order to be committed to reaching goals on time.
3. Process Approach: Adhering to processes is critical in quality management. Processes ensure that the
proper steps are taken at the right time to ensure consistency and speed up production.
4. Integrated System: Typically, a business has many different departments, each with their own specific
functions and purposes. These departments and functions should be interconnected with horizontal processes
that should be the focus of Total Quality Management. But sometimes these departments and functions
operate in isolated silos. In an integrated system, everybody in every department should have a thorough
understanding of policies, standards, objectives, and processes. Integrated systems help the company to look
for continual improvement in order to achieve an edge over the competition.
5. Strategic and Systematic Approach: The International Organization for Standardization (ISO) describes
this principle as: “Identifying, understanding and managing interrelated processes as a system contributes
to the organization’s effectiveness and efficiency in achieving its objectives.” Multiple processes within a
development or production cycle are managed as a system of processes in an effort to increase efficiency.
6. Continual Improvement: Optimal efficiency and complete customer satisfaction do not happen in a day—
your business should continually find ways to improve processes and adapt your products and services as
customer needs shift.
7. Fact-based Decision-making: Analysis and data gathering lead to better decisions based on the available
information. Making informed decisions leads to a better understanding of customers and your market.
8. Communications: Everybody in your organization needs to be aware of plans, strategies, and methods that
will be used to achieve goals. There is a greater risk of failure if you don’t have a good communication plan.
Steps in Total Quality Management

~~ Step 1: Identification of customers/customer groups: Through a team approach (a technique called
Multi-Voting), the firm should identify major customer groups. This helps in generating priorities in the
identification of customers and critical issues in the provision of decision-support information.
~~ Step 2: Identifying customer expectations: Once the major customer groups are identified, their
expectations are listed. The question to be answered is - What does the customer expect from the firm?
~~ Step 3: Identifying customer decision-making requirements and product utilities: By identifying the need
to stay close to the customers and following their suggestions, a decision- support system can be developed,
incorporating both financial and non-financial information, which seeks to satisfy user requirements. This
way, the firm finds out the answer to - What are the customer’s decision-making requirements and product
utilities? The answer is sought by listing out managerial perceptions and not by actual interaction with the
customers.
~~ Step 4: Identifying perceived problems in decision-making process and product utilities: Using
participative processes such as brainstorming and multi-voting, the firm seeks to list out its perception of
problem areas and shortcomings in meeting customer requirements. This will list out areas of weakness
where the greatest impact could be achieved through the implementation of improvements. Here, the firm
identifies the answer to the question - What problem areas do we perceive in the decision-making process?
~~ Step 5: Comparison with other firms and benchmarking: Detailed and systematic internal deliberations
allow the firm to develop a clear idea of their own strengths and weaknesses and of the areas of most
significant deficiency. Benchmarking exercise allows the firm to see how other companies are coping with
similar problems and opportunities.

~~ Step 6: Customer Feedback: Steps 1 to 5 provide a information base developed without reference to the
customer. This is rectified at Steps 6 with a survey of representative customers, which embraces their views
on perceived problem areas. Interaction with the customers and obtaining their views helps the firm in
correcting its own perceptions and refining its processes.
~~ Steps 7 & 8: Identification of improvement opportunities and implementation of Quality Improvement
Process: The outcomes of the customer survey, benchmarking and internal analysis, provides the inputs for
Steps 7 and 8, i.e., the identification of improvement opportunities and the implementation of a formal
improvement process. This is done through a six-step process called PRAISE, in short.
6C’s and 4P’s

The essential requirements for successful implementation are described as the six C’s of TQM as tabulated
belew:
The 6C’s
Commitment If a TQM culture is to be developed, total commitment must come from top management.
It is not sufficient to delegate ‘quality’ issues to a single person. Quality expectations must
be made clear by the top management, together with the support and training required for
its achievement.
Culture Training lies at the centre of effecting a change in culture and attitudes. Negative
perceptions must be changed to encourage individual contributions and to make ‘quality’
a normal part of everyone’s job.
Continuous TQM should be recognised as a ‘continuous process’. It is not a ‘one-time programme’.
Improvement There will always be room for improvement, however small it may be.
Co-operation TQM visualises Total Employee Involvement (TEI). Employee involvement and co-
operation should be sought in the development of improvement strategies and associated
performance measures.
Customer Focus The needs of external customers (in receipt of the final product or service) and also the
internal customers (colleagues who receive and supply goods, services or information),
should be the prime focus.
Control Documentation, procedures and awareness of current best practice are essential if TQM
implementations are to function appropriately. Unless control procedures are in place,
improvements cannot be monitored and measured nor deficiencies corrected.
It is possible that the organisation is led to Total Quality Paralysis, instead of improvement, by improper
implementation of TQM. To avoid such disruption and paralysis the following principles (called the four P’s) of
TQM should be followed:
The 4P’s
People To avoid misdirection, TQM teams should consist of team spirited individuals who have
a flair for accepting and meeting challenges. Individuals who are not ideally suited to
the participatory process of TQM, should not be involved at all, e.g., lack of enthusiasm,
non-attendance at TQM meetings, failure to complete delegated work, remaining a “Mute
Spectator” at TQM meetings, etc.

Process It is essential to approach problem-solving practically and to regard the formal process as
a system designed to prevent participants from jumping to conclusions. As such, it will
provide a means to facilitate the generation of alternatives while ensuring that important
discussion stages are not omitted.
Problem Problems need to be approached in a systematic manner, with teams tackling solvable
problems with a direct economic impact, allowing for immediate feedback together with
recognition of the contribution made by individual participants.
Preparation Additional training on creative thinking and statistical processes are needed in order to
give participants a greater appreciation of the diversity of the process. This training must
quickly be extended beyond the immediate accounting circle to include employees at
supervisory levels and also who are involved at the data input stagey
Case 2. The Customer Knows Best (AtlantiCare)

TQM isn’t an easy management strategy to introduce into a business; in fact, many attempts tend to fall flat. More
often than not, it’s because firms maintain natural barriers to full involvement. Middle managers, for example, tend
to complain their authority is being challenged when boots on the ground are encouraged to speak up in the early
stages of TQM. Yet in a culture of constant quality enhancement, the views of any given workforce are invaluable.
One firm that’s proven the merit of TQM is New Jersey-based healthcare provider AtlantiCare. Managing 5,000
employees at 25 locations, AtlantiCare is a serious business that’s boasted a respectable turnaround for nearly two
decades. Yet, in order to increase that margin further still,
managers wanted to implement improvements across the Profits Before:
board. Because patient satisfaction is the single-most $280m
important aspect of the healthcare industry, engaging in a
renewed campaign of TQM proved a natural fit. The firm Employees: Profits After:
chose to adopt a ‘plan-do-check-act’ cycle, revealing gaps 5000 $650m
in staff communication – which subsequently meant
longer patient waiting times and more complaints. To AtlantiCare
tackle this, managers explored a sideways method of in numbers
internal communications. Instead of information trickling
down from top-to-bottom, all of the company’s employees were given freedom to provide vital feedback at each
and every level.
AtlantiCare decided to ensure all new employees understood this quality culture from the onset. At orientation,
staff now receive a crash course in the company’s performance excellence framework – a management system
that organises the firm’s processes into five key areas: quality, customer service, people and workplace, growth
and financial performance. As employees rise through the ranks, this emphasis on improvement follows, so that
managers can operate within the company’s tight-loose-tight process management style.
After creating benchmark goals for employees to achieve at all levels – including better engagement at the point
of delivery, increasing clinical communication and identifying and prioritising service opportunities – AtlantiCare
was able to thrive. The number of repeat customers at the firm tripled, and its market share hit a six-year high.
Profits unsurprisingly followed. The firm’s revenues shot up from $280m to $650m after implementing the quality
improvement strategies, and the number of patients being serviced dwarfed state numbers.
(Resource: www.europeanceo.com/business-and-management/total-quality-management-three-case-studies-from
-around -the-world_25.01.2022)

PRAISE
Identification of improvement opportunities and implementation of quality improvement process, of the TQM
Process is through a six-step activity sequence, identified by the acronym ‘PRAISE’.
Sl. Activity Elements

1 Problem ●● Areas of customer dissatisfaction.
Identification ●● Absence of competitive advantage.
2 Ranking ●● Prioritise problems and opportunities by –

1. Perceived importance, and
2. Ease of measurement and solution.
3 Analysis ●● Ask “Why?” to identify possible causes. Keep asking ‘Why?’ beyond to the
move symptoms and to avoid jumping to premature conclusion.
●● Ask ‘What?’ to consider potential implications.
●● Ask ‘How much?’ to quantify cause and effect.
4 Innovation ●● Use creative thinking to generate potential solutions.

●● Operationalise these solutions by identifying:
1. Barriers to implementation,
2. Available enablers, and
3. People whose co-operation must be sought.
5 Solution ●● Implement the preferred solution.
●● Take appropriate action to bring about the required changes.
●● Reinforce with training and documentation back-up.
6 Evaluation ●● Monitor the effectiveness of actions.

●● Establish and interpret performance indicators to track progress towards
objectives
●● Identify the potential for further improvements and return to Step 1.
Difficulties in PRAISE Analysis

Step Activity Difficulties Remedies
1 Problem ●● Effects of a problem are apparent, but ●● Participative approaches like
Identification the problems themselves are difficult brainstorming, multi- voting, panel
to be identified. discussion.
●● Problem may be identifiable, but it ●● Quantification and precise definition
is difficult to identify a measurable of problems.
improvement opportunity.
●● Some problems are too vague to
define e.g., morale, communication,
productivity etc.

Step Activity Difficulties Remedies

2 Ranking ●● Difference in perception of ●● Participative Approach.
individuals in ranking ●● Subordination of individual to group
●● Difference in preferences based on interest.
functions, e.g., production, finance,
marketing etc.
●● Lack of consensus between
individuals.
3 Analysis ●● Adoption of adhoc approaches and ●● Lateral Thinking.
quick-fix solutions. ●● Brainstorming.
4 Innovation ●● Lack of creativity or expertise. ●● Systematic evaluation of all aspects

●● Inability to operationalise ideas, i.e., of each strategy.
convert thoughts into action points.
5 Solution ●● Resistance from middle managers. ●● Effective internal communication.
●● Training of personnel and managers.
●● Participative approach.
6 Evaluation ●● Problems in implementation. ●● Effective Control System to track

●● Lack of measurable data for actuals.
comparison of expectations with ●● Feedback system.
actuals.
Central to the PRAISE system are - (a) Quality Control - the search for continuous improvements in quality -and
(b) Total Employee Involvement - the co-operation and commitment of employees. This dual approach provides a
single focus - the customer - whose increased satisfaction remains the primary goal of the procedure.
Implementation of PRAISE Process

A three-point action plan for implementation of the process is -
1. Small to Big Issues: Big improvement opportunities are generally complex and require extensive
interdepartmental co-operation. The choice of a relatively small problem in the first instance provides a
greater chance of success. Therefore, the TQM team has to proceed from small to big issues gradually.
2. Solvable Problem: The problem selected should not be trivial, but it should be one with a potential impact
and a clear improvement opportunity. Measurable progress towards implementation should be accomplished
within a reasonable time in order to maintain the motivation of participants and advertise the success of the
improvement itself.
3. Recognition of Participants: The successful projects and team members should receive appropriate
recognition. Prominent individuals should be rewarded for their efforts through monetary / non-monetary
prices as a measure of personal recognition and as encouragement to others.
Pareto Analysis
Pareto Analysis is a rule that recommends focus on the most important aspects of the decision making in order
to simplify the process of decision making. It is based on the 80:20 rule that was a phenomenon first observed by
Vilfredo Pareto, a nineteenth century Italian economist. He noticed that 80% of the wealth of Milan was owned

by 20% of its citizens. This phenomenon, or some kind of approximation of it say, (70: 30 etc.) can be observed in
many different business situations. The management can use it in a number of different circumstances (including
TQM) to direct management attention to the key control mechanism or planning aspects. It helps to clearly establish
top priorities and to identify both profitable and unprofitable targets.
Usefulness of Pareto Analysis: It provides the mechanism to control and direct effort by fact and not by
emotions. It helps to clearly establish top priorities and to identify both profitable and unprofitable targets. Pareto
analysis is useful to:
1. Prioritize problems, goals, and objectives to Identify root causes.
2. Select and define key quality improvement programs.
3. Select key customer relations and service programs.
4. Select key employee relations improvement programs.
5. Select and define key performance improvement programs.
6. Maximize research and product development time.
7. Verify operating procedures and manufacturing processes.
8. Product or services sales and distribution.
9. Allocate physical, financial and human resources.
Application of Analysis: Pareto analysis may be applicable in the presentation of Performance Indicators data
through selection of representative process characteristics that truly determine or directly or indirectly influence or
conform the desired quality or performance result or outcome. The Pareto Analysis is generally applicable to the
following business situations:
(i) Pricing of a Product: In the case of a firm dealing with multi products, it would not be possible for it to
analyse cost-profit-price –volume relationships for all of them. In practice, in case of such firm approximately
20% of products may account for about 80% of total sales revenue. Pareto Analysis is used for analysing
the firm’s estimated sales revenues from various products and it might indicate that approximately 80% of
its total sales revenue is earned from about 20% of its products. Such analysis helps the top management
to delegate the pricing decision for approximately 80% of its products to the lower levels of management,
thus freeing themselves to concentrate on the pricing decisions for products approximately 20% which
are essential for the company’s survival. Thus, a firm can adopt more sophisticated pricing methods for
small proportion of products that jointly accounts for approximately 80% of total sales revenue. For the
remaining 80% of the products which account for 20% of total sales revenue the firm may use cost based
pricing method.
(ii) Customer Profitability Analysis: Instead of analyzing products, customers can be analysed for their
relative profitability to the organisation. Again, it is often found that approximately 20% of customers
generate 80% of the profit. There will always be some customers who are less profitable than others, just
as some products are less profitable than others. Such an analysis is useful for evaluation of the portfolio
of customer profile and decision making such as whether to continue serving a same customer group, what
is the extent of promotion expenses to be incurred.
(iii) ABC analysis – Stock Control: Another application of Pareto analysis is in stock control where it may
be found that only a few of the goods in stock makeup most of the value. In practice approximately 20%
of the total quantity of stock may account for about 80% of its value. The outcome of such analysis is that
by concentrating on small proportion of stock items that jointly accounts for 80% of the total value, a firm
may well be able to control most of monetary investment in stocks.

(iv) Application in Activity Based Costing: In Activity Based Costing it is often said that 20% of an
organization-cost-drivers are responsible for 80% of the total cost. By analysing, monitoring and controlling
those cost drivers that cause most cost, a better control and understanding of overheads will 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
reported problems can usually be traced to 20% of the various underlying causes. By concentrating once
efforts on rectifying the vital 20%, one can have the greatest immediate impact on product quality. The
Pareto Analysis indicates how frequently each type of failure (defect) occurs. The purpose of the analysis
is to direct management attention to the area where the best returns can be achieved by solving most of
quality problems, perhaps just with a single action.
Example 1:
A Toy company performs a Pareto analysis, given a set of ‘defect types’ and frequencies of their occurrence.
The sample data consists of information about 84 defective items. The items have been classified by their ‘defect
types’ as follows:
Defect Type No. of Items

Cracks (due to mishandling of raw material) 10
Improper shapes 8
Incomplete 8
Surface scratches 53
Others (due to bad quality raw material) 5
Frequency table indicating the frequency of occurrence of defects in decreasing order of their occurrence will
be as follows:
Defect Type No. of items (%) Cumulative %

Surface scratches 53 63.10 63.10
Cracks 10 11.90 75.00
Improper shape 8 9.52 84.52
Incomplete 8 9.53 94.05
Others 5 5.95 100.00
The purpose of Pareto analysis in this example, is to direct attention to the area where best returns can be
achieved by solving most of the quality problems, perhaps just with a single action. In this case, use of good
quality raw material say plastic may solve 63% of problem and if raw material is handled properly at least 75% the
problems may be overcome.
2.4 Lean Accounting

Lean Manufacturing
Idle resources have always remained the fiercest enemy of every cost manager. It could be idle labour, idle
machines, idle facilities, idle stocks; anything and everything remaining idle tantamount to an undue fixed burden
which diminishes the impact of value chain.

Lean management is one fascinating concept that supports the efforts of the Cost Manager in the elimination of
waste of any kind. It advocates the fundamental that ‘Process, next in line, is the most important customer; Process,
just before in line, is the most important vendor’.
Benjamin Franklin contributed greatly to waste reduction thinking. Henry Ford cited Franklin as a major influence
on his business practices. They believed that a penny saved is a penny gained. They reinvented the writing on the
wall, “Costs do not exist to be Calculated; Costs do exist to be Reduced”. There started a number of right initiatives
relating to Modern Lean Management.
Taiichi Ohno (1912-1990) is more a symbol of Japan’s manufacturing resurgence after the Second World War.
Born in Dalian, in eastern China, he joined Toyota Automatic Loom Works between the wars. Ohno felt that there
was no reason other than inefficiency and wastefulness why Toyota’s productivity should be any lower than that of
Detroit. Hence, he set out to eradicate inefficiency and eliminate waste in that part of the production process that
he was responsible for. This became the core of the so-called Toyota Production System (TPS) that he and others
subsequently developed between the mid-1940s and the mid-1970s. Several elements of this system have become
familiar in the West; for example, muda (the elimination of waste), jidoka (the injection of quality) and kanban (the
tags used as part of a system of just-in-time stock control).
Lean was evolved from the manufacturing philosophy of the Toyota Production System. The cornerstone of
lean is the elimination of waste from processes with a mindset of continuous improvement. In its most basic form,
Lean Manufacturing is the systematic elimination of waste by focusing on production costs, product quality and
delivery, and worker involvement. It is said that the famed Toyota Production system was inspired by what the
Toyota executives learned during their visits to the Ford Motor Company in the 1920s and developed by Toyota
leaders such as Taiichi Ohno and consultant Shigeo Shingo after World War II.
Broadly speaking, Lean Manufacturing represents a fundamental paradigm shift from traditional “batch and
queue” mass production to production systems based on product aligned “single-piece flow, pull production.”
Whereas “batch and queue” involves mass-production of large inventories of products in advance based on
potential or predicted customer demands, a “single-piece flow” system rearranges production activities in a way
that processing steps of different types are conducted immediately adjacent to each other in a continuous and single
piece flow. If implemented properly, a shift in demand can be accommodated immediately, without the loss of
inventory stockpiles associated with traditional batch-and-queue manufacturing.
While Japanese manufacturers embraced Lean as their biggest hope in recovering effectively from a war-torn
economy in the 1950’s, today companies embrace Lean Manufacturing for three fundamental reasons:
(i) First, the highly competitive, globalized market of today requires that companies lower costs to increase
margins and/or decrease prices through the elimination of all non-value added aspects of the enterprise.
(ii) Second, meeting rapidly changing customer “Just-In-Time” demands through rapid product mix changes
and increases in manufacturing velocity in this manufacturing age is the key for survival.
(iii) Finally, goods must be of high and consistent quality. Lean manufacturing facilitates these three goals.
Lean is centered on preserving value with less work. Lean manufacturing is a variation on the theme of efficiency
based on optimizing flow; it is a present-day instance of the recurring theme in human history towards increasing
efficiency, decreasing waste, and using empirical methods to decide what matters, rather than uncritically accepting
pre-existing ideas. As such, it is a chapter in the larger narrative that also includes such ideas as the folk wisdom
of Thrift, Time and Motion Study, Taylorism, the Efficiency Movement, and Fordism. Lean manufacturing is often
seen as a more refined version of earlier efficiency efforts, building upon the work of earlier leaders such as Taylor
or Ford, and learning from their mistakes.
Major elements of lean are derived from the Toyota Product System (TPS), which is Toyota’s unique approach to

manufacturing. Lean methods and other improvement techniques, such as Six Sigma, Total Quality Management,
and Theory of Constraints, have dominated manufacturing trends in the United States since the 1980s. Lean is the
most commonly used approach. Many of these practices have now expanded beyond manufacturing into other
business functions to create lean enterprises.
Lean is a process, a continuous journey, with renewable goals; it is not a destination. Once you achieve your
current targets, it begins all over again with new ones. It never ends because you can always make it better. The
journey to achieve higher efficiency, greater waste reduction, and ongoing continuous improvement is, however,
daunting. Lean is doing more with less. That means achieving more using fewer resources-people, machine, material,
capital, etc. And, doing only those activities that are essential to satisfy customer orders, and doing them well.
Lean is the pursuit of greater operational performance by elimination of waste throughout the organization. The
benefits include:
~~ Reduced lead times
~~ Improved delivery performance
~~ Shorter order-to-cash cycle
~~ Increased sales revenue
~~ Increased profits
~~ Lower operating costs
~~ Reduction in inventory (greater inventory turns)
~~ Improved customer satisfaction
~~ Enhanced supplier relationships
~~ Greater employee morale and retention
~~ Improved product and service quality
~~ Reduced physical space requirement
~~ Availability of additional working capital
Despite its origin in manufacturing, lean principles apply to the whole enterprise. Often along the way, when
lean is implemented properly, most organizations change their thinking about their business practices. It brings the
whole business into the focus from customer order to receiving payment.
Lean Accounting
Lean Accounting is the application of lean thinking to all accounting and finance processes and systems. It is an
essential component of a successful lean transformation for any organization.
Lean accounting uses a method that categorizes costs by value stream rather than by department. This approach
“provides the basis for sound management decisions”. The researchers define value stream accounting as “tracking
revenue and the associated variable costs required to generate those sales.” It is experienced that value stream
costing includes a simpler cost collection method and reduces the number of cost centers. They also list features
of value stream accounting as:
●● Costs calculated weekly
●● No distinction made between direct or indirect costs – all costs of the value stream are considered direct costs
●● Value stream costs include labour, materials, production support, machines and equipment, operation
support, facilities and maintenance

●● Value stream costing provides a more accurate picture by elimination of unnecessary costs outside control
of value stream managers
Lean accounting groups together costs that fall outside of the value stream as “business sustaining costs” that do
not get included in value stream costs. This, in turn, helps the businesses to find better price points for products and
do further research into high-cost areas. The bottom line is that Lean accounting can help business leaders quickly
know if they are heading in the right direction or need to make a change.
Three principles guide Lean Accounting and form the foundation for all of accounting’s work and interaction
with the organization:
i. Customer value: Delivering the relevant and reliable information in a timely manner to all users of the
information inside the organization.
ii. Continuous improvement: Improving Continuous

accounting processes, cross-functional business Improvement
processes and the information used inside the Customer Respect for
business for analysis and decision making. Value People
iii. Respect for people: Adopting a learning
attitude by seeking to understand root causes Principles of
of business problems and issues in a cross- Lean Accounting
functional, collaborative manner.
Lean Accounting facilitates the changes that are required to a company’s accounting, control, measurement, and
management processes to support lean manufacturing and lean thinking.
Most of the companies embarking on lean manufacturing may soon find that their accounting processes and
management methods are at odds with the lean changes they are making. The reason for this is that traditional
accounting and management methods were designed to support traditional manufacturing; they are based upon mass
production thinking. Lean manufacturing breaks the rules of mass production, and so the traditional accounting
and management methods warrant due modifications in tune with the lean changes that the company is embarking.
Lean Accounting enables identification and elimination of non-value adding waste in the accounting and
reporting processes; Improves visual reporting on product lines; and realigns accounting activities to a consulting
role rather than a transaction role. Lean accounting empowers the finance and accounting functions to partner with
the evolving lean enterprise. When the finance department revamps its processes in line with the lean methods, the
time savings and communication gains are substantial.
The purpose of lean accounting is to tell the managers about the flow through the Value Stream; to tell them about
the capacity for extra work in the Value stream; and to tell them about the incremental costs of alternative decisions
and actions. Lean accounting provides a stage that enables the accounting team to move from a transaction focus
to a new high value role of consulting within other areas of the company.
Enterprises using Lean accounting have better information for decision-making, have simple and timely reports
that are clearly understood by everyone in the company. They understand the true financial impact of lean changes;
they focus the business around the value created for the customers, and accounting actively drives the lean
transformation. This helps the company to grow, to add more value for the customers, and to increase cash flow
and value for the stock-holders and owners.
The benefits of Lean Accounting, thus, are:
i. Creating capacity in accounting by eliminating waste in accounting processes.
ii. Accounting fully participating in cross-function continuous improvement.

iii. Flowing relevant and reliable information to all internal customers for effective decision making.
iv. Leveraging accounting’s analytical skills as lean financial coaches throughout the organization.
In other words, Lean Accounting provides service excellence to all of accounting’s customers. Lean accounting
ensures the right people have the right information at the right time to make the right decision in the areas of
pricing, production, sourcing, inventory management, performance measuring, etc.
Principles, Practices and Tools of Lean Accounting

Sl. Principles Practices Tools of lean accounting
1 Lean & simple Continuously eliminates ●● Value stream mapping; current & future state
business accounting waste from the transactions ●● Kaizen (lean continuous improvement)
processes, reports, and other
●● PDCA (Planning, Doing, Checking) and
accounting methods
Acting problem solving
2 Accounting Management control & ●● Performance Measurement Linkage Chart;
processes that continuous improvement linking metrics for cell/process, value streams,
support lean plant & corporate reporting to the business
transformation strategy, target costs, and lean improvement
●● Value stream performance boards containing
breakthrough and continuous improvement
projects
●● Box scores showing value stream performance
Cost management ●● Value stream costing

●● Value stream income statements
Customer & supplier value Target costing

and cost management
3 Clear & timely Financial reporting ●● “Plain English” financial statements
communication of ●● Simple, largely cash-based accounting
information
Visual reporting of financial Primary reporting using visual performance
& nonfinancial performance boards; division, plant, value stream, cell/ process
measurements in production, product design, sales/ marketing,
administration, etc.
Decision-making Incremental cost & profitability analysis using
value stream costing and box scores
4 Planning Planning & budgeting ●● Hoshin policy deployment
from a lean ●● Sales, operations, & financial planning (SOFP)
perspective
Impact of lean improvement ●● Value stream cost and capacity analysis
●● Current state & future state value stream maps
●● Box scores showing operational, financial,
and capacity changes from lean improvement.
●● Plan for financial benefit from the lean changes

Sl. Principles Practices Tools of lean accounting

Capital planning ●● Incremental impact of capital expenditure on
value stream box-score. Often used with 3P
approaches
Invest in people ●● Performance measurements tracking
continuous improvement participation,
employee satisfaction, & cross-training
●● Profit sharing
5 Strengthen internal 1. Internal control based on ●● Transaction elimination matrix

accounting control lean operational controls ●● Process maps showing controls and SOX risks
2. Inventory valuation ●● Simple methods to value inventory without

the requirement for perpetual inventory
records and product costs can be used when
the inventory is low and under visual control.
While Lean Accounting is still a work-in-process, there is now an agreed body of knowledge that is becoming
the standard approach to accounting, control, and measurement. These principles, practices, and tools of Lean
Accounting have been implemented in a wide range of companies at various stages on the journey to lean
transformation. These methods can be readily adjusted to meet any company’s specific needs and they rigorously
maintain adherence to GAAP and external reporting requirements and regulations. Lean Accounting is itself lean,
low-waste, and visual, and frees up finance and accounting people’s time so they can become actively involved in
lean change instead of being merely “bean counters.”
2.5 Six Sigma

Concept
Six Sigma is a set of practices originally developed by Motorola to systematically improve processes by
eliminating defects. A defect is defined as non-conformity of a product or service to its specifications. While the
particulars of the methodology were originally formulated by Bill Smith at Motorola in 1986, Six Sigma was
heavily inspired by six preceding decades of quality improvement methodologies such as quality control, TQM,
and Zero Defects. Like its predecessors, Six Sigma asserts the following:
a. Continuous efforts to reduce variation in process outputs is key to business success
b. Manufacturing and business processes can be measured, analyzed, improved and controlled
c. Succeeding at achieving sustained quality improvement requires commitment from the entire organization,
particularly from top-level management.
The term “Six Sigma” refers to the ability of highly capable processes to produce output within specification. In
particular, processes that operate with six sigma quality produce at defect levels below 3.4 defects per (one) million
opportunities (DPMO). Six Sigma’s implicit goal is to improve all processes to that level of quality or better.
A six-sigma process is one in which 99.99966% of all opportunities to produce some features of a part are
statistically expected to be free of defects. It is a disciplined, data-driven approach and methodology for eliminating
defects (driving toward six standard deviations between the mean and the nearest specification limit) in any process
– from manufacturing to transactional and from product to service.

Six Sigma has two key methodologies: DMAIC and DMADV, both inspired by W. Edwards Deming’s Plan-Do-
Check- Act Cycle: DMAIC is used to improve an existing business process, and DMADV is used to create new
product or process designs for predictable, defect-free performance.
DMAIC
Basic methodology consists of the following five (5) steps:
~~ Define the process improvement goals that are consistent with customer demands and enterprise strategy.
~~ Measure the current process and collect relevant data for future comparison.
~~ Analyze to verify relationship and causality of factors. Determine what the relationship is, and attempt to
ensure that all factors have been considered.
~~ Improve or optimize the process based upon the analysis using techniques like Design of Experiments.
~~ Control to ensure that any variances are corrected before they result in defects. Set up pilot runs to establish
process capability, transition to production and thereafter continuously measure the process and institute
control mechanisms.
DMIADV
Basic methodology consists of the following five steps:
~~ Define the goals of the design activity that are consistent with customer demands and enterprise strategy.
~~ Measure and identify CTQs (critical to qualities), product capabilities, production process capability, and
risk assessments.
~~ Analyze to develop and design alternatives, create high-level design and evaluate design capability to select
the best design.
~~ Design details, optimize the design, and plan for design verification. This phase may require simulations.
~~ Verify the design, set up pilot runs, implement production process and handover to process owners.
Key roles required for successful implementation of Six Sigma

Six Sigma identifies several key roles for its successful implementation:
1. Executive Leadership includes CEO and other key top management team members. They are responsible
for setting up a vision for Six Sigma implementation. They also empower the other role holders with the
freedom and resources to explore new ideas for breakthrough improvements.
2. Champions are responsible for the Six Sigma implementation across the organization in an integrated
manner. The Executive Leadership draws them from the upper management. Champions also act as mentors
to Black Belts. At GE this level of certification is now called “Quality Leader”.
3. Master Black Belts, identified by champions, act as in-house expert coaches for the organization on Six
Sigma. They devote 100% of their time to Six Sigma. They assist champions and guide Black Belts and
Green Belts. Apart from the usual rigour of statistics, their time is spent on ensuring integrated deployment
of Six Sigma across various functions and departments.
4. Experts this level of skill is used primarily within Aerospace and Defense Business Sectors. Experts work
across company boundaries, improving services, processes, and products for their suppliers, their entire
campuses, and for their customers. Raytheon Incorporated was one of the first companies to introduce
Experts to their organizations. At Raytheon, Experts work not only across multiple sites, but across business
divisions, incorporating lessons learned throughout the company.

5. Black Belts operate under Master Black Belts to apply Six Sigma methodology to specific projects. They
devote 100% of their time to Six Sigma. They primarily focus on Six Sigma project execution, whereas
Champions and Master Black Belts focus on identifying projects/functions for Six Sigma.
6. Green Belts are the employees who take up Six Sigma implementation along with their other job
responsibilities. They operate under the guidance of Black Belts and support them in achieving the overall
results.
7. Yellow Belts are employees who have been trained in Six Sigma techniques as part of a corporate-wide
initiative, but have not completed a Six Sigma project and are not expected to actively engage in quality
improvement activities.
Case 3:
Case Study: Six Sigma Reduces Costs & Improve Environmental Impact (Ford Motors)
The Red Flag: Ford’s balanced scorecard system provides reporting tools that offer monthly values versus target
figures, year-to-date/year-end values against target, and a prioritization system using red/green/yellow evaluations
to pinpoint where improvement is needed. Using this evaluation system, the automaker classifies data as:
●● Green: measures are on or over target.
●● Yellow: metrics are under target, but better than last year.
●● Red: results are under target.
In the fall of 2009, data for body paint consumption for the Focus and Kuga were classified as red, thus capturing
the attention of plant officials. A quick review of historical data
showed basecoat paint consumption stood at 3.74 kg/unit in 2007, Performance metrics signaled increases
while current consumption was 4.18 kg/unit. Sensing an opportunity, in basecoat paint consumption at
Ford officials selected this improvement as a Six Sigma Black Belt Ford’s vehicle operations center in
project, offering an ideal fit with the One Ford strategy that focuses Saarlouis, Germany
on “working together effectively as one team.”
Six Sigma Black Belt Project: The project began in October A cross-functional Six Sigma team was
2009 with team member selection. Of the plant’s 7,000 employees, chartered to solve the problem using a
more than 50 are Six Sigma Black Belts and another 400 are trained DMAIC approach
as Green Belts, thus providing a pool of qualified team members
to assist with the project. Team leader and Six Sigma Black Belt
Martin Fischer based his selections on a candidate’s responsibilities, Using a variety of quality tools, the team
subject- matter expertise and process ownership, and on relative identified root causes before developing
need throughout project development, planning, implementation, and testing potential solutions
and follow up. Other factors included communication skills and the
candidate’s ability to interact in a team-based structure.
By reducing paint expenditures, the
Applying the define, measure, analyze, improve, and control
team achieved a $2 million annual
(DMAIC) approach, the team began by defining project stakeholders
savings
using a SIPOC (Suppliers, Inputs, Process, Outputs, Customers)
analysis. This analysis led to three groups— internal, external, and
a mixed group that contained both internal and external customers.
Ford entered this project in ASQ’s 2011
The mixed group included not only customers who purchase the
International Team Excellence Award
cars, but also internal customers such as the process owners, in this
competition where it earned finalist
case the paint shop and the quality control group.
honors

Define: The goals of the project were threefold:

1. Reduce costs: Reduce paint consumption to lower production costs.
2. Improve customer satisfaction: Improve process capability to better meet customer needs.
3. Lower environmental impact: Reduce solvent consumption to achieve a better VOC balance.
The team predicted the degree of impact for each goal by measuring anticipated benefits against organizational
goals and measures.
They determined:
●● The degree of impact for cost reduction was high, as $1.5 million could be saved annually.
●● Customer satisfaction impact was medium with a target of 127.000 ppm (defective parts per million)
reduction.
●● Environmental impacts were also medium with a projected 50.000 kg annually in VOC savings.
Measure: Several tools were used early in the measurement phase. For example, value-stream mapping served as
a visual tool to help the team understand the flow of material and the paint application process. Statistical measures
helped them filter, evaluate, and obtain strong data for the project. Cause-and effect diagrams were useful for
identifying the root causes of consumption and performance issues, and brainstorming sessions were used to rate
all potential causes. The next step was creating a data collection plan to help narrow the list of potential root causes
by focusing on the following factors or critical Xs:
1. Daily basecoat consumption. Is there any dependency based on day or shift?
2. Paint film thickness check. Is there an increase, and if so, why?
3. Consumption per robot (automated painter). Are there differences, and if so, why?
4. Consumption per manual painter. Monitor consumption to check the process capability.
5. First-time through rate versus consumption. A low rate means more repairs, which translates to higher
basecoat use.
6. Application equipment. Check for damages or technical problems.
Analyze: The Six Sigma team conducted a 5 Why analysis, as well as test trials on the six potential root causes.
The results showed that factors one, two, four, and five were not significant. Factor three, consumption per
robot, showed an increase for the liftgate robot. Through testing of factor six—application equipment—the team
discovered a damaged solvent recovery valve that warranted further investigation. Additional testing uncovered
that a defective solvent recovery valve was causing a direct paint flow from the color changer to the recycling tank,
thus increasing consumption. Normally, the solvent recovery valve opens only for the cleaning program to bring
the cleaning solvent back to a recycling tank.
Improve: The team used a variety of tools to develop solutions/improvement actions to address the two likely
root causes. Value-stream mapping and benchmarking activities proved useful in the search for a manual solution
to monitor the valve. On the other hand, while zeroing in on the robot issue, the team reviewed the value-stream
map and discovered they could change the automatic process to a manual one for painting the liftgates. Also,
through research and discussions with suppliers, they realized the plant could apply paint more efficiently by
upgrading to an electrostatic paint application process.
Based on the outcome of the analyze phase, four potential improvement actions were identified for the defective
solvent recovery valve factor:
1. Replace plastic valves with stainless steel valves.

2. Create an automatic recovery valve check system.

3. Check the valves weekly.
4. Eliminate the solvent recovery process.
The team used four primary methods to select the final improvement actions: test trials to evaluate stainless steel
valves against plastic valves, technical research to develop an automatic recovery valve check system, brainstorming
and value-stream mapping to determine the effectiveness of a weekly valve check, and the elimination of the
solvent recovery process.
The test results revealed that a quick, inexpensive change from plastic to stainless steel valves would result in a
45 percent performance improvement. Testing also demonstrated that an automatic recovery valve check system
would be cost effective and could offer an effective error-proofing device.
For the liftgate robot factor, three potential solutions were identified:
1. Develop a new cleaning program.
2. Change the robot process to a manual paint application.
3. Upgrade to an electrostatic paint application.
Testing focused on improving the existing cleaning program and then comparing the consumption data from the
robot process to a manual process. The team also created a cost-benefit analysis for an upgrade to an electrostatic
paint application. Tests showed there was no significant difference between the old and the new cleaning program.
But, by simply changing to manual only painting processes for interior painting, it was estimated that Ford could
save 0.28 kg/unit. Finally, the team also determined that upgrading to an electrostatic paint application system
would not be cost effective.
Once the solutions were finalized, the team created a three-step implementation plan that included the following
steps:
●● Think: Plan all necessary implementation activities.
●● Act: Implement the solutions.
●● Control: Check if solutions were correctly implemented.
Yet another critical element in the project was overcoming stakeholder resistance to the solutions. This was
accomplished through effective relationship building as well as providing data, training, and opportunities to
discuss the project solutions.
Once the solutions were implemented, the team achieved every project goal and even exceeded the expected
cost reduction by a half million dollars annually. More specifically, in meeting these goals, the basecoat paint
consumption dropped from 4.18 kg/unit to a mean consumption of 3.3 kg/unit.
Control: The new monitoring system and standard operating procedures are vital to helping the Saarlouis plant
sustain the results gained in this project. This system provides a real-time view of paint consumption in detail for
each of the four paint booths. All of the plant’s standard operating procedures are part of the plant’s ISO 9001
compliant quality management system and are therefore included in routine audits. This helps assure that paint
consumption will remain within specifications.
Honors
Because of the project’s results, Ford’s global Six Sigma organization nominated the team to compete in ASQ’s
International Team Excellence Awards (ITEA) process. The project earned finalist honors, and team members had

the opportunity to present their project at the 2011 World Conference on Quality and Improvement. This project
was a strong candidate for the competition because it was a cross-functional team that included members from
production, maintenance, quality, manufacturing engineering, and the supplier: “They worked together as a team
in an excellent way, proving the power of a team and the sum of competencies in a team.”
(Resource: Making the Case for Quality, Ford Team Uses Six Sigma to Reduce CostsWhile Improving
Environmental Impact, Janet Jacobsen. (www.asq.org/2011/09))
Terms to Master
Quality: Quality is that characteristic or a combination of characteristics that distinguishes one article from the
other or goods of one manufacturer from that of competitors or one grade of product from another when both are
the outcome of the same factory.
Quality Management: Quality Management is defined as “coordinated activities to direct and control an
organization with regard to quality” (ISO 9000:2000).
Prevention Costs: Prevention Costs are all costs incurred in the process of preventing poor quality from
occurring.
Appraisal costs: Appraisal Costs are incurred in the process of uncovering defects.
Internal Failure Costs: Internal Failure Costs are associated with discovering poor product quality before the
product reaches the customer site.
External Failure Costs: External Failure Costs are incurred when inferior products are delivered to customers.
Total Quality Management: Total Quality Management is a philosophy of continuously improving the quality
of all the products and processes in response to continuous feedback for meeting the customers’ requirements.
Lean Accounting: Lean Accounting is the application of lean thinking to all accounting and finance processes
and systems.
Six Sigma: Six Sigma is a set of techniques and tools for process improvement.
1. Write an elaborative note on managing quality in a competitive environment.
2. Detail and discuss the costs of quality.
3. “Total Quality Management is vital for growth” – Justify.
4. Narrate the steps for implementing the Total Quality Management.
5. What do you understand by 6C’s?
6. State the relevance of PRAISE analysis.
7. Comment about the utility of Pareto Analysis.
8. Discuss the significance of lean accounting.
9. Narrate the principles, practices, and tools of lean accounting.
10. Define and discuss DMAIC.
11. Define and discuss DMIADV.

QQ1. TQM stands for

A. Technical Quantitative Management
B. Total Quality Management
C. Theory of Queuing Management
D. None of the Above Answer: B.
QQ2. Four Ps of Total Quality Management

A. Principles, Project, Problem, & Process
B. People, Process, Problem & Preparation
C. Product identification, Product quality, Product utility & Product expectation
D. None of the above Answer: B.
QQ3. PRAISE stands for

A. Appreciating someone
B. Product, Recognition, Adoption, Invention, Solution & Evaporation
C. Problem Identification, Ranking, Analysis, Innovation, Solution & Evaluation
D. None of the above Answer: C.
QQ4. Six Sigma is about

A. Quality systems
B. Quality control process
C. Statistical technique
D. None of the above Answer: A.
QQ5. DMIADV is a methodology associated with

A. Pareto Analysis
B. PRAISE
C. Six Sigma
QQ6. Pareto analysis recognizes

A. 80:20 Rule
B. 50:50 Rule
C. 20:80 Rule
QQ 7. Cost of Rework is a cost related to

A. Internal failure
B. Appraisal
C. Prevention

QQ 8. The cost incurred to ensure that failures do not happen

A. External failure cost
B. Internal failure cost
C. Prevention cost
QQ 9. Which of the following is not the quality parameter for service organizations?
A. Consistency
B. Friendliness
C. Durability
D. Promptness Answer: C.
Question: Match the following:
(a) Staff training i. Six Sigma

(b) ISO 9000:2000 ii. Internal Failure cost
(c) Package Inspection iii. Quality control costs
(d) DMAIC iv. Quality Systems
(e) Six C v. Appraisal Cost
(f) Six Sigma vi. External Failure Cost
(g) Down time due to quality defects vii. Prevention Cost
(h) Cost for achieving high quality viii. Total Quality Management
(i) Lost sales ix. 3.4 DPMO
Answer: (a) – vii, (b) – iv, (c) – v, (d) – i, (e) – viii, (f) – ix, (g) – ii, (h) – iii, (i) - vi
Problems for Practice

Problem 1
Zebra Limited introduced a quality improvement program and following results are observed -
` In lakhs
Particulars 2019-20 2020-21
Sales 10,000 10,000
Scrap 100 50
Rework 650 550
Production inspection 250 325
Product Warranty 500 250
Quality Training 125 250
Materials inspection 120 90

Required:
(a) Classify the quality costs and express each class as a percentage of sales
(b) Compute the increase in the amount of profit due to quality improvement
Solution
(a) Classification of Quality Costs
` Lakhs As % to Sales
Sl Cost classification Element
2019-20 2020-21 2019-20 2020-21
1 Prevention Costs Quality Training 125 250
Material Inspections 120 90
Sub Total 245 340 2.45% 3.40%
2 Appraisal Costs Production Inspection 250 325 2.50% 3.25%
3 Cost of Internal Failures Scrap 100 50
Rework 650 550
Sub Total 750 600 7.50% 6.00%
4 Cost of External Failures Product Warranty 500 250 5.00% 2.50%
5 Total 1,745 1,515 17.45% 15.15%
(b) Increase in profits due to quality improvement

Quality costs incurred in 2019 -20 = ` 1,745 lakhs
Quality costs incurred in 2020 -21 = ` 1,515 lakhs
Total cost saving during 2020 -21 = ` 230 lakhs
So, increase in profits during 2020 -21due to quality improvement = ` 230 lakhs
Problem 2
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 100 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 100 units, with defect rate of 5%. If the defectives are not detected,
they are utilized in production causing a damage of ` 180 per 100 units of the defective component.
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.
Required:
(a) Please justify the Inspection at the point of receipt and give your working for the same.
(b) Assuming a total requirement of 10,000 units, ascertain the lowest supplier.

Solution
Step 1: Computation of Cost per 100 units of good components without Inspection
Sl. Particulars X Ltd Y Ltd

1 Number of units Purchased 10,000 10,000
2 Purchase Price (180 ÷ 100) × 10,000 = ` 18,000 (174 ÷ 100) × 10,000 = ` 17,400
3 Production Damage (Units) (10,000 × 3%) = 300 units (10,000 × 5%) = 500 units
4 Cost of Production Damage (300 ÷100) × 180 = ` 540 ((500 ÷100) × 180 = ` 900
5 Total Cost (2+4) 18,000+540 = ` 18,540 17,400+900 = ` 18,300
6 Number of good components (10,000- 300) = 9,700 units (10,000 – 500) = 9,500 units
7 Cost per 100 good (18,540 ÷ 9,700) × 100 = ` 191.13 (18,300 ÷ 9,500) × 100 = ` 192.63
components (5 ÷ 6)
Step 2: Computation of Cost per 100 units of good components with Inspection

1 Number of units Purchased 10,000 10,000
2 Defective Units 3% of 10,000 = 300 units 5% of 10,000 = 500 units
3 Defectives not detected (10%) 30 units 50 units
4 Defectives detected (2-3) 270 units 450 units
5 Components paid for (1 - 4) 9,730 units 9,550 units
6 Purchase Price (9,730 ÷ 100) × 180 = ` 17,514 (9,550 ÷ 100) × 174 = ` 16,617
7 Inspection Cost (10,000 ÷ 100) × 24 = ` 2,400 (10,000 ÷ 100) × 24 = ` 2,400
8 Cost of Production Damage (30÷100) × 180 = ` 54 ((50÷100) × 180 = ` 90
9 Total Cost (6+7+8) 17,514 + 2,400 + 54 = ` 19,968 16,617 + 2,400 + 90 = ` 19,107
10 Cost per 100 good (19,968 ÷ 9,730) × 100 = ` 205.22 (19,107 ÷ 9,550) × 100 = ` 200.07
components (9 ÷ 5)
Step 3: Comparison of Cost per 100 good components

1 Without Inspection ` 191.13 ` 192.63
2 With Inspection ` 205.22 ` 200.07
3 Observation Cost with inspection is higher Cost with inspection is higher

4 Lowest Supplier X without inspection is the
cheapest

Recommendation:
a. Inspection at the point of receipt is not advantageous, due to additional cost per 100 good components, i.e.
(` 205.22 – ` 191.13) = ` 14.09 in case of X Ltd, and (` 200.07 - ` 192.63) = ` 7.44 in case of Y Ltd.
b. Purchase from X Ltd. without inspection is cheaper, as there is a cost saving of ` 1.50, i.e. (192.63 -191.13)
per 100 good components
Problem 3
Rags Ltd. manufactures and sells premium quality of sports shoes in India. Noted sports clubs and its members
are the main customers. Finished products show some rectifiable defects. These problems can be detected and
rectified during internal inspection. Inspection cost is ` 30 per unit. Rectification cost is ` 18 per unit.
During 2021, 60000 pairs of shoes were manufactured and sold. After inspection defect was detected in respect
of 5% of output. Inspection cost is ` 30 per pair. After sales, customers reported defects in respect of 6% of output.
These shoes were received back from customers at a transportation cost of ` 10 per pair. Due to negative publicity
arising out of sale of defective materials, loss in sales is expected in next year to the extent of 5% of external failures.
Required:
a. Analyze the cost of quality showing its elements separately with working.
b. If the selling price per pair of shoes is ` 600 and variable cost is 60% of sales, fixed cost is ` 5,50,000 p.a.,
prepare the profitability statement for the product during 2021.
Solution
(a) Statement of Costs of Quality
Sl. Element `
(a) Inspection or Appraisal Cost (30 × 60,000 shoes) 18,00,000
(b) Internal failure (re-work) cost (5% × 60,000 × ` 18) 54,000
(c) External failure cost (i.e., transportation + re-work cost) 1,00,800
[6% × 60,000 × ` 10 + 18)]
(d) Opportunity cost (i.e., loss of contribution) 43,200
[Loss in Sales @ 5% × (6% × 60,000) × ` 600 × 40%)]
(e) Total Quality Cost 19,98,000
(b) Profitability statement

Sl. Element `
(a) Sales (60,000 × ` 600) 3,60,00,000
(b) Less: Variable Cost (60%) 2,16,00,000
(c) Contribution 1,44,00,000
(d) Less: Quality Cost (as above) 19,98,000
(e) Contribution, net of Quality Costs 1,24,02,000
(f) Less: Fixed Cost 5,50,000
(g) Profit 1,18,52,000

Decision Making Techniques (Case Study-Based Approach)
Decision Making Techniques (Case

Study-Based Approach)
3

3.1 Decisions Involving Alternative Choices
3.2 Pricing Decisions and Strategies
3.3 Transfer Pricing
3.4 Relevant Cost Analysis
3.5 Target Costing
3.6 Product Life Cycle Costing
3.7 Asset Life Cycle Costing
3.8 Decision Making using Probability

Decision Making Techniques (Case Study-

Based Approach) 3
3.1 Decisions Involving Alternative Choices
Decision Making
Decision making is the outcome resulting from the process of evaluation of the available alternatives and
choosing the best. Some instances of alternative choice decisions are: make or buy, change the product-mix, take
or refuse orders, place special orders, export versus local, shut down or continue, expand or contract, own or lease,
retain or replace, repair or renovate, now or later, change versus status quo, slower or faster, select sale territories,
replace present equipment with new machinery, sell at split-up point or process further, etc.
A famous American poet, Robert Frost, wrote, “Two roads diverged in a wood, and I took the one less travelled
by, and that has made all the difference.” But unfortunately, not every decision is as simple as “Let’s just take this
path and see where it goes,” especially when a decision is related to business. Whether you manage a small team
or are at the head of a large corporation, your success and the success of your company depend on you making the
right decisions—and learning from the wrong decisions.
That said, the business decision-making is a step-by-step process allowing professionals to solve problems by
weighing facts, examining alternatives, and choosing a path from there. This defined process also provides an
opportunity, at the end, to review whether the decision was the right one. Though there are many slight variations of
the decision-making framework floating around in business textbooks, and in leadership presentations; professionals
most commonly use the following seven steps.
1. Identify the Problem: In order to make a decision, you must first identify the problem you need to solve or
the question you need to answer. Clearly
define your problem. If you mis-identify the Identify the
problem to be solved, or if the problem Problem
you’ve chosen is too broad, you’ll knock the
decision train off the track before it even
Review the Gather Relevant
leaves the station. If you need to achieve a
Results Information
specific goal from your decision, make it
measurable and timely.
2. Gather Relevant Information: Once you Implement Identify the
have identified your problem for decision the Choice Alternatives
making, it’s time to gather the information
relevant for the purpose. Do an internal
assessment, seeing where your organization Choose from Evaluate the
has succeeded and failed in areas related to Alternatives Evidence
your decision. Also, seek information from
external sources, including studies, market research, and, in some cases, evaluation from external consultants.

Keep in mind, you can become bogged down by too much information and that might only complicate the
process.
3. Identify the Alternatives: With relevant information now at your fingertips, identify possible solutions to
your problem. There is usually more than one option to consider when trying to meet a goal. For example, if
your company is trying to gain more engagement on social media, your alternatives could include paid social
advertisements, a change in your organic social media strategy, or a combination of the two.
4. Evaluate the Evidence: Once you have identified multiple alternatives, evaluate the evidence for or against
said alternatives. See what companies have done in the past to succeed in these areas, and take a good look at
your organization’s own wins and losses. Identify potential pitfalls for each of your alternatives, and weigh
those against the possible rewards.
5. Choose from Alternatives: This is the part of the decision-making process where you actually make the
decision. Hopefully, you’ve identified and clarified what decision needs to be made, gathered all relevant
information, and developed and considered the potential paths to take. You should be prepared to choose.
6. Implement the Choice: Once you’ve made your decision, do act on it! Develop a plan to make your decision
tangible and achievable; and then assign tasks to your team.
7. Review the Results: After a predetermined amount of time—which you defined in step one of the decision-
making process—take an honest look back at your decision. Did you solve the problem? Did you answer the
question? Did you meet your goals? If so, take note of what worked for future reference. If not, learn from
your mistakes as you begin the decision-making process again.
Relevant to recall is that Strategic Cost Management encompasses the entire spectrum of value addition process
which involves taking crucial decisions. Here, we go to understand vital concepts relating to decision making tools
and techniques.
Cost Behaviour
Cost Behaviour refers to the changes in input costs in relation to the level of production. Costs may increase or
decrease proportionately with increasing or decreasing level of production, such costs being called variable costs;
or they may not change at all with the increases or decreases in the level of production, such costs being termed as
fixed costs. Some costs, semi-variable in nature, may have both variable and fixed elements. Such of these costs
may increase more or less than in direct proportion, and there may be step changes in costs. To a large extent
cost behaviour may be dependent on a relevant range of production capacity and the time period assumed for the
purpose.
Each product or service has variable costs that are incurred when the product is produced. The examples cover
Raw Material, Direct Wages, Power, Fuel, Chemicals & Other Consumables, Packing Material, Sales Commission,
Distribution Expenses, and so on. Each business has certain fixed costs which must be paid for every month, whether
or not any production takes place. The examples include Employee Cost, certain categories of Administrative
Expenses, Period related Contractual Expenses, Interest Burden on fixed loans, etc.
There are semi-variable costs that go up or down depending on the level of business activity. The examples that
can be stated are Stores & Spares, Repairs & Maintenance, Certain items of Administrative & Other Expenses,
etc. Semi variable costs can be segregated into variable and fixed elements by adopting an appropriate statistical
technique.
Cost is a fact, and so is the Cost Behaviour. Analysis of Cost Behaviour is the key for effective Cost Control.
Proper segregation of costs into variable and fixed elements enables adopting relevant control tools and techniques.
Variable Costs are controlled by means of standards at the operational level whereas fixed costs are controlled by

means of budgets at the strategic level. Variable Costs are prone to control even at the lower level; whereas Fixed
Costs are prone to better controls from the higher level. It is a proven experience that some of the fixed elements
too can be converted into variable elements through long term strategic progressions.
The main objective of any costing system is to determine scientifically the cost of a product or service. Costs are
of various kinds as may be detailed in a cost sheet. But all of them can be segregated into two distinct categories,
viz. direct costs and indirect costs.
Direct costs are the costs which are traceable to the products or the services that are being offered. On the other
hand, indirect costs, which are traditionally called ‘overheads’, are not traceable to the products or services. Hence
these overheads are first identified, classified, allocated, and apportioned to a convenient cost centre, reapportioned
to production centres and finally absorbed by the cost units i.e., the products or services.
Direct costs have traditionally been the target of management scrutiny and evaluation. Indirect costs, on the other
hand, have not had that level of scrutiny they deserve. Indirect costs get pooled at the cost centre level. The problem
associated with such a pooling is that it is very difficult to have the visibility to know what costs are truly necessary
and what are not. The lack of adequate visibility impaired the level of scrutiny of indirect costs.
Charging the direct costs to the products is comparatively simple and can be done with remarkable accuracy.
Broadly speaking, all the direct costs are variable by nature whereas all the indirect costs are subject to multiple
behaviour patterns. The following table provides some examples relating to the general behaviour pattern of
elements of cost.
General Behaviour Pattern of Elements of Cost
Item Traceability Behaviour

Raw Materials Direct Variable
Process Materials and Chemicals Direct Variable
Utilities (Power, Fuel, etc.) Direct Variable
Direct Employee Cost Direct Variable
Direct Expenses Direct Variable
Consumables, Stores & Spares Indirect Semi Variable
Repairs & Maintenance Indirect Semi Variable
Quality control Expenses Indirect Semi Variable
Research & Development Expenses Indirect Discretionary
Technical know-how Fee /Royalty Indirect Contractual
Depreciation / Amortization Indirect Fixed
Other Production Overheads Direct / Indirect Variable / Semi Variable
Primary Packing Cost Direct Variable
Administrative Overheads Indirect Semi Fixed
Secondary Packing Cost Indirect Variable
Selling and distribution overheads Direct / Indirect Variable / Semi Variable
Interest and Financing charges Indirect Semi Variable / Fixed

The concept of Contribution

Marginal costing technique has given birth to the concept of contribution wherein contribution is calculated as
sales revenue less variable cost (marginal cost). Contribution may be defined as the profit before the recovery of
fixed costs. Contribution is excess of the Sales Value over the Variable Cost. It represents the margin available to
meet the Fixed Costs. Excess of Contribution over Fixed Cost denotes the Profit. The ratio of Contribution to Sales
is known as Profit Volume (PV) Ratio. We, thus, have the derivations:
Contribution = Sales – Variable Costs
Profit = Contribution – Fixed Costs
Profit Volume Ratio = (Contribution / Sales) × 100
Sales = Contribution / Profit Volume Ratio
Fixed costs will be the same for any volume of sales and production provided that the level of activity is
within the ‘relevant range’; Revenue will increase by the sales value of the item sold; Cost will increase by the
variable cost per unit and Profit will increase by the amount of contribution earned from the extra item. The total
contribution margin generated by an entity represents the earnings available to pay for the fixed expenses and to pool
into the profit.
Example 1:
ABL manufactures a high-end tractor viz. ‘Model T’. The contribution analysis of the tractor for a month is
furnished in the table that follows.
ABL: Contribution Analysis of ‘Model T’ for the month of …..
Serial Particulars Data

1 Sales (Number) 900
2 Sales
i. Selling Price (`. / Piece) 7,00,000
ii. Sales (`. Lakhs) 6300.00
3 Variable Costs (`. Per Piece)
i. Raw Material 4,34,000
ii. Variable Expenses 1,26,000
iii. Sub Total (i + ii) 5,60,000
iv. % to Selling Price 80.00
4 Contribution
i. `. Per Piece (2(i) - 3(iii)) 1,40,000
ii. Total (`. Lakhs) (1 × 4(i)) 1260.00
iii. Profit Volume Ratio (%) 20.00
5 Fixed Costs (`. Lakhs) 882.00
6 Profit (`. Lakhs) (4(ii) - 5) 378.00

It may be observed from the analysis that ‘Model T’ generates a contribution of `. 1,40,000 per piece and `.1260
lakhs per month. After deducting Fixed Costs of `. 882.00 lakhs, ABL is left with a profit of `. 378 lakhs. The
variable costs work out to 80% and the PV ratio computes to 20%. The contribution margin concept can be applied
throughout a business, for individual products, product lines, profit centers, subsidiaries, distribution channels,
sales by customer, and for an entire business.
Break Even Analysis

Another important offshoot of marginal costing is break even analysis. It enables the enterprise to determine with
better accuracy whether a product is a profitable one or not. Best of all, the analysis can be applied to evaluate every
product or service that is on offer. In simple terms, break-even analysis is a simple way to determine how much of
the product must be sold to generate a specific level of profitability.
Break Even Point (BEP) signifies the level of activity at which there is neither profit nor loss. It is the point
where ‘Total Revenues’ equal ‘Total Costs’. It is also the level of activity where Contribution equals the Fixed
costs. Impliedly, BEP also signifies that Contribution is just sufficient to meet the Fixed Costs. Performance above
the breakeven level reflects profit. Sales above the breakeven level reflect the Margin of Safety. Performance
below the breakeven level reflects loss. BEP Sales in value can be ascertained by dividing the Fixed Costs with PV
Ratio. Taking forward the illustration introduced in the preceding paragraphs, the BEP Sales of ‘Model T’ can be
calculated as demonstrated in the following table followed by a graph:
ABL: BEP Analysis of ‘Model T’ for the month of …..
Serial Particulars Data
1 Sales (`. Lakhs) 6300.00

2 Contribution (`. Lakhs) 1260.00
3 Profit Volume Ratio (%) 20.00
4 Fixed Costs (`. Lakhs) 882.00
5 BEP Sales (`. Lakhs) (4/3) 4410.00
6 BEP Sales (Number) (4410.00/7.00) 630.00
The workings in the table show that ABL breaks even at a sale level of ` 4,410 lakhs. The BEP Sales computes
to 630 in numbers and works out to 70.00% ((630/900) × 100) of the total sales. At this level, a contribution of
` 882.00 lakhs (630 × 1,40,000) is generated which is equivalent of the Fixed Costs. Fixed costs having already
been covered by the breakeven sales, the contribution accruing from margin of safety equals to the profit which
in the instant case works out ` 378 lakhs being 20% of 1890 lakhs (i.e., 6,300 - 4,410). A higher margin of safety
indicates better financial strength whereas a lower margin of safety throws up financial concerns.

ABL: Break Even Graph of ‘Model T’
We, thus, derive:

Break Even Point = Fixed Costs ÷ Profit Volume Ratio
Margin of Safety = Total Sales – Breakeven Sales
Profit = Margin of Safety × Profit Volume Ratio
Break-even pricing is a pricing methodology in which the price is set at a point where the product will earn
zero profit. Break-even pricing is a common tool used by many an organisation to set the pricing strategy of
their portfolio of products. The methodology helps the entity in setting up the lowest acceptable price. The main
motive, in such instances, would be to increase the market share rather than earning profits. Numerous managerial
decisions can be taken with the help of marginal costing, some of which are discussed in the following paragraphs.
Profit Planning
Contribution analysis is quite helpful in determining the profit targets and sales levels. Assuming that ABL
intends to achieve a profit target of `400 lakhs for ‘Model T’ as against the existing amount of `378 lakhs, the
relevant computations will move as tabulated below:
ABL: Profit Plan of ‘Model T’
Serial Particulars Formula / Workings Result

1 Profit Target ( ` Lakhs) Intention 400.00

Serial Particulars Formula / Workings Result

2 Contribution Target (Fixed Costs + Target Profit) 1282.00
= 882.00 + 400.00
3 Sales Target ( ` Lakhs) (Contribution ÷ PV Ratio) 6410.00
= 1282.00 ÷ 20%
4 Sales Target (Number) (Sales in Lakhs ÷ Sale Price) 915.71
= 64,10,00,000 ÷ 7,00,000 i.e., say 916 units
At a production level of 916 units, the additional sixteen units will bring in an additional contribution of `22.40
lakhs (i.e.,16 units x `1,40,000 per unit) and push up the profit from the existing amount of `378.00 lakhs to the
intended level of `400.40 lakhs.
Key Factor Analysis

Key Factor Analysis enables allocation of the available resources towards achieving maximum contribution and
thereby maximum profits. When there is any limitation in relation to any of the input factors, the choice can be
made by ascertaining the contribution per unit of that factor of production which is limited in the given situation.
Such a factor of production which is limited in the question is called key factor or limiting factor. The limiting
factors could be any of the critical input resources such as scarce raw materials, skilled labour hours, or special
machine hours, and so on. In such an eventuality, the input resources can be allocated amongst the competing
products on the basis of contribution per unit of the input. The product with the highest contribution is given the
first preference followed by others in a similar suit.
Impact Analysis
The technique of Marginal Costing facilitates analysis of the impact on profits of various changes in production
and cost factors. In the event that ABL can increase or decrease its production by 50 units of ‘Model T’, the impact
analysis would run as follows.
ABL: Impact Analysis for Different Levels of Production of ‘Model T’
Serial Particulars Existing Level Increased Level Decreased Level

1 Number of Units 900 950 850
2 Sales @ `7,00,000 per unit (` Lakhs) 6300.00 6650.00 5950.00
3 Contribution @ 20% PV Ratio 1260.00 1330.00 1190.00
4 Fixed Costs (` Lakhs) 882.00 882.00 882.00
5 Profit (` Lakhs) 378.00 448.00 308.00
6 Profitability (%) 6.00 6.74 5.18
7 Impact on Profit (` Lakhs) 70.00 (70.00)
8 Impact on Profitability (% Points) 0.74 (0.82)
The computations in the table are self-explanatory. The increase in production by 50 units will add up `70 lakhs
to the profits whereas the decrease by 50 units will reduce the profits by the same amount. However, in case of

reduction the impact on profitability is higher viz. 0.82 percentage points as against 0.74 percentage points for the
increase. Similar impact analysis can be carried out for any changes in relation to Sale Price, Variables Costs, and
other relevant factors.
Evaluation of Alternatives
Contribution Analysis is helpful in determination of profitability of the products as also choosing between the
competing products. In a situation where ABL has a choice of using its enhanced level of capacity either for
producing 50 units of ‘Model T’ or 50 units of another model called ‘Model P’, the evaluation can be carried out
as under.
ABL: Evaluation of ‘Model T’ versus ‘Model P’
Serial Particulars Model T Model P

1 Number of Tractors 50 50
2 Selling Price ( ` / Piece) 7,00,000 8,00,000
3 Variable Costs ( ` Per Piece) 5,60,000 6,40,000
4 Contribution
i. ` Per Piece (2-3) 1,40,000 1,60,000
ii. Total ( ` Lakhs) (1 × 4(i)) 70.00 80.00
5 Differential Contribution ( ` Lakhs) 10.00
6 Preferred Choice Model P
Between the two products, ‘Model T’ and ‘Model P’, per unit contribution of ‘Model P’ is higher at `1,60,000/-
in comparison to the per unit contribution of `1,40,000/- of ‘Model T’. Hence the obvious choice, for utilising the
enhanced capacity, falls on ‘Model P’ whereby differential contribution of ` ten lakhs is generated in comparison.
The evaluation can extend to many other decisions such as Make or Buy, Accept or Reject an order, Determination
of selling price in different conditions, Replace one product with some other product, Shutdown or Continue and
so on. The illustrative examples that follow reflect the real time situations at the ground level and are symbolical
to case studies.
Illustration 1. (Computation of BEP & Profit Planning)

The income statement of Ashok Gears Ltd. is summarized as below:
Net Revenue ……………………………………………………. ` 80,00,000
Less: Expenses (including `40,00,000 of Fixed Cost) …………. ` 88,00,000
Net Loss……………………………………………. …………… ` 8,00,000
The manager believes that an increase of `20,00,000 as fixed expenditure in advertising outlays will increase the
sales substantially. His plan was approved by the Board.
You are required to calculate:

(i) At what sales volume will the Company have break even?
(ii) What sales volume will result in a Net Profit of ` 4,00,000?

Answer:
(i) Computation of Break-Even Sales
Net Revenue = ` 80,00,000
Variable Expenses = ` (88,00,000 - 40,00,000) = ` 48,00,000
Contribution = (80,00,000 – 48,00,000) ` 32,00,000
Contribution Margin Ratio = 32,00,000 ÷ 80,00,000 = 40%
Revised Fixed Cost = (Existing 40,00,000 +20,00,000 of Advertising) = ` 60,00,000
Break Even Sales = (Fixed Cost ÷ Contribution Margin Ratio) = (60,00,000 ÷ 40%)
= ` 1,50,00,000
(ii) Computation of sales level to earn a Net Profit of ` 4,00,000
Targeted Contribution = (Fixed Cost + Profit) = (60,00,000 + 4,00,000)
= ` 64,00,000
Required Sales = (Targeted Contribution ÷ Contribution Margin Ratio) = (64,00,000 ÷ 40%)
= ` 1,60,00,000
(Explanatory Comment: The problem brings forth the primary application of marginal costing in manufacturing
sector for the purposes of calculating the BEP and profit planning.)
Illustration 2. (Accept or Reject)

A manufacturing company currently operating at 80% capacity has received an export order from Middle East,
which will utilise 40% of the capacity of the factory. The order has to be either taken in full and executed at 10%
below the current domestic prices or rejected totally. The current sales and cost data are given below:
Sales ` 16.00 lakhs
Direct Material ` 5.80 lakhs
Direct Labour ` 2.40 lakhs
Variable Overheads ` 0.60 lakhs
Fixed Overheads ` 5.20 lakhs
The following alternatives are available to the management:

A. Continue with domestic sales and reject the export order.
B. Accept the export order and allow the domestic market to starve to the extent of excess of demand.
C. Increase capacity so as to accept the export order and maintain the domestic demand by:
(i) Purchasing additional plant and increasing 10% capacity and thereby increasing fixed overheads
by ` 65,000, and
(ii) Working overtime at one and half time the normal rate to meet balance of the required capacity.
Required: Evaluate each of the above alternatives and suggest the best one.

Answer:
Alternative (A): Continue with domestic sales and reject the export order.
Serial Description Workings ` Lakhs
1 Capacity Given – 80%

2 Sales Given 16.00
3 Variable Costs Given
a. Direct Material 5.80
b. Direct Labour 2.40
c. Variable Overheads 0.60
d. Sub Total 8.80
4 Contribution (2 - 3) 7.20
5 Fixed Costs Given 5.20
6 Profit (4 – 5) 2.00
Alternative (B): Accept the export order and allow the domestic market to starve to the extent of excess of
demand
This alternative envisages utilization of 40% of the capacity for the export order and 60% of the capacity for
domestic market. Further, the export order is to be executed at 10% below the current domestic prices. Accordingly:
Sales at 100% Capacity = (16 ÷ 80%) = `20 Lakhs
Value of the export order = (40% of Capacity × 90% of the Price) = (20 × 40% × 90%) = ` 7.20 lakhs.
Value of the domestic sales = (20 × 60%) = ` 12.00 lakhs.
1 Capacity Export 40% + Domestic 60%

2 Sales 7.20 + 12.00 19.20
3 Variable Costs
a. Direct Material (5.80 / 80%) 7.25
b. Direct Labour (2.40 / 80%) 3.00
c. Variable Overheads (0.60 / 80%) 0.75
d. Sub Total 11.00
5 Fixed Costs Given 5.20
6 Profit (4 – 5) 3.00
Alternative (C): Increase capacity so as to accept the export order and maintain the domestic demand by:
(i) Purchasing additional plant and increasing 10% capacity and thereby increasing fixed overheads by
` 65,000, and

(ii) Working overtime at one and half time the normal rate to meet balance of the required capacity.
1 Capacity Export 40% + Domestic 80%

2 Sales 7.20 + 16.00 23.20
3 Variable Costs
a. Direct Material (5.80 / 80%) × 120% 8.70
b. Direct Labour (2.40 / 80%) × 120% 3.60
c. Variable Overheads (0.60 / 80%) × 120% 0.90
d. Overtime Premium (2.40 / 80%) × 10% × 50% 0.15
e. Sub Total 13.35
5 Fixed Costs (5.20 + 0.65) 5.85
6 Profit (4 – 5) 4.00
Suggestion: Alternative (C) with the highest profit of `4.00 lakhs works out to be the best.
(Explanatory Comment: The problem is a good example to understand the methodology for evaluation of various
alternatives with the help of marginal costing.)
Illustration 3. (Limiting Factor Analysis & Optimum Mix)

A manufacturer has three products A, B, and C. Current sales, cost and selling price details and processing time
requirements are as follows:
Product A Product B Product C
Annual sales (units) 6000 6000 750
Selling Price (`) 20 31 39
Unit Cost (`) 18 24 30
Processing time required per unit (hour) 1 1 2
The firm is working at full capacity (13,500 processing hours per year). Fixed manufacturing overheads are
absorbed into unit costs by a charge of 200% of variable costs. This procedure fully absorbs the fixed manufacturing
overhead.
Assuming that:
(i) Processing time can be switched from one product line to another.
(ii) The demand at current selling price ( `) is:
Product A Product B Product C
11,000 8,000 2,000
(iii) The selling prices are not be altered.
You are required to calculate the best production programme for the next operating period and to indicate the
increase in net profit that this should yield. In addition, identify the shadow price of processing hour.

Answer:
Computation of Contribution per Labour Hour & Preference:
Serial Description A B C
1 Selling price ` 20 31 39
2 Unit Cost ` 18 24 30
3 Variable cost (1/3rd of Unit Cost) ` 6 8 10
4 Contribution per unit (1 – 3) ` 14 23 29
5 Processing hours per unit 1 1 2
5 Contribution per hour ` 14 23 14.50
6 Preference III I II
Computation of Current Profit:
Serial Description A B C TOTAL
1 No of units 6,000 6,000 750
2 Contribution per unit ` 14 23 29
3 Total contribution ` 84,000 1,38,000 21,750 2,43,750
4 Fixed cost per Unit (2/3rds of Unit Cost) ` 12 16 20
5 Total Fixed cost ` 72,000 96,000 15,000 1,83,000
6 Profit (3-5) ` 60,750
Statement showing Optimum Mix & Profit at that Mix:
Serial Description A B C Total
1 Order of Preference III I II
2 Process hours per unit 1 1 2
3 Demand (Units) 11,000 8,000 2,000
4 Hours Needed 11,000 8,000 2,000 21,000
5 Hours Allocated 1,500 8,000 4,000 13,500
6 No of units 1,500 8,000 2,000
7 Contribution per unit ` 14 23 29
8 Total contribution ` 21,000 1,84,000 58,000 2,63,000
9 Fixed cost ` 1,83,000
10 Profit ` 80,000
Increase in Profit = (80,000 - 60,750) = ` 19,250/-

Shadow Price: Shadow price is the opportunity cost of one unit of resource relevant for the decision maker. In
the present case every extra processing hour will increase the production of A by one unit and the contribution by
` 14. Therefore, the shadow price of processing hour is ` 14.
Working Note for allocation of Hours
Total Hours Available = 13,500
Hours for B = 8000 × 1 = 8.000
Hours Available for C & A = (13,500 – 8,000) = 5,500
Hours for C = 2,000 × 2 = 4,000
Hours Available for A = (5,500 – 4,000) = 1,500
(Commentary: The problem serves as a good example for understanding the Limiting Factor Analysis and Opti-
mum Product Mix.)
Illustration 4. (Optimum Product Mix & Maximisation of Profit)

As a part of its rural upliftment programme, the Government has put under cultivation a farm of 96 hectors to
grow tomatoes of four varieties: Royal Red, Golden Yellow, Juicy Crimson and Sunny Scarlet. Of the total 96
hectors, 68 hectors are suitable for all four varieties, but the remaining 28 hectors are suitable for growing only
Golden Yellow and Juicy Crimson. Labour is available for all kinds of farm work and there is no constraint. The
market requirement is that all four varieties of tomatoes must be produced with a minimum of 1,000 boxes of any
one variety. The farmers engaged have decided that the area devoted to any crop should be in terms of complete
hectors and not in fractions of a hector. The other limitation is that not more than 22,750 boxes of any one variety
should be produced. The following data are given.
Golden Juicy Sunny

Particulars Royal Red
Yellow Crimson Scarlet
Annual Yield (Boxes per hector) 350 100 70 180
Direct Material Costs (` per hector) 4,760 2,160 1,960 3,120
Labour Costs (`)
a. Growing per hector 8,960 6,080 3,710 5,280
b. Harvesting & packing per box 36 32 44 52
c. Transportation per box 52 52 40 96
Market price per box 153.80 158.70 183.80 222.70
Fixed Overheads per annum
Growing ` 1,12,000
Harvesting ` 74,000
Transportation ` 72,000
General Administration ` 1,02.000

Required
(i) Product Preference within the given constraints
(ii) Optimum Product Mix & Maximum Profit
(iii) A nationalized bank has come forward to help in an improvement programme for the piece of 28 hectors
in which only Golden Yellow and Juicy Crimson used to grow, with a loan of `50,000 at a very nominal
interest of 6% per annum. After this improvement is carried out, there will be a saving of `12.50 per box
in the harvesting cost of Golden Yellow and the 28 hectors will become suitable for growing Royal Red
in addition to the existing Golden Yellow and Juicy Crimson varieties. Assuming that other constraints
continue, find the maximum total profit that would be achieved after the improvement programme is
carried out.
Explanatory Comments
While seeking solutions in terms of product preference, optimum product mix, maximum profit and evaluation
of alternatives, the problem sets certain constraints. The constraints are:
(i) 68 hectors are suitable for all four varieties, but the remaining 28 hectors are suitable for growing only
Golden Yellow and Juicy Crimson
(ii) All four varieties of tomato must be produced with a minimum of 1,000 boxes of any one variety
(iii) The area devoted to any crop should be in terms of complete hectors
(iv) Not more than 22,750 boxes of any one variety should be produced
(v) After an improvement is carried out the 28 hectors will become suitable for growing Royal Red in addition
to the existing Golden Yellow and Juicy Crimson varieties
The problem can be solved by adopting five steps:
(i) Determination of Contribution per hector & product preference
(ii) Computation of Optimum Product Mix
(iii) Computation of Maximum Profit
(iv) Computation of Optimum Mix after the improvement programme
(v) Computation of Profit after the improvement programme
Here follows the stepwise solution. In order to assimilate the concepts, the students are advised to go through the
notes, furnished at relevant places, carefully.
Answer:
Step 1: Determination of Contribution per hector & product preference
Amount (`)
Golden Juicy Sunny

Serial Particulars Royal Red
1 Sales per hector
a. Boxes per hector 350 100 70 180
b. Price per Box 153.80 158.70 183.80 222.70
c. Sales (a × b) 53,830 15,870 12,866 40,086

Golden Juicy Sunny

Serial Particulars Royal Red
2 Variable costs
a. Direct material 4,760 2,160 1,960 3,120
b. Growing cost 8,960 6,080 3,710 5,280
c. Harvesting and packing
Per Box 36 32 44 52
Per hector 12,600 3,200 3,080 9,360
d. Transport
Per Box 52 52 40 96
Per hector 18,200 5,200 2,800 17,280
e. Total Variable Cost 44,520 16,640 11,550 35,040
3 Contribution per hector (1 – 2) 9,310 -770 1,316 5,046
4 Order of Preference 1 4 3 2
Note: Order of preference is decided on the basis of contribution per hector
Step 2: Computation of Optimum Product Mix

Golden Juicy Sunny
Particulars Royal Red Total
Minimum Area 1,000 1,000 1,000 1,000
Minimum boxes 350 100 70 180
Boxes per hector 2.85 14.28 5.55
Minimum Area (Hectors) i.e.,3.00 10.00 i.e.15.00 i.e.6.00 34.00
Balance Area (96 – 34) 62.00
Maximum area for 22,750 boxes 65 227.50 32.14 126.39
(22750 / Boxes per hector)
Allocation of area
68 hectors suitable for all varieties being 62.00 6.00
distributed for preferences 1 and 2
28 hectors suitable for Golden yellow &

Juicy Crimson 10.00 18.00
Total 62.00 10.00 18.00 6.00 96.00

Notes:
(i) In case of Royal Red, the minimum area of 2.85 hectors has been rounded off to the next higher multiple 3.
(ii) In case of Juicy Crimson, the minimum area of 14.28 hectors has been rounded off to the next higher

multiple 15.
(iii) In case of Sunny Scarlet, the minimum area of 5.55 hectors has been rounded off to the next higher multiple 6.
(iv) Of the 68 hectors suitable for all varieties, 62 acres have been apportioned to Royal Red after allocating
the minimum area of 6 to Sunny Scarlet.
(v) Of the 28 hectors suitable for Golden yellow & Juicy Crimson, 18 acres have been apportioned to Juicy
Crimson after allocating the minimum area of 10 to Golden yellow.
Step 3: Computation of Maximum Profit
(Amount in `)
Golden Juicy Sunny

Serial Particulars Royal Red Total
1 Area (Hectors) 62 10 18 6 96
2 Contribution per hector 9310 (770) 1316 5046
3 Total contribution 5,77,220 (7,700) 23,688 30,276 6,23,284
4 Fixed costs
a. Growing 1,12,000
b. Harvesting 74,000
c. Transport 72,000
d. General Administration 1,02,000
e. Sub Total (a..d) 3,60,000
5 Profit 2,63,484
Step 4: Computation of Optimum Mix & Profit after the improvement programme
Golden Juicy Sunny
Particulars Royal Red Total
Minimum Area (hectors) 3.00 10.00 15.00 6.00 34.00
Balance area being apportioned on the 62.00 62.00
basis of product preference
Total area (hectors) 65.00 10.00 15.00 6.00 96.00
Note: Product-wise apportionment of the area has been done by following a similar process as has been outlined
in step2.
Step 5: Computation of Profit after the improvement programme

(Amount in `)
Golden Juicy Sunny
1 Area (Hectors) 65 10 15 6 96

Golden Juicy Sunny

2 Contribution per hector
Existing 9310 (770) 1316 5046
Savings after the improvement 1250
Revised
9310 480 1316 5046
3 Total contribution 6,05,150 4,800 19,740 30,276 6,59,966
4 Fixed costs
a. Growing 1,12,000
b. Harvesting 74,000
c. Transport 72,000
d. General Administration 1,02,000
e. Interest @ 6% on ` 50,000/- 3,000
f. Sub Total (a..d) 3,63,000
5 Profit 2,96,966
(Commentary: Be it be manufacturing sector, service sector or agriculture sector, the application of Marginal
Costing is Universal.)
Illustration 5. (Profit Planning)

MN Agarwal owns a Gift-Shop, a Restaurant and a Lodge in Shillong. Typically, he operates these only during
the season period of 4 months in a year. For the past season the occupancy rate in the Lodge was 90% and level of
activity in case of Gift-Shop and Restaurant was 80%. The relevant data for the past season were as under-
(Amounts in `)
Gift-Shop Restaurant Lodge

Amount % Amount % Amount %
1. Receipts/ Sales 48,000 100 64,000 100 1,80,000 100
2. Expenditure:
Cost of Sales Supplies 26,400 2,400 55 35,200 6,400 55 - -
Insurance & Taxes 1,920 2,880 5 6,400 8,000 10 14,400 36,000 8
Depreciation Salaries 4,800 4,800 3,200 39,600 25,200
4 10 20
Electricity Charges 960 13,500
6 12.50 22
10 7.50 14
2 5 7.50
Total 39,360 82 64,000 100 1,28,700 71.50
3. Profit 8,640 18 - - 51,300 28.50

Additional information:
(a) Cost of Sales and Supplies vary directly with the occupancy rate in case of Lodge and level of activity in case
of Gift Shop and Restaurant.
(b) Insurances and Taxes and Depreciation are for the entire period of twelve months.
(c) Salaries paid are for the season period except a Chowkidar for the Lodge who is paid for the full year at `400
per month.
(d) Electricity Charges include Fixed Charges of `640, `1,920 and `9,900 for Gift-5hop, Restaurant and Lodge
respectively.
The balance amount varies directly with occupancy rate in case of Lodge and level of activity in case of Gift-
Shop and Restaurant. Fixed Electric Charges are for the season except in case of Lodge where `6,900 is for the
season and `3,000 for the entire period of twelve months.
Mr. Agarwal is interested in increasing his Net Income. The following options are under consideration -
(a) To continue the operations during the season period only by inserting advertisement in newspapers thereby
occupancy rate to reach 100% in case of Lodge and 90% level of activity in respect of Gift-Shop and
Restaurant. The costs of advertisement are estimated at `12,000.
(b) To continue operations throughout the entire period of twelve months comprising season period of four
months and offseason period of eight months. The occupancy rate is expected at 90% and 40% during season
period and off-season period respectively in case of the Lodge. The room rents are bound to be reduced
to 50% of the original rates during offseason period. The level of activity of Gift-Shop and Restaurant is
expected at 80% and 30% during season and offseason period respectively but 5% discount on the original
rates will have to be offered during off-season period.
Which option is profitable? As a Cost Accountant would you like to suggest him any other alternative based upon
the above figures, which can be adopted to earn more net profit? (Use Incremental Revenue and Cost Approach.)
Answer:
(a) Option 1: Operate during Season only
Incremental Revenues and Costs in `
Particulars Gift- Shop Restaurant Lodge Total
Incremental Revenue Given ` 48,000 at Given ` 64,000 at Given ` 1,80,000 at 34,000

80%, Addl. Revenue 80%, Addl. Revenue 90%, Addl. Revenue
for extra 10% = for extra 10% = for extra 10% =
48,000 × (10/80) = 64,000 × (10/80)= 180,000 × (10/90)
6,000 8,000 =20,000
Incremental Costs
Cost of Sales 6,000 × 55% = 3,300 8,000 × 55% = 4,400 Nil 7,700
Supplies 6,000 × 5% = 300 8,000 × 10% = 800 20,000 × 8% = 1,600 2,700
Electricity Charges (960 - 640) × (10/ 80) (3,200 - 1,920) × (13,500 - 9,900) × 600
= 40 (10/80) = 160 (10/90) = 400

Advertisement 12,000
Total of Incremental Costs 23,000
Incremental Profit 11,000
(b) Option 2: Operate during all 12 months
Incremental Revenues and Costs in `
Particulars Gift- Shop Restaurant Lodge Total
Incremental Revenue 48,000 × 2 × (30% / 64,000 × 2 × (30% / 1,80,000 × 2 × (40% / 1,59,800
80%) × 95% = 34,200 80%) × 95% = 45,600 90%) × 50% = 80,000
Incremental Costs
Cost of Sales 36,000 × 55% =19,800 48,000 × 55% =26,400 Nil 46,200
Supplies 36,000 × 5% =1,800 48,000 × 10% = 4,800 1,60,000 × 8% = 12,800 19,400
Electricity Charges – 640 × 2 = 1,280 1,920 × 2 = 3,840 6,900 × 2 = 13,800 18,920
Fixed
Electricity Charges - (960-640) × 2 × (3,200 -1,920) × 2 × (13500- 9900) × 2 × 4,400
Variable (30%/80%) =240 (30%/80%) = 960 (40%/90%) = 3,200
Total of Incremental Costs 1,48,920
Incremental Profit 10,880
Suggestion
Both options are desirable since there is an Incremental Net Income. Option 1 is slightly better than Option 2 by
`120. However, it is suggested that the Firm should adopt a combination of both options in which case, the Total
Additional Profit will be `11,000 + `10,880 = `21,880.
Illustration 6. (Make or Buy)

S.H.Ltd., a cycle manufacturing company, has drawn up a programme for the manufacture of a new product for
the purpose of fuller utilization of its capacity. The scheme envisages the manufacture of baby tricycle fitted with a
bell. The company estimates the sales of tricycles at 10,000 during the first year and expects that from the second
year onwards the sales estimates will stabilize at 20,000 tricycles. Since the company has no provision for the
manufacture of the small bells specially required for the tricycles, the requirement of the bells is initially proposed
to be met by way of purchase from the market at `8 each. However, if the company desires to manufacture the bell
in its factory by installation of new equipment, it has two alternative proposals as under
Installation of Super X Installation of Janta

Machine Machine
Initial Cost of Machine ` 3.00 Lacs ` 2.00 Lacs
Life 10 Years 10 Years

Fixed Overheads p.a. other than depreciation ` 54,000 ` 28,000
Variable expenses per unit ` 4.00 ` 5.00

Required:
a. For each of the two levels of output namely 10,000 and 20,000 bells state with suitable workings whether
the company should purchase the bells from market or install new equipment for manufacture of bells. If
your decision is in favour of the installation of new equipment, which of the two new machines should be
installed?
b. What would be your decision in case the forecast of requirement from the second year onwards is estimated
at 40,000 bells instead of 20,000 bells?
c. At what volume of bells will the installation of the two machines break even.
Answer:
a. Cost-Benefit Analysis of two machines at Output Level of 10,000 and 20,000 units
Output 10000 units 20000 Units

Details Super X Janta Super X Janta
Cost of buying @ ` 8 80000 80000 160000 160000
Cost of Manufacturing
Variable cost 40000 50000 80000 100000
Depreciation on Machine 30000 20000 30000 20000
Fixed overheads 54000 28000 54000 28000
Total cost 124000 98000 164000 148000
Decision Buy from Market Install Janta Machine
b. Buy/ manufacture decision at level of 40,000 units
Super X Janta
Cost of Buying @ ` 8 3,20,000 3,20,000
Cost of Manufacturing
Variable Cost 1,60,000 2,00,000
Depreciation on Machine 30,000 20,000
Fixed Overheads 54,000 28,000
Total Cost 2,44,000 2,48,000
Cost Saving on Manufacture 76,000 72,000
Decision – As Super X machine gives better saving, it should be installed at an estimated volume of 40000
units
c. Break – even volume of two machines: It is that volume of production at which a manufacturer is indifferent
as to which machine he should install as total cost on both machine is the same. This point is known as cost
indifference point.
Let Break-even volume = x units

Cost on super-X Machine for x units = 54,000 + 30,000 + 4x = 84,000 + 4x …(1)

Cost on Janata Machine for “x” units = 20,000 + 28,000 + 5x = 48,000 + 5x …(2)
At cost indifference point total cost under two alternatives will be equal.
Therefore,
84,000 + 4x = 48,000 + 5x or x = 36,000 units.
So, at 36,000 units the installation of the two machines will break even.
Illustration 7. (Make or Buy & Evaluation of Alternatives)
Household Equipments Ltd. is producing kitchen equipment from five components three of which are made
using general purpose machines and two by manual labour. The data for the manufacture of the equipment is as
follows:
Components A B C D E Total
Machines hours reqd. per unit 10 14 12 36 hrs
Labour hours reqd. per unit 2 1 3hrs
Variable cost per unit (in `) 32 54 58 12 4 160
Fixed cost per unit (apportioned) ` 48 102 116 24 36 316
Total component cost ` 80 156 174 36 30 476
Assembly cost/unit (all variable) ` 40
Selling price/unit ` 600
The marketing department of the company anticipates 50% increase in demand during the next period. General
purpose machinery used to manufacture. A, B and C is already working to the maximum capacity of 4752 hours
and there is no possibility of increasing this capacity during the next period. But labour is available for making
components D and E and also for assembly according to demand. The management is considering the purchase of
one of the components A, B or C from the market to meet the increase in demand. These components are available
in the market at the following prices: Components A: ` 80, Components B: ` 160, Components C: ` 125
Required:
(a) Profit made by the company from current operations.
(b) If the company buys any one of the components A, B or C, what is the extent of additional capacity that can
be created?
(c) Assuming 50% increase in demand during the next period, which component should the company buy from
the market?
(d) The increase in profit, if any, if the component suggested in (c) is purchased from the market.
Answer:
(a) Statement showing profit at current operations
Amount (`)
SP 600

Amount (`)
Variable Costs
Cost of Machining 160
Cost of Assembly 40
Total 200
Contribution per Unit 400
No. of units 4752 ÷ 36 132 Units
(Maximum hours ÷ Hours per unit)
Total Contribution 52,800
Fixed Cost (132 units × ` 316 p.u.) 41,712
Profit 11,088
(b) Computation of additional capacity created if components are bought from outside:
(i) If A is bought
Capacity released = 10 hours × 132 units = 1320 hours
Machine hours needed per unit of B & C = 14+12 = 26 hours
Additional units that can be manufactured = 1320 ÷26 = 50.77
Increase in Capacity = (50.77÷132) × 100 = 38.46%
(ii) If B is bought
Additional units that can be manufactured = 1848 ÷22 = 84
Increase in Capacity = (84÷132) × 100 = 63.64%
(iii) If C is bought
Additional units that can be manufactured = 1584 ÷24 = 66
Increase in Capacity = (66÷132) × 100 = 50.00%
(c) Evaluation as to buy which component assuming 50% increase in demand during the next period
Computation of Preference for Buying
Amount (`)
A B C
Buying cost 80 160 125
Variable Cost 32 54 58
Excess buying Cost 48 106 67

A B C
Excess buying cost per hour 4.8 7.571 5.583
Preference for buying 1 3 2
It is better to buy component A from the market because excess buying cost per machine hour is less. But the
increase in capacity will be just 38.46% and hence not sufficient to meet the expected demand for next year.
Therefore, next preference is buying the next cheaper component. i.e., C whereby the increase in capacity will be
exactly equal to the increase in demand of 50% during the next year.
Hence, component ‘C’ should be bought from the market.
(d) Statement showing computation of profit by buying C from outside:
Amount
(`)
SP 600
Variable Costs
Cost of Machining (160 + 67) 227
Cost of Assembly 40
Total 267
Contribution per Unit 333
No. of units 4752 ÷ 24 198 Units
Total Contribution 65.934
Fixed Cost 41,712
Profit 24,222
Existing Profit 11.088
Increase in Profit 13,134
Illustration 8. (Evaluation of Alternatives for Profit Planning)

AB Limited has two divisions Alfa & Beta. Alfa produces components, two units of which are required for one
unit of final product produced by Beta. Alfa has a capacity to produce 20,000 units and entire quantity is supplied to
Beta @ ` 200/unit. Variable cost component at Alfa is ` 190 & fixed cost ` 20 per unit. For final product of Beta,
per unit variable cost excluding component is ` 700, fixed cost `200 and selling price is ` 1500. Alfa has placed a
proposal for increasing the transfer price to ` 220 i.e. the market price. Facility at Alfa can be rented out @ ` 3.00
Lacs p.a. Manager at Alfa wants to opt for this alternative. Beta can buy this component from outside market @ `
210. If capacity of Alfa is augmented to 40,000 units with an additional investment of ` 15 lacs, it can sell 20,000
units to external market and balance to Beta @ ` 210 per unit. Fixed cost for Alfa will be up by ` 1.00 lac. Evaluate
and give you opinion on.
a. Facility of Alfa is rented out and Beta buys from market @ `210 per unit
b. Alfa sells to outside market @ `220 and Beta buys @ 210 per unit from market
c. Capacity enhancement at a cost of capital of 12% p.a.

Answer:
(i) Present position on transfer of Alfa @ `200 to Beta
Particulars Division Alfa Division Beta

Units sold 20,000 10,000
Selling price per unit (`) 200 1,500
Variable cost per unit (`) 190 700 + (2×200) = 1,100
Contribution per unit (`) 10 400
Fixed cost per unit (`) 20 200
Profit per unit (`) (-) 10 200
Total Profit/ Loss (`) (-)2,00,000 20,00,000
Overall profit for the company = (-2,00,000 + 20,00,000) = ` 18,00,000
Total Fixed Cost for Alfa = (20,000 × 20) = ` 4,00,000
Total Fixed Cost for Beta = (10,000 × 200) = ` 20,00,000
(ii) Alternative (a), i.e. Facility of Alfa is rented out and Beta buys from market @ `210 per unit

Units sold 0 10,000
Selling price per unit (`) 1,500
Variable cost per unit (`) 700 + (2×210) = 1,120
Contribution per unit (`) 380
Total Contribution (`) 38,00,000
Fixed Cost (`) 20,00,000
Rental Income (`) 3,00,000
Total Profit (`) 3,00,000 18,00,000
Overall profit for the company = (3,00,000 + 18,00,000) = ` 21,00,000
(iii) Alternative (b), i.e. Alfa sells to outside market @ `220 and Beta buys @ 210 per unit from market

Units sold 20000 10000
Selling price per unit (`) 220 1500
Variable cost per unit (`) 190 700 + (2×210) = 1120
Total Contribution (`) 6,00,000 38,00,000


Fixed Cost (`) 4,00,000 20,00,000
Total Profit (`) 2,00,000 18,00,000
Overall profit for the company = (2,00,000 + 18,00,000) = ` 20,00,000
(iv) Alternative (c), i.e., Capacity enhancement of Alfa at a cost of capital of 12% p.a.
Division Alfa
Particulars Division Alfa (Transfer) Division Beta
(Sale)
Units sold 20000 20000 10000
Selling price per unit (`) 220 210 1500
Variable cost per unit (`) 190 190 700 + (2×210) = 1120
Contribution per unit (`) 30 20 380
Total Contribution (`) 6,00,000 4,00,000 38,00,000
Fixed Cost (`) 4,00,000 1,00,000 20,00,000
Cost of Capital @ 12% 12% of 15,00,000 = 1,80,000
Total Profit (`) 2,00,000 1,20,000 18,00,000
Overall profit for the company = (2,00,000 + 1,20,000 + 18,00,000) = ` 21,20,000
(v) Evaluation
Serial Alternative Overall Profit (`)

(i) Present position on transfer of Alfa @ `200 to Beta 18,00,000
(ii) Alternative (a), i.e. Facility of Alfa is rented out and Beta buys from 21,00,000
market @ `210 per unit
(iii) Alternative (b), i.e. Alfa sells to outside market @ `220 and Beta 20,00,000
buys @ 210 per unit from market
(iv) Alternative (c), i.e. Capacity enhancement of Alfa at a cost of capital 21,20,000
of 12% p.a.
Opinion: Since overall profit is the highest, i.e. `21,20,000/- in alternative ‘c’, it can be adopted.
Illustration 9. (Optimum Crop Mix & Profit Planning)

An agro-based farm is planning its production for next year. The following is relating to the current year:
Product/Crop M N O P
Area Occupied (Acres) 125 100 150 125
Yield per acre (ton) 50 40 45 60

Product/Crop M N O P
Selling Price per ton (`) 100 125 150 135
Variable Cost per acre (`)
Seeds 150 125 225 200
Pesticides 75 100 150 125
Fertilizers 62.50 37.50 50 62.50
Cultivation 62.50 37.50 50 62.50
Direct Wages 2000 2250 2500 2850
Fixed overhead per annum `13,44,000. The land that is being used for the production of O and P can be used for
either crop. But not for M and N; the land that is being used for the production of M and N can be used for either
crop, but not for O and P. In order to provide adequate market service, the company must produce each year at least
1,000 tons of each of M and N and 900 tons each of O and P.
Required:
(i) Determine the profit for the production mix fulfilling market commitment.
(ii) Assuming the land could be cultivated to produce any of the four products and there was no market
commitment, calculate the profit amount of most profitable crop and break-even point of most profitable
crop in terms of acres and sales value.
Answer:
(i) Determination of Profit for Production Mix fulfilling the market commitment:
a. Statement of Recommended Product Mix
Serial Product M N O P
1 Yield per acre (ton) 50 40 45 60
2 Selling Price per ton (`) 100 125 150 135
3 Sales Revenue per acre (`) 5000 5000 6750 8100
4. Variable Cost per acre (`)
a. Seeds 150 125 225 200
b. Pesticides 75 100 150 125
c. Fertilizers 62.50 37.50 50 62.50
d. Cultivation 62.50 37.50 50 62.50
e. Direct Wages 2000 2250 2500 2850
f. Sub Total (a..e) 2350 2550 2975 3300
5. Contribution per acre (`) 2650 2450 3775 4800
6. Rank 1 2 2 1

Serial Product M N O P
7. Minimum Sales per 1000 1000 900 900
annum (tons)
(Minimum Market
Commitment)
8. Minimum Area (acres) (1000 ÷ 50) (1000 ÷ 40) (900 ÷ 40) (900 ÷ 60)
=20 = 25 =20 =15
9. Occupied Area (acres) 125 100 150 125
10. Recommended Mix {(125+100)- 25 20 {(150+125)
(acres) 25} = 200 (Minimum) (Minimum) -20} =255
b. Statement of Profit
Serial Particulars Workings Rupees
1 Contribution for the recommended
product Mix
M (200 × 2650) = 5,30,000 5,30,000
N (25 × 2450) = 61,250 61,250
O (20 × 3775) = 75,500 75,500
P (255 × 4800) = 12,24,000 12,24,000
Sub Total 18,90,750
2 Fixed Cost 13,44,000
3 Profit 5,45,750
(ii) Most profitable crop

Product P gives highest contribution of `4,800/- per acre and hence is the most profitable crop.
Statement of Profit if complete land is used for P:
Contribution = (500 × 4800) = ` 24,00,000
Fixed cost = ` 13,44,000
Profit = ` 10,56,000
Break-even point in acres for P = 1344000÷4800 = 280 acres
Break-even point in sales value = 280 × 135 × 60 = ` 22,68,000
(Commentary: The problem reveals the utility of marginal costing with respect to maximisation of crop
income, i.e. agriculture sector.)
Illustration 10 (Continue or Discontinue)
S.G Ltd produces four products in its factory. The volume of production and sales achieved is considerably lower
than normal and so there has been substantial under recovery of overheads. The sales and cost particulars are as
under:

(` In lakhs)
Products
Total
A B C D
Sales 160 200 80 40 480
Costs:
Direct Material 24 32 16 3 75
Direct Wages 40 48 32 8 128
Factory Overheads 48 64 40 8 160
Selling & Admn. (15% Sales) 24 30 12 6 72
Total 136 174 100 25 435
Profit / Loss 24 26 (20) 15 45
Under recovery of overheads 24
Profit before tax 21
40% of factory overheads are variable at normal volume and the selling and administration overheads are variable
to the extent of 5% of sales. 20% of sales of product C are done in connection with Product A in as much as the
discontinuance of Product C will bring down the sale of Product A by 10%. Alternatively, the sale of product C can
be reduced to 20% of the present level to maintain the sales of product A.
In view of the loss reported for Product C the management has for consideration three proposals, viz;
(a) Discontinue product C. In that event the co. can save a sum of `8 lakhs p.a. in fixed expenses.
(b) Maintain the sales of product C to the extent of 20% of the present sales as sales service to product A. In that
event the reduction of fixed expenses will be ` 3 lakhs p.a.
(c) Discontinue product C totally and increase the sales of product D for which demand is available to the extent
of another `40 lakhs. This can be done without any change in fixed expenses.
Present the data to the management bringing out the financial implications of the aforesaid three proposals as
compared with the annual operating results generating a profit before tax of `21 lakhs. Suggest a course of action
to be followed by the S.G Ltd.
Answer
Step 1: Computation of Variable Factory Overheads & Fixed Factory Overheads
` In lakhs
A B C D Total
Sl. Element
(`) (`) (`) (`) (`)
1 Factory Overheads recovered 48.00 64.00 40.00 8.00 160.00
2 (+) under recovery (apportioned in the 7.20 9.60 6.00 1.20 24.00
ratio of 48:64:40:8)

A B C D Total
Sl. Element
(`) (`) (`) (`) (`)
3 Overheads at normal value 55.20 73.60 46.00 9.20 184.00
4 Variable Overheads (40% of the total) 22.08 29.44 18.40 3.68 73.60
5 Fixed Overhead (60% of the total) 33.12 44.16 27.6 5.52 110.40
Step 2: Rearranging the data in ‘Contribution’ format ` In lakhs
A B C D Total
Sl. Element
(`) (`) (`) (`) (`)
1 Sales 160.00 200.00 80.00 40.00 480.00
2 Variable Costs
Direct Material 24.00 32.00 16.00 3.00 75.00
Direct Wages 40.00 48.00 32.00 8.00 128.00
Variable Overheads 22.08 29.44 18.40 3.68 73.60
Variable Selling & Distribution Overheads 8.00 10.00 4.00 2.00 24.00
(@ 5% of Sales)
Total 94.08 119.44 70.40 16.68 300.60
3 Contribution 65.92 80.56 9.60 23.32 179.4
(% to Sales) (41.20) (40.28) (12.00) (58.30)
4 Fixed Costs
Fixed Factory Overheads 33.12 44.16 27.60 5.52 110.40
Fixed Selling & Distribution Overheads 16.00 20.00 8.00 4.00 48.00
(@ 10% of Sales)
Total 49.12 64.16 35.60 9.52 158.40
5 Profit / (Loss) 16.80 16.40 (26.00) 13.80 20.56
Step 3: Evaluation of Alternatives

Alternative (a) Computation of Profit if Product is discontinued ` In lakhs
A B C D Total
Sl. Element
(`) (`) (`) (`) (`)
1 Contribution 59.33 80.56 - 23.32 163.21
(35.92 – 10% of 65.92)
2 Fixed Costs (Reduction by ` 8 lakhs) 150.40
3 Profit 12.81

Alternative (b) Computation of Profit if Product is maintained at 20% level

` In lakhs
A B C D Total
Sl. Element
(`) (`) (`) (`) (`)
1 Contribution 65.92 80.56 1.92 23.32 171.72
(20%)
2 Fixed Costs 155.40
(Reduction by ` 3 lakhs)
3 Profit 16.32
Alternative (c) if product C is discontinued totally and the sales of product D is increased to the extent of
another ` 40 lakhs ` In lakhs
A B D Total
Sl. Element
(`) (`) (`) (`)
1 Contribution 59.33 80.56 46.64 186.53
2 Fixed Cost 158.40
3 Profit 28.13
Suggested Course of action: From the above computations, it may be observed that profit is more in alternative
C i.e., in discontinuing Product C completely & increasing the sales of Product D by100% (`.40 lakhs). Hence,
alternative C is suggested.
Illustration 11 (Make or Buy & Choosing between the Alternatives)

T.T.D Ltd., manufacturing a single product, has normal working capacity of 8,000 units per annum. The sales
manager has projected a sale of 10,000 units for the year 2021-22 at a price of `250 per unit. The operating budget
for 2021-22 is as under:
` in lakhs ` in lakhs
Sales:8,000 units @ ` 250 each 20.00

Cost of production
Raw material 12.00
Direct wages 3.00
Works overhead (50%Fixed) 1.40
Admn. overhead (all fixed) 0.60
Selling & Distribution OH (80%fixed) 1.00 18.00
Profit 2.00
In order to increase production to meet the sales demand, two proposals have been put forward as under:
(1) Sub-contracting the production of 2,000 units at ` 225 per unit.

(2) Installing additional machine which will entail the following expenses:
a. Cost of machine ` 2,00,000; Life 20years
b. Recruitment of 10 workers including direct workers to operate the machine at a wage rate of ` 500 each
per month. Add 25% towards fringe benefits. (None of the existing workers will be utilised for this
purpose).
c. Interest on capital required for the purchase of machine15% p.a.
The following additional fixed expenses will be required in respect of both alternatives: Administration expenses
- ` 10,000 per year & Selling & Distribution expenses- ` 20,000 per year. You are required to prepare:
1. A statement showing respective profitability of the two methods of increasing the production.
2. Comment upon the choice of one of the two proposals.
Answer
Statement Showing Computation of Profit at Present Position and Proposed Alternatives:
Present Sub Own

Serial Particulars
Position Contract Expansion
1 Option 1 2 3
2 Number of Units
Own 8,000 8,000 10,000
Sub Contact - 2,000 -
Total 8,000 10,000 10,000
3 Sales (` Lakhs) 20.00 25.00 25.00
4 Variable Costs (` Lakhs)
Raw Materials 12.00 12.00 15.00
Direct Wages 3.00 3.00 3.00
Works Overhead 0.70 0.70 0.875
Selling & Distribution Overhead 0.20 0.20 0.25
Sub Contract Cost for 2000 units @ ` 225/- p.u. 4.50
Additional Workers 0.75
Total 15.90 20.40 19.875
5 Contribution 4.10 4.60 5.125
6 Fixed Costs 2.10 2.40 2.80
7 Profit 2.00 2.20 2.325
Comment: Option 3, i.e., own expansion gives the maximum profit of `2.325 lakhs and hence the same is
recommended.
Working Notes
1. Works Overheads of `1.40 lakhs have been segregated into 50% fixed (i.e.`0.70 lakhs) and 50% variable (i.e.
`0.70 lakhs).

2. Selling & Distribution OH of `1.00 lakhs has been segregated into 80% fixed (i.e.`0.80 lakhs) and 20%
variable (i.e. `0.20 lakhs).
3. Fixed Costs in Option 1 (Present Position) consist of `0.70 lakhs of works overhead, `0.60 lakhs of Admn.
Overhead and ` 0.80 lakhs of Selling & Distribution Overhead; all together aggregating to `2.10 lakhs.
4. Fixed Costs in Option 2 (Sub Contract) consist of `2.10 as at present position and additional fixed expenses
of `0.30 lakhs; both together aggregating to `2.40 lakhs.
5. Fixed Costs in Option 3 (Own Expansion) consist of `2.40 as in Option 2, depreciation of `0.10 lakhs and
interest on working capital of `0.30 lakhs; all together aggregating to `2.80 lakhs.
Illustration 12 (Make or Buy and Evaluation of Alternatives)
A Company manufacturing a highly successful line of cosmetics intends to diversify the product line to achieve
fuller utilization of its plant capacity. As a result of considerable research made the company has been able to
develop a new product called ‘EMO’. EMO is packed in tubes of 50 grams capacity and is sold to the wholesalers
in cartons of 24 tubes at `240 per carton. Since the company uses its spare capacity for the manufacture of EMO,
no additional fixed expenses will be incurred. However, the cost accountant has allocated a share of `4,50,000 per
month as fixed expenses to be absorbed by EMO as a fair share of the company’s present fixed costs to the new
production for costing purposes.
The company estimated the production and sale of EMO at 3,00,000 tubes per month and on this basis the
following cost estimates have been developed.
` per carton
Direct Materials 108

Direct Wages 72
All overheads 54
Total costs 234
After a detailed market survey, the company is confident that the production and sales of EMO can be increased
to 3,50,000 tubes and the cost of empty tubes, purchased from outside will result in a saving of 20% in material and
10% in direct wages and variable overhead costs of EMO. The price at which the outside firm is willing to supply
the empty tubes is `1.35 per empty tube. If the company desires to manufacture empty tubes in excess of 3,00,000
tubes, new machine involving an additional fixed overheads `30,000 per month will have to be installed.
Required:
(i) State by showing your working whether company should make or buy the empty tubes at each of the three
volumes of production of EMO namely 3,00,000; 3,50,000 and 4,50,000 tubes.
(ii) At what volume of sales will it be economical for the company to install the additional equipment for the
manufacture of empty tubes?
(iii) Evaluate the profitability on the sale of EMO at each, of the aforesaid three levels of output based on your
decision and showing the cost of empty tubes as a separate element of cost.
Answer:
(i) Make or Buy
Total Cost per tube of EMO:

Direct Material = (108 ÷ 24) = `

4.50
Direct Wages = (72 ÷ 24) = ` 3.00
Variable Overheads = {(54 ÷ 24) – (450000 ÷ 300000) = ` 0.75
Particulars Total Cost (`) Tube Cost (`) Product Cost (`)
Material 4.50 20% of total cost = 0.90 3.60
Wages 3.00 10% of total cost = 0.30 2.70
Variable Overhead 0.75 10% of total cost = 0.075 0.675
Total 8.25 1.275 6.975
Cost of Making = (3,00,000 × 1.275) = ` 3,82,500
Cost of Buying = (3,00,000 × 1.35) = ` 4,05,000
Therefore, It is better to make the tubes at 3,00,000 level of output.
Computation of Cost for additional tubes at the level of 3,50,000 and 4,50,000:
Particulars 3,50,000 4,50,000

Additional tubes needed over 3,00,000 50,000 1,50,000
Cost of Making (`) 93,750 2,21,750
[(50,000 × 1.275) + 30,000] [(1,50,000 × 1.275) + 30,000]
Cost of Buying (`) 67,500 2,02,500

(50,000 × 1.35) (1,50,000 × 1.35)
From the above, it is better to buy the empty tubes at the level of 3,50,000 and 4,50,000.
(ii) The level at which it is beneficial to make the tubes over and above 300000 units
Additional Fixed Overheads = ` 30,000/-
Excess of buying cost over variable cost = (1.35 - 1.275) = `0.075
Indifference Point = (Additional Fixed Overheads ÷ Excess Buying Cost)
= 30,000 ÷ 0.075 = 4,00,000 units
Therefore, the Company will be justified to install the additional Equipment for the manufacture of Empty
tubes at a sales volume of 400000 units.
(iii) Evaluation of Profitability at the three levels of output
SL Particulars 3,00,000 3,50,000 4,50,000

I. Sales @ ` 10 p.u. 30,00,000 35,00,000 45,00,000
II. Product Cost @ ` 6.975 p.u. 20,92,500 24,41,250 31,38,750
(3,00,000 × 6.975) (3,50,000 × 6.975) (4,50,000 × 6.975)

III. Tube Cost (`) 3,82,500 4,72,500 6,07,500

(3,00,000 × 1.275) (3,50,000 × 1.35) (4,50,000 × 1.35)
IV. Fixed cost (`) 4,50,000 4,50,000 4,50,000
V. Total Cost (`) 29,25,000 33,63,750 41,96,250
VI. Profit (I–V) (`) 75,000 1,36,250 3,03,750
Illustration 13 (Evaluation of Alternative Choices)

ABC Computer Ltd. is planning to introduce a new computer “Speedo”. The maximum production capacity will
be 40,000 units per annum. The company plans to produce full capacity in the first year. The cost per computer is
as follows:
(`)
Direct material 6000
Direct labour 5000
Variable factory overheads 3000
Fixed factory overheads is `1600 Lakhs and selling and distribution overheads will be `800 lakhs per annum.
Fixed factory overheads are estimated on the basis of full capacity. The marketing department has come out with
the following price and demand forecast for the first year.
Price Range Sales Volume
14001 -24000 36000
24001 – 30000 32000
30001 – 36000 18000
36001 – 42000 10000
ABC Computers has decided to price the computers at full cost plus 20% for the first year
a. Work out the price/unit at which ABC wishes to sell the computer for the first year and arrive at the demand.
b. Can you work out a better proposal?
c. Determine the profit and the value of stock for year 1 for figures obtained under (a) above following Marginal
cost approach (for the demand arrived at based on company’s pricing policy for 1st year)
d. Determine the profit and the value of stock for year 1 for figures obtained under (a) above following
Absorption cost approach (for the demand determined for better proposal for 1st year)
Answer
(a) Computation of Price/unit at which ABC wishes to sell the computer for the first year
Per unit Total for 40000 units

Particulars
(`) (` In Lakhs)
Variable Costs
Direct Materials 6000 2400

Per unit Total for 40000 units

Particulars
(`) (` In Lakhs)
Direct Labour 5000 2000
Variable factory overheads 3000 1200
Total Variable Costs 14000 5600
Fixed Costs
Factory Overheads 4000 1600
Selling and Distribution overheads 2000 800
Total Fixed Costs 6000 2400
Total Costs 20000 8000
Add Markup @ 20% 4000 1600
Selling Price 24000 9600
At a selling price of `24,000/- per unit, the maximum demand, as given in the price – sales matrices, is
36,000. Therefore, the price per unit at which ABC wishes to sell the computer for the first year is `24,000/-
and the demand is 36,000.
(b) Workings for a better the Proposal
Contribution per unit (`) = Contribution for the

Volume Price per unit (`) (Price – Total Variable Costs entire Volume of Sales
of ` 14000) (` Lakhs)
36000 24000 10000 3600
32000 30000 16000 5120
18000 36000 22000 3960
10000 42000 28000 2800
The contribution is maximum (`.5120 lakhs) at a sale volume of 32,000 units which, evidently, is a better
proposal
(c) Determination of the profit and the value of stock for year 1 for figures obtained under (a) above
following Marginal Cost Approach:
Number of units produced = 40,000
Number of Units to be sold = 36,000
Selling Price = ` 24,000/-
Contribution per Unit = ` 10,000/-
Contribution for the entire volume of Sales = (36,000 × 10,000) = ` 3600 lakhs
Fixed Costs = (Factory Overheads + Selling and Distribution Overheads) = 1600 + 800 = ` 2400 lakhs
Profit on Sales = (Contribution – Fixed Costs) = (3,600 - 2,400) = ` 1,200 lakhs

Closing Stock = (Production – Sales) = (40000 - 36000) = 4000 units

Value of Closing Stock @ Marginal Cost = (4,000 × 14,000) = ` 560 lakhs
Profit on Production = (1,200 + 560) = ` 1,760 lakhs
(d) Determination of the profit and the value of stock for year 1 for figures obtained under (a) above
following Absorption-Cost-Approach:
Number of units produced = 40,000
Number of Units to be sold = 32,000
Selling Price = ` 30,000/-
Contribution per Unit = ` 16,000/-
Contribution for the entire volume of Sales = (32,000 × 16,000) = ` 5,120 lakhs
Fixed Costs Absorbed = (Factory Overheads @ ` 4,000 per unit + Selling and Distribution Overheads @
` 2,000 per unit) = 1,280 + 640 = ` 1,920 lakhs
Profit on Sales = (Contribution – Fixed Costs) = (5,120 - 1,920) = ` 3,200 lakhs
Closing Stock = (Production – Sales) = (40,000 - 32,000) = 8000 units
Rate per Valuation = (Variable Cost + Factory Overheads) = (14,000 + 4,000) = ` 18,000/-
Value of Closing Stock @ Absorbed Cost = (8,000 × 18,000) = ` 1,440 lakhs
Profit on Production = (5,120 + 1,440) = ` 6,560 lakhs
Note: The aspect over absorption of overheads is not considered while computing the profit.
(Commentary: The problem reveals multiple conceptual dimensions during the course of evaluation of
alternatives.)
Illustration 14 (BE Sales and Profit Analysis)
S K started a catering service to supply food to patients admitted in hospitals and those who were recovering
from the pandemic. The cost of food and the disposable packing during a month of 30 days is ` 100 per meal.
She sells each meal at ` 160. She has an arrangement with a delivery agency that quickly reaches for pick up and
delivers to the customers. The agency charges her ` 120 per delivery, on condition that not more than 10 meals
be transported by one person on one trip, i.e. ` 120 is charged irrespective of the number of meals subject to a
maximum of 10 meals. She incurs a fixed expense of ` 1,44,000 per month.
(a) At what volume of sales will she break-even at the earliest? How many deliveries will be required?
(b) If she is able to sell 5000 meals in a month, what will be her maximum profits?
(c) What will be her worst income at this level? Assume she will not entertain any delivery for less than 3 meals
per trip.
Answer
(a) Break Even at the earliest and Number of Deliveries
The earliest break-even will occur when the transport cost per unit is the minimum, i.e. when all her sales are
delivered in batches of 10. Then:
Cost of Food & Disposable Packing – `100/-
Delivery Cost = 120 ÷ 10 = `12/-
Contribution per meal= (160 –100–12) = `48.

Break Even Sales = Fixed Cost ÷ Contribution per Unit

= (1,44,000 ÷ 48) = 3000 meals per month
Number of deliveries required = (3000 ÷ 10) = 300 per month
(b) Profit at maximum sales of 5,000 per month
Contribution at a sale of 5,000 meals = 5000 × 48 = ` 2,40,000/-
Fixed Cost = ` 1,44,000/-
Profit = (2,40,000 – 1,44,000) = ` 96,000/-
(c) Worst income at the level of 5,000 meals
Contribution per Meal before delivery Cost = (160 - 100) = ` 60/-
Delivery cost at 3 meals per delivery = (120 ÷ 3) = 40
Contribution per meal = (60 - 40) = ` 20/-
Contribution at a sale of 5,000 meals = 5000 × 20 = ` 1,00,000/-
Profit = (1,00,000 – 1,44,000) = (` 44,000/-)
In a worst situation the loss is ` 44,000/-
Illustration 15 (Fixation of Selling Price)
Look Ahead Ltd. wants to fix proper selling prices for their products ‘A’ and ‘B’ which they are newly introducing
in the market. Both these products will be manufactured in Department D, which is considered as a Profit Centre.
The estimated data are as under: -
A B
Annual Production (units) 1,00,000 2,00,000
` `
Direct Materials per unit 15.00 14.00
Direct Labour per unit 9.00 6.00
(Direct Labour Hour Rate = ` 3)
The proportion of overheads other than interest, chargeable to the two products are as under:
Factory overheads (50% fixed) 100% of Direct Wages. Administration overheads (100% fixed) 10% of factory
costs. Selling and Distribution overheads (50% variable) ` 3 and ` 4 respectively per unit of products A and B.
The fixed capital investment in the Department is `50 lakhs. The working capital requirement is equivalent to
6 months stock of cost of sales of both the products. For this project a term loan amounting to `40 lakhs has been
obtained from Financial Institutions on an interest rate of 14% per annum. 50% of the working capital needs are
met by bank borrowing carrying interest at 18% per annum. The Department is expected to give a return of 20%
on capital employed.
You are required to:
a. Fix the selling price of products A and B such that the contribution per direct labour hour is the same for both
the products.
b. Prepare a statement showing in details the overall profit that would be made by the Department.

Answer
(a) Fixation of Selling Price
Step 1: Statement of Cost
Product A Product B
Element
Amount (`) Amount (`)
Direct Material 15 14
Direct Labour 9 6
Prime Cost 24 20
Factory Overhead (100% on Direct Labour) 9 6
Factory Cost 33 26
Administration Overhead (10% of Factory Cost) 3.30 2.60
Cost of production 36.30 28.60
Selling and Distribution 3 4
Cost of Sales per Unit 39.30 32.60
Step 2: Computation of Variable Costs
Product A Product B
Element
Prime Cost 24 20
Variable Factory Overhead (9 × 50%) & (6 × 50%) 4.50 3
Variable Selling and Distribution (50%) 1.50 2
Total 30 25
Step 3: Computation of Required Return on Total Capital Employed
Description Workings Rupees

Fixed Capital 50,00,000
Working Capital
A (1,00,000 ÷ 2) × 39.30 = 19,65,000
B (2,00,000 ÷ 2) × 32.60 = 32,60,000
Total Working Capital 52,25,000
Total Capital employed 1,02,25,000
Required Return @ 20% on Total Capital employed 20,45,000

Step 4: Computation of Required Contribution
Description Workings Rupees

Cost of Sales
A 1,00,000 × 39.30 = 39,30,000
B 2,00,000 × 32.60 = 65,20,000
Total Cost of Sales 1,04,50,000
Required Return @ 20% on Total Capital employed 20,45,000
Required Sales Value (1,04,50,000 + 20,45,000) 1,24,95,000
Variable Cost
A 1,00,000 × 30 = 30,00,000
B 2,00,000 × 25 = 50.00,000
Total Variable Cost 80,00,000
Required Contribution (1,24,95,000 – 80,00,000) 44,95,000
Required Contribution (1,24,95,000 – 80,00,000) 44,95,000
Labour Hours
A 1,00,000 × 3 = 3,00,000
B 2,00,000 × 2 = 4.00,000
Total Labour Hours 7,00,000
Contribution per hour 44,95,000 ÷7,00,000 6.4214
Contribution for unit of ‘A” 3 × 6.4214 19.2643
Contribution for unit of ‘B” 2 × 6.4214 12.8428
Step 5: Computation of Selling Price
Product A Product B
Element
Variable cost 30.00 25.00
Add: Required Contribution 19.2643 12.8428
Selling Price 49.2643 37.8428
(b) Statement showing in details the overall profit that would be made by the Department
Serial Element Amount (`)

1 Sales 1,24,95,000


2 Cost 1,04,50,000
3 Profit Before Interest 20,45,000
4 Interest on term loan (40,00,000 × 14%) (5,60,000)
5 Interest on Working Capital (50% of 52,25,000 × 18%) (4,70,250)
6 Profit 10,14,750
Illustration 16 (Fixation of Selling Price)

S.V.Ltd budgets to make 1,00,000 units of product P. The variable cost per unit is ` 10. Fixed costs are `6,00,000.
The finance Director suggested that the cost-plus approach should be used with a profit mark-up of 25%. However,
the Marketing Director disagreed and has supplied the following information:
Price per unit Demand

(`) (Unit)
18 84,000
20 76,000
22 70,000
24 64,000
26 54,000
As Management Accountant of the Company, analyse the above proposals and comment.
Answer
Calculation of selling price as per Finance Director’s approach
Amount (`)
Variable Cost 10
Fixed Cost (6,00,000/1,00,000) 6
Total Cost 16
Add: Profit mark up 25% 4
Selling Price 20
Evaluation of Marketing Director’s Proposal
Contribution Total
Selling Price No. of units Fixed Cost Profit
per unit contribution
(`) (`) (`) (`) (`)
18 8 84,000 6,72,000 6,00,000 72,000
20 10 76,000 7,60,000 6,00,000 1,60,000

Contribution Total
Selling Price No. of units Fixed Cost Profit
per unit contribution
(`) (`) (`) (`) (`)
22 12 70,000 8,40,000 6,00,000 2,40,000
24 14 64,000 8,96,000 6,00,000 2,96,000
26 16 54,000 8,64,000 6,00,000 2,64,000
Comment: At the selling price of ` 24 per unit, the profit is maximum and hence that price must be fixed for the
product.
3.2 Pricing Decisions and Strategies
Concept
Pricing can make or break a business. Setting prices for the products or services does not simply come down to
a simple calculation. Prices can be practical tools for making ends meet. To figure out the best way to set prices, it
is worthwhile to examine the idea of what the business wants that its pricing strategy should achieve.
Product prices determine the revenue stream of a business. Prices must be sufficient to cover the costs and profit.
Before lowering prices, it is preferable to lower costs to maintain a stable profit margin and a stable cash flow
into the business. Any pricing strategy must be chosen to ensure a maximum of profit. Knowing the market and
customer base are key elements to choosing the right pricing strategy.
Key Strategies
The key pricing strategies may, broadly, be listed as:
i. Profit Orientation
ii. Competition Based
iii. Demand Based
iv. Cost Plus
v. Mark-up
Profit-Orientation: In a sense, all pricing strategies are profit-oriented because, even if the prices are set with
other objectives in mind, the entity still needs to earn a profit to stay in business. Profit-oriented pricing makes
profit the top priority when figuring out the ideal price to set. A profit-oriented pricing strategy looks for the sweet
spot that allows the entity to charge as much as possible for the offerings without charging so much that potential
customers are alienated and money is lost through missed sales. This type of pricing objective can either aim to
maximize profit per unit relative to cost of goods sold and other operating costs, or it can aim to maximize the
overall profit by setting a price that is competitive enough to increase the overall number of units you sell.
Competitor-Based Pricing: Competitor-based pricing uses the price that is set to appeal to customers and
define the niche relative to the entity’s competitors. Competitive pricing is charging a price that is comparable
to other vendors selling the same item. It does not necessarily rely on setting a lower price than other available
options, although this strategy will certainly make the products appeal to customers who shop on the basis of price
alone. One can also use competitor-based pricing effectively by setting a price that is in the same ballpark as other
products in the same niche, or by choosing a higher price to send the message that the entity’s product is superior
and worth the extra money.

Selling a well-established product at a similar price to competitors is an option for small retailers who want to
draw customers to their businesses. Keeping customers there, however, often means distinguishing themselves on
bases other than price. Relying on a competitive pricing strategy may be risky if volume cannot be maintained or
if costs suddenly rise.
Vendors use a competitive pricing strategy when several other businesses sell the same product and there is
little to distinguish one vendor from another. A market leader will generally set the price for the product and other
vendors will usually have no option but to follow suit in order to remain competitive. Vendors will either match the
pricing of the market leader or set prices within a comparable range.
Vendors who are not market leaders can use the accepted price as a starting point. From there they can opt
to charge slightly more on the basis of factors such as superior customer service or an extended warranty on a
product. Retailers must be fully informed of the prices their competitors charge and also know how discerning
their customers are on price alone. Once price is established, sales volume must be monitored to see if the strategy
is working.
Demand Based: Demand Based Pricing is a pricing method based on the customer’s demand and the perceived
value of the product. In this method the customer’s responsiveness to purchase the product at different prices is
compared and then an acceptable price is set. Demand pricing is determined by establishing the optimal relationship
between profit and volume; a smaller per-unit profit is acceptable if volume is increased significantly. Demand
based pricing includes Price Skimming, Price Discrimination and Price Penetration.
In case of price skimming, the initial price is set very high so that only the customers with more purchasing
power can buy the product. After that the price is reduced gradually so that the price-sensitive customers who
were not able to buy the product at first can now buy. Finally, the price at which the company can operate in profit
is set up. This way a company gets ahead of any competition and by the time other companies can come to the
market this company already makes the profit. In general, electronic products are priced this way. If customers are
passionate about the entity’s products and willing to pay extra to be the first to have them, one can charge initial
high prices when the entity first introduces a new innovation or a new line, and then lower the prices after attracting
the people who are willing to pay more.
Price Discrimination is where customers are charged differently based on different demand levels. For example,
the airline ticket prices increase as the travel date gets closer. Inelastic demand during the end makes the price very
high. Another type of price discrimination is when customers in different markets/areas are charged differently for
the same product or service.
Price Penetration is the exact opposite to the price skimming. In this method the initial price is kept really
low to attract more customers and increase the market share. Discounts, inaugural price, first 100 buyers etc
are some of the methods. Price penetration strategy can be risky because customers do not like growing prices,
once accustomed to a low price and then being asked to pay more. However, this approach can be successful if
the products really do have qualities other than price that will make customers want to buy them, such as unique
features or unusually high quality.
Cost Plus Pricing: In cost-plus pricing, a set profit margin is added to the total cost of a product -- including
materials, labour and overhead. In cost-plus pricing, a company first determines its break-even price for the product.
This is done by calculating all the costs involved in the production, marketing and distribution of the product. Then
a markup is set for each unit, based on the profit the company needs to make, its sales objectives and the price it
believes customers will pay.
Cost plus also is used to price large development projects, particularly in government contracts. It is not always
easy to predict the total amount of money needed to design or build an aircraft carrier or a new piece of military

equipment, for example. Instead, companies estimate the amount of work needed and the time it will take to
complete and then specify a how much profit they will charge over and above the final cost of the project.
Another area that applies cost-plus pricing is services, particularly those provided to federal and state governments
by large and small businesses. Some examples are contractor support services and logistics support. In this case,
the government often buys a certain number of hours of work from the contractor at a fixed price, plus a percentage
for profit.
Cost-plus pricing, commonly, is used in processing credit card transactions. A pricing system called interchange
plus adds a merchant service provider’s fee to the rate charged by the credit card provider for each transaction.
This price model is good for merchants because it tells them exactly how much each credit card transaction will
cost them to process.
One problem with cost-plus pricing is that it does not take into account the price of competing products. If a
competing product is selling for less, cost-plus may not be a good strategy. Cost-plus pricing also ignores what the
product is worth to the buyer. Buyers may be willing to pay more for some products. A cost-plus strategy may not
be responsive to changes in the market and can be an obstacle to long-term success.
Mark-up pricing: Mark-up pricing is where a percentage is added to the wholesale cost of a product. Mark up
refers to the value that a player adds to the cost price of a product. The value added is called the mark-up. The
mark-up added to the cost price usually equals retail price. The difference between cost plus pricing and mark-up
pricing is hair-thin and both the terms are used one for the other very often.
For example, a FMCG company sells a bar of soap to the retailer at ` 10. This is the cost price. The retailer adds
` 2 as his value and sells the soap to the final consumer at ` 12. The margin of ` 2 between the cost price and MRP
is the mark-up.
The amount of mark-up allowed to the retailer determines the money he makes from selling every unit of the
product. Higher the markup, greater the cost to the consumer, and greater the money the retailer makes. In FMCG,
typically, the MRP is low and the retailer is allowed a lower markup, from anywhere between 5% and 8%. Low
margins mean a retailer makes less money on every unit, but the number of units sold is very high in FMCG. So
overall, the amount of money made evens out.
A well-established FMCG company like Hindustan Lever can give less margins to the retailers because the
volume of sales of its wide range of products is very high. On the other hand, a new and unknown product and
company will need to pay more margins to the retailers to entice them to stock the product in the first place.
Effective Pricing
Effective Pricing is the one that satisfies all the stakeholders, viz. the producer, distributor and the consumer. It
fits into the criteria of profit orientation, competition, demand base as also the cost plus and markup. In a way it
may be called long run calibrator of price equilibrium over a business cycle. It is the price set by the producer and
accepted by all. It is what that all stakeholders can bear.
Steps involved in determining an effective price may be listed as:
i. Analysis of Financial Statements
ii. Analysis of Cost Behaviour
iii. Analysis of the Profit Gap
iv. Evolving Cost Reduction Strategies
v. Determination of Feasible Prices for different Capacity level
vi. Determination of Effective Price

vii. Establishing Cost Controls

viii. Review, Revise and Reset
Three important approaches that warrant discussion in relation to effective pricing are:
(i) Product Differentiation
(ii) Cost Leadership
(iii) Yield Management
Product Differentiation
Product Differentiation is the process of distinguishing a product or service from others, to make it more attractive
to a particular target market. This involves differentiating it from competitors’ products as well as the firm’s own
products. The concept was proposed by Edward Chamberlin in 1933 in his ‘Theory of Monopolistic Competition’.
The strategy of Product Differentiation is adopted to build up specific competitive advantages over competitors
by tapping the unique resource endowments exclusive to an entity. The major sources of product differentiation
may be traced to differences in quality, differences in functional features, and differences in availability (e.g.,
timing and location).
The objective of differentiation is to develop a position that potential customers see it as unique. As a result,
the unique features of the product create a perception of esteem value for the product, which goes beyond pricing
considerations. Well established differentiation makes customers in a given segment developing a lower sensitivity
to the non-price features of the product.
Many a time product differentiation is driven by the factors of esteem value. The implication of differentiation
often enables the possibility of charging a price premium.
One of the innovative research papers observes that the growing market of physically challenged persons can be
a source of competitive advantage for the airlines if they differentiate their products and services by fulfilling the
needs of the physically challenged. That is where the innovative value of Product Differentiation could lie!
Cost Leadership
Cost Leadership is a generic strategy adopted to gain competitive advantage. The Strategy aims at the firm
winning market share by appealing to cost-conscious or price-sensitive customers. This is achieved by having the
lowest prices in the target market segment, or at least the lowest price to value ratio (price compared to what
customers receive). To succeed at offering the lowest price while still achieving profitability and a high return on
investment, the firm must be able to operate at a
lower cost than its rivals. I.Cost
Conscious
Cost leadership strategy drives the i.Optimum Concurrent
Culture
management to constantly work on reducing Utilisation of Value Chain
costs at every level and to remain competitive Assets Control
as also profitable. The three-fold dimensions, in
this context, consist of:
i. Optimum Utilisation of Assets COST
LEADERSHIP
ii. Cost Conscious Culture
iii. Concurrent Value Chain Control
Optimum Utilisation of Assets: The first and foremost is achieving a high asset utilization. In manufacturing,

it will involve production of high volumes of output. In service industries, this may mean for example a restaurant
that turns tables around very quickly, or an airline that turns around flights very fast. These approaches mean fixed
costs are spread over a larger number of units of the product or service, resulting in a lower unit cost, i.e., the firm
hopes to take advantage of economies of scale and experience curve effects. For industrial firms, mass production
becomes both a strategy and an end in itself. Higher levels of output both require and result in high market share,
and create an entry barrier to potential competitors, who may be unable to achieve the scale necessary to match the
firms low costs and prices.
Cost Conscious Culture: The second dimension is inculcating a cost conscious culture across the organisation
and achieving low direct and indirect operating costs. This is achieved by offering high volumes of standardized
products, offering basic no-frills products and limiting customization and personalization of service. Production
costs are kept low by using fewer components, using standard components, and limiting the number of models
produced to ensure larger production runs. Overheads are kept low by collective efforts. Maintaining this strategy
requires a continuous search for cost reductions in all aspects of the business. This will include outsourcing,
controlling production costs, increasing asset capacity utilization, and minimizing other costs including distribution,
R&D and advertising. The associated distribution strategy is to obtain the most extensive distribution possible.
Promotional strategy often involves trying to make a virtue out of low-cost product features.
Concurrent Value Chain Control: The third dimension is control over the value chain encompassing all
functional groups (finance, supply/procurement, marketing, inventory, information technology etc..) to ensure low
costs. For supply/procurement chain this could be achieved by bulk buying to enjoy quantity discounts, squeezing
suppliers on price, instituting competitive bidding for contracts, working with vendors to keep inventories low
using methods such as Just-in-Time purchasing or Vendor-Managed Inventory. Wal-Mart is famous for squeezing
its suppliers to ensure low prices for its goods. Other procurement advantages could come from preferential access
to raw materials, or backward integration. Keep in mind that if you are in control of all functional groups this is
suitable for cost leadership; if you are only in control of one functional group this is differentiation. For example,
Dell Computer initially achieved market share by keeping inventories low and only building computers to order
via applying Differentiation strategies in supply/procurement chain.
Cost leadership strategies are certainly viable for large firms with the opportunity to enjoy economies of scale
and large production volumes and big market share. Small businesses can be “cost focused”, but not “cost leaders”
if they enjoy any advantages conducive to low costs. For example, a local restaurant in a low rent location can
attract price-sensitive customers if it offers a limited menu, rapid table turnover and employs staff on minimum
wage. Innovation of products or processes may also enable a startup or small company to offer a cheaper product
or service where incumbents’ costs and prices have become too high. An example is the success of low-cost budget
airlines who, despite having fewer planes than the major airlines, were able to achieve market share growth by
offering cheap, no-frills services at prices much cheaper than those of the larger incumbents. At the beginning, low-
cost budget airlines chose “cost focused” strategies but later when the market grow, big airlines started to offer the
same low-cost attributes, and so cost focus became cost leadership!
A cost leadership strategy may have the disadvantage of lower customer loyalty, as price-sensitive customers
will switch once a lower-priced substitute is available. A reputation as a cost leader may also result in a reputation
for low quality, which may make it difficult for a firm to rebrand itself or its products if it chooses to shift to a
differentiation strategy in future.
The low-cost leadership strategies are prone to be imitated by the competitors as well, and thus low-cost
leadership is not a onetime process. A successful way of adopting this strategy can be by using the Japanese mantra
of “Kaizen” that focuses on continuous improvement. Target Costing is perceived as the most effective means
in this direction. Continuous rethinking is important for the implementers of this strategy. Continuous efforts to
improve the operations and reduce the costs make an entity more efficient, effective and economical, in comparison
to its competitors, which in turn lead to higher profit margins for the entity as a whole.

The higher profitability of the cost leaders gives them enough space to innovate, manoeuvre, and survive as
compared to their lower-margin competitors, especially in price centered industries. It also acts as a strong barrier
for the entry of new competitors. As such, cost leadership strategy is factored to bring in competitive advantage
over the long run. Global giants Wal-Mart and McDonalds are cited as interesting examples of being cost effective
leaders in their respective fields.
In the Indian perspective, Big Bazaar is, often, mentioned as one example that has been focusing on low-cost
leadership strategy. The major USP of ‘Big Bazaar,’ is low pricing. Big Bazaar sells the same branded products
that the other retailers are also selling; but it sells these products at a price, assumably, ten to fifteen percent lower
than that of the others.
“Cost Leadership is fostered by continuous Cost Reduction “. In the ultimate, it is the magnitude of successful
implementation of ‘Cost Leadership Strategy’ that determines the leader amongst the peers.
Yield Management
The core strength of Cost Management is ‘Prudent Deployment and Optimum Utilisation of the Available
Resources’. At the same time, it is one of the biggest challenges too for every Cost Manager, for many a resource
tends remain idle for incomprehensible reasons. It could be an unfilled seat in a flight, a vacant berth in a train,
an unoccupied hotel room, or an empty bed in a hospital. In all such eventualities, capacity unutilised is revenue
lost. Yield Management, also known, as Revenue Management is the innovation that addresses the ticklish issue
of underutilisation of available capacity.
Deregulation is generally regarded as the catalyst for yield management in the airline industry. As the history
would have it, Yield Management was devised by American Airlines in 1985 to overcome the stiff competition
posed by PeopleExpress. The Airline Deregulation Act in 1978 paved the way for deregulation of the airline
industry in USA and facilitated the entry of new players into the sector. It also enabled flexibility in determining
the fares and schedules. This was a huge change from a totally restricted industry to complete freedom for the
Aviation Industry in America. PeopleExpress was one of the new entrants into aviation, almost 70% smaller than
the then bigger airlines, but started offering very low competitive fares. The cut throat competition dented the
bigger airlines severely, American Airlines being the most affected.
On January 17, 1985, American Airlines launched its “Ultimate Super Saver Fares”. People thought it was a joke,
a final attempt to avoid bankruptcy, but it was real. American introduced low fares, just like PeopleExpress, or in
some cases even lower. There were only two differences:
a. If a passenger wanted to purchase an “Ultimate Super Saver” fare he had to book at least two weeks prior to
departure, and stay at his destination over a Saturday night.
b. The number of seats that could be sold for the discounted price was restricted. In this way American could
save seats for full fare customers who book just days before departure.
With these two changes American Airlines segmented the market between leisure travelers and business travelers.
Both segments preferred the major airline’s better service. As a result, eventually PeopleExpress was pushed to
the edge. That is how; Yield Management is stated to have come into effective practice. The concept spread to the
other travel and transportation companies in the early 1990s, and gradually to many other sectors all over the world.
Concept: Yield Management is a set of revenue maximization strategies and tactics meant to improve the
business profitability. It is a technique that determines the best pricing policy for optimising profits. It adopts the
principle of pricing the products and services at what the market can bear. In the process, it facilitates optimum
utilisation of the resources.
Yield management was devised as the scientific way of dynamically managing prices, inventories, and capacities
of perishable services. It is a scientific technique that combines Operations Research, Statistics and Customer
Relationship Management (CRM); and categorizes customers into price bands. It is the process of understanding,
anticipating and influencing consumer behaviour in order to maximize revenue and profits from fixed and perishable
resources such as airline seats, hotel rooms, hospital beds, etc. The underlying challenge is to sell the right resources
to the right customer at the right time for the right price. The process may lead to price discrimination, wherein an
enterprise charges different prices to different customers for identical goods or services.
Yield management is a large revenue generator for several major industries. The general principles of revenue
management are widely applicable all across, even though each particular application needs to carefully address the
requirements of a specific industry. It is the art and science of price-driven and capacity-based profit maximization.
It is a proven technique that helps service industries to maximize revenue.
Yield Management involves several aspects of management control, including price management, revenue streams
management, and distribution channel management, just to name a few. It is a multidisciplinary strategy that blends
the elements of marketing, operations, and financial management into a highly successful integrated approach. A
revenue manager ought to work in cohesion with the other departments while designing and implementing revenue
management strategies.
Yield Management Strategy is being used by many a sector such as Aviation, Hospitality, Health Care, Power
Distribution, Telecommunications, etc. The demonstrative examples include lower tariffs for advance reservation
by airlines; weekend discounts by hotels; time sensitive tariffs by power generation & distribution companies; the
differential pricings adopted by Telecom Services, Broadcasting Media, Railways, and so on.
Features
The industries that are amenable to the strategy of Yield
Management do exhibit specific features such as Fixed Capacity,
Perishable Products, Low Marginal Costs, Price Elastic Demand,
Segmented Market, and Advance Booking of the products and
services that are being offered.
Fixed Capacity: The first of the precincts, governing yield
management, is that the quantum of the products or services
available for sale is governed by the principle of Fixed Capacity.
In relation to the airline industry seats are the products; in case of
hotel industry hotel rooms are the products; and the capacity of
hospitals is the number beds they have for patients. The capacity
of the seats in a flight remains fixed as also the rooms in a hotel or
beds in a hospital. In line with the upward and downward swings
in demand, it is not feasible to add extra seats for any particular
trip of a flight, reduce the rooms in a hotel, or do away with some
beds in a hospital - on a day-to-day basis. The capacity of the
enterprise, thus, remains constant for the time being.
Perishable Products: The second of the precincts relates to
the perishable character of the products and services. The life
span of the products and services is very limited in character; the
products and services tend to perish after a time limit; and they
cease to be of no value thereafter. An airline seat that remains
vacant for the trip or a hotel room that remains unoccupied for a

night or a hospital bed that does not have a patient for the day - adds no value at all for the period. These products
and services cannot be stored in a warehouse and their value cannot be preserved. If not sold in time, the value is
lost forever.
Low Marginal Costs: Yield management is of especially high relevance in cases where the fixed costs are
relatively high compared to the variable costs. Such of these industries are heavily capital intensive with high
fixed costs and low marginal costs. Once the capacity is created by incurring the fixed (capacity) costs, the cost
of serving an additional customer is quite meagre. Rationally, an additional unit of the product can be offered at
a lower margin if the demand can be increased. The high fixed cost and low marginal cost nature of the business
enables the application of price differentiation as a tool to generate additional revenues. The fundamental principle
is that the sales can be pushed up till the point that marginal revenue continues to be greater than marginal costs.
Price Elastic Demand: The Demand for the products and services where Yield Management can be applied
is characterized by price elastic demand. Lower prices would draw more customers whereas higher prices would
wean away the unwilling customers. There could also be seasonal fluctuations in the demand. In that, in peak
season, the supplier can increase the revenues by raising the prices, while during lean season the sale volumes
can be maintained by lowering prices. A higher profit through higher prices is the guiding parameter for peak
season; and better capacity utilisation through lower prices happens to be the key strategy to tide over the pitfalls
of slack season. Past data will offer the manager a way to forecast as to when and how these periods of high and
low demand may occur.
Segmented Market: The market for the products and services is segmented wherein different classes of customers
are willing to pay different prices for using the same amount of the products or services. If all customers would
pay the same price for using the same quantum of resources, the challenge would perhaps be limited to selling as
quickly as possible and minimize the holding costs. Airlines and Hotels typically segment their customer base
into a set of categories based on the price each category is willing to pay. Typical categories include the business
traveller and the vacation traveller. Because demand patterns for each of these categories may vary significantly,
the service providers find it difficult to satisfy all of the demand simultaneously.
A good example is the comparison between the time-conscious business executive and the price sensitive
vacation customer. The former is willing to pay a higher price in exchange for flexibility of being able to book at
the last minute while the latter is willing to give up some flexibility for the sake of a more inexpensive pricing.
Yield Management tries to maximize revenues by managing the trade-off between a low occupancy and higher
rate scenario of business customers versus a high occupancy and lower rate of vacation customers. Such a strategy
allows airlines and hotels to fill the seats and rooms that would otherwise have been empty.
Advance Booking: More often than not, requests for bookings of the products and services start early. It could
be an airline seat, hotel room, or a maternity bed; enough scope exists for the customer to foresee a time line and
make the reservations well in advance. Therefore, the suppliers have enough leeway to adjust prices based on the
variation between advance bookings and expected demand. If all products are sold at the same time, the supplier
does not have the flexibility to adjust prices upward if demand picks up later. The trade-off occurs when a supplier
is faced with the option of accepting an early reservation from a customer who wants a low price, or waiting to see
if a higher paying customer will eventually show up.
The Process
The system of Yield Management is based on optimization methodologies developed from advanced statistical
and analytical models. In order to arrive at a solution, the processers need to evaluate several decisions, which
require a significant investment of skills, hardware and time.
Many Yield Management practitioners prefer to breakdown the actual business scenario into four sub-problems,
viz. Identification of Market Segments, Forecasting and Pricing, Segment-wise Allocation of Inventory, and

Overbooking. An individual solution to some or all of these sub-problems is arrived thereafter. This would
significantly reduce the number of potential non-optimal decisions thereby providing
fewer choices, leading to quicker results.
Identification of
Identification of Market Segments: The first and foremost step in Yield Market Segments
Management system is the identification of the various market segments for the
products and services, followed by implementation of a differential pricing scheme.
The objective is expansion of the market through customer temptation. In relation
to aviation, it may be observed that customers in the business class segment are Forecasting
less sensitive to higher prices as opposed to those in the vacation segment. Yield and Pricing
Management system helps the service providers to create additional price-points by
building physical and logical fences around the different market segments.
Forecasting and Pricing: The next step in Yield Management process is Segment wise
forecasting demand and pricing of the different market segments. Pricing and Allocation
demand are inter-related and need to be coordinated. Considering the example of
the hotel industry, demand for a room is cyclical in nature depending upon the day of
a week or months of a year and follows a trend of demand growth due to economic
upswing. These forecasts are seldom precise but provide the decision-maker with an
approximate set of inputs that are used in the planning process. Yield Management Over–booking
models help pinpoint demand by minimizing uncertainty and producing the best
possible forecast.
Segment-wise Allocation: The next important step in a Yield Management process is the allocation of the
products and services to different market segments. The ratio of discounted versus full priced products is not fixed
during the reservation period; rather, it is tweaked appropriately as the date of providing the service approaches.
The opportunity cost of selling a discounted product instead of a full priced one has to be measured in order to
make the best decision. Thus, when a customer approaches the hotel for a discounted price, the manager needs to
evaluate this scenario with the expected revenue from another customer who might come at a later date, willing
to pay a higher price for the same room. The manager would accept the request only if the discounted price now
is more than the expected price at which the room might be booked by the second customer. The key word here
is ‘expected’. Yield Management systems use mathematical algorithms to arrive at this decision using techniques
such as Littlewoods and Expectation Maximization, referred to as the EM algorithm.
Over-booking: Overbooking is the practice of intentionally selling more products than are available in order
to offset the effect of cancellations and no-shows. Studies estimate that although a hotel is fully booked, a small
percentage of the rooms may remain vacant on any given date. Poor overbooking decisions can prove to be very
expensive for the hotel. In the short run, it is only a loss of room revenue, but over the long-term, casualties may
include decreased customer loyalty, loss of hotel reputation, etc. American Airlines developed an optimization
model that maximizes net revenues associated with overbooking decisions for the airline industry. The driving
force behind the model is the evaluation of the trade-off between additional revenue accrued by selling an already-
reserved seat versus the downslide from doing so. It has been found that net revenue increases with overbooking
until the point where the downslide from overbooking a seat exceeds customer revenues. Beyond that point, the
negative impact of overbooking increases rapidly because fewer and fewer customers appreciate being turned away.
Complexities
Yield Management system does enable increased revenues; at the same time, it can be quite complicated to design;
and requires high levels of expertise for implementation. Some of the concerns being faced by the industry in the
implementation of a robust and accurate Yield Management system may be stated as difficulties in performance
measurement, impact on customer loyalty, impact on employee motivations and certainty in customer response.

Performance Measurement: Measuring performance of any Yield Management system is a major issue.
Occupancy rates and yield are measures that are affected by external competition. An ideal measurement can be
done using an opportunity model that indicates where the company
stands in comparison to its maximum.
Customer Loyalty: Differential pricing is here to stay and customers
seem resigned to the fact that the service provider charges different
Performance
prices for the same service. However, some customers do not like this
Measurement
practice and penalize the service provider by not becoming a patron.
Therefore, in a fiercely competitive environment where quality of
service is the key to success, Yield Management may not work. In Differential
evaluating the efficiency of a Yield Management system, the trade-off Pricing
between generating short-term profits and creating long-term customer
loyalty and mindshare needs to be studied carefully.
When Yield Management was introduced in the early 1990s, primarily Employee
in the airline industry, many suggested that despite the obvious Motivations
immediate increase in revenues, it might harm customer satisfaction
and loyalty, interfere with relationship marketing, and drive customers
from firms that used Yield Management to firms that do not use Yield Customer
Management. To some extent, frequent flier programs were developed Response
as a response to regain customer loyalty and reward frequent & high
yield passengers. Today, Yield Management is nearly universal in many
industries, apart from airlines.
Employee Motivations: From an operational point of view, Yield Management can impact the motivational
level of the employees. In many cases, Yield Management takes much of the guess work out of employees, thereby
reducing their decision-making responsibilities. Sometimes, employees taking reservations are paid a percentage
of the sales they make, motivating them to make group bookings, which in turn may be contradictory with the
objectives of a Yield Management system.
Customer Response: Despite optimising revenue in theory, introduction of yield management can sometimes
fail to achieve this in practice because of corporate image problems. In 2002, Deutsche Bahn, the German national
railway company, experimented with yield management for frequent loyalty card passengers. The fixed pricing
model that had existed for decades was replaced with a more demand-responsive pricing model, but this reform
proved highly unpopular with passengers, leading to widespread protests and a decline in passenger numbers. Yield
Management would be successful only if customer response can be gauged properly.
Capacity Optimisation
Adoption of Yield Management implies predicting potential capacity, and developing a pricing strategy that will
enable optimum capacity utilisation and maximum revenue. Yield Management attempts to derive the operational
solutions by means of methods similar to aggregate and hierarchical production planning techniques often employed
in the manufacturing industry.
Firms that engage in yield management usually use software-based systems to do so. The Internet has greatly
facilitated this process. Enterprises that use yield management periodically review transactions for goods or
services already supplied and for goods or services to be supplied in the future. The models attempt to forecast total
demand for all products or services they provide, by market segment and price point. Since total demand normally
exceeds what the particular firm can produce in that period, the models attempt to optimize the firm’s outputs to
maximize revenue.

The optimization attempts to answer the question: Given our operating constraints, what is the best mix of
products and or services for us to produce and sell in the period, and at what prices, to generate the highest expected
revenue? Optimization can help the firm adjust prices and to allocate capacity among market segments to maximize
expected revenues.
Taking the example of airlines, the passenger capacity is fixed for every scheduled flight; and when the aircraft
departs, the unsold seats can be said to have perished. Selling of these vacant seats even at lower prices would
lead to augmentation of the trip revenues and better utilization of passenger capacity; and that is where revenue
management comes into play.
Airlines keep monitoring the trend of reservations and respond by offering the probable vacant seats at
discounted prices to leisure travellers. Statistical analysis of past data helps in forecasting demand and establishing
the appropriate price bands. The same modus of operandi can be extended to Hotels, Car Rentals, Road Transport,
Rail Transport, Hospitals, Stadiums, Cinema Halls, Apartment Housing, and so on.
The application of Yield Management enhances the capacity utilisation whereby fixed costs per unit are brought
down to the feasible minimum, thus fulfilling the objectives of Marginal Costing. Obviously, Yield Management is
an extension of the techniques of Cost Volume Profit Analysis of Marginal Costing.
Yield Competencies
According to Professor Peter Bell, Richard C. Ivey School of Business, “Revenue management concepts will be
applied to almost everything that will be sold and will prove to be such a powerful competitive weapon that major
firms will be living, and in many cases dying, according to revenue management algorithms.”
As part of ongoing changes in the industry, companies throughout the world spectrum are placing a strong
emphasis on implementing major operational changes. Beyond recognizing that meaningful cost reductions must
be achieved without compromising safety, capacity and service levels, they are also looking at reducing costs by
increasing flexibility and improving asset utilization through Yield Management strategy. In doing so, they continue
to reassess their true core competencies that lead to optimize business efficiencies and increase profitability.
Yield Competency matrix may be drawn by finding answers to the following six simple questions that govern the
specific features of Yield Management.
1. Is the unit of product or service governed by the principle of Fixed Capacity?
2. Is the unit of product or service Perishable?
3. Does the product or service warrant Low Marginal Costs?
4. Is the unit of product or service prone to Price Elastic Demand?
5. Is the unit of product or service poised for a Segmented Market?
6. Can the unit of product or service be offered by means of Advance Booking?
If the answers are “Yes”, it is time to tread towards the path of Yield Management and catch the train of Revenue
Maximisation.
As the Yield Management, being software driven application, its scope can be unending. The path is open for a
plethora of Indian SMEs encompassing Transportation, Hospitality, Logistics, Education, Power Distribution, etc.
etc. A seat in a bus, a table in a restaurant, some space in a warehouse, a seat in a college, power for farmers, flat in a
rental apartment - everything is amenable to YM! It is for the Cost Managers to search out, evolve and implement
the strategy of Yield Management across ‘Make in India’.
If customer is the King, Yield Management is the Strategy!

Case Study 1: Wal-Mart pulls off its growth through Price Perfection
Many retailers are trying to replicate the success of Wal-Mart Stores Inc., the world’s largest retailer that was
founded over 60 years ago, on “Everyday Low” prices. The central goal of Wal-Mart is to keep retail prices low
-- and the company has been very successful at this. Experts estimate that Wal-Mart saves shoppers at least 15
percent on a typical cart of groceries.
Wal-Mart has grown, over the years, into more than just the world’s largest retailer. It is an economic force and
a cultural phenomenon. It all started with a simple philosophy from founder Sam Walton: ‘Offer shoppers lower
prices than they get anywhere else’. That basic strategy has shaped Wal-Mart’s culture and driven the company’s
growth.
Sam Walton opened his first five-and-dime in 1950. His vision was to keep prices as low as possible. Even if
his margins weren’t as fat as competitors, he figured he could make up for that in volume. Wal-Mart has been able
to keep its prices low through cutting-edge technology, a push to make suppliers sell merchandise at cheaper and
cheaper prices, and a frugal corporate culture.
Wal-Mart pushed the retail industry to establish the universal bar code, which forced manufacturers to adopt
common labelling. Over a decade back, Wal-Mart became the first major retailer to demand manufacturers use
Radio Frequency Identification Technology (RFID).
The stories of how Wal-Mart pushes manufacturers into selling the same product at lower and lower prices are
legendary. One example is Lakewood Engineering & Manufacturing Co. in Chicago, a fan manufacturer. In the
early 1990s, a 20-inch box fan costs $20. Wal-Mart pushed the manufacturer to lower the price, and Lakewood
responded by automating the production process. Lakewood also badgered its own suppliers to knock down the
prices of parts. Then, in 2000, Lakewood opened a factory in China, where workers could be as cheap as 25 cents
an hour. By 2003, the price on the fan in a Wal-Mart store had dropped to about $10.
In a 2003 Los Angeles Times article, part of a Pulitzer Prize-winning series about Wal-Mart, tells of a Wal-Mart
buyer named Celia Clancy, who was in charge of clothing and demanded that each supplier either lower the price or
increase the quality every year on every item. This philosophy is known as “plus one.” In “The Wal-Mart Effect,”
author Charles Fishman discusses how the price of a four-pack of GE light bulbs decreased from $2.19 to 88 cents
during a five-year period.
Wal-Mart’s impact extends beyond just small suppliers. It also affects how even major, established companies
like Coca-Cola and PepsiCo do business. At Wal-Mart’s request, Coke and its largest bottler Coca-Cola Enterprises
announced that they are changing the way they deliver PowerAde in the United States, altering a basic distribution
method for drinks that has been in place for more than a century. Coke also now allows Wal-Mart in on the
research-and-development process. In 2005, Coke planned to launch one new diet cola called Coke Zero. At Wal-
Mart’s request, it changed the name to Diet Coke with Splenda and launched a separate product called Coke Zero.
This kind of retailer involvement was unheard of at Coke decades ago. Pepsi also came up with a line of diet drinks,
called Slice One, to initially be sold exclusively in Wal-Mart.
Walton continued to drive an old pickup truck and share budget-hotel rooms with colleagues on business trips,
even after Wal-Mart made him very rich. He demanded that his employees also keep expenses to a bare minimum
-- a mentality that is still at the heart of Wal-Mart culture. The company has continued to grow rapidly even after
his death in 1992 and now operates many retail divisions.
Now that Wal-Mart is so huge, it has unprecedented power to shape labour markets globally and change the way
entire industries operate. Ninety percent of the U.S. population is stated to be living within 15 miles of a Wal-Mart,
according to “The Wal-Mart Effect.”
The key learning could be that Wal-Mart considers ‘Everyday Low Prices’ are the prices that would be afforded

by its customers which in turn would enable customer retention and customer attraction whereby the revenues are
propped up. In the process Wal-Mart pulls off its voluminous growth, through perfecting ‘Everyday Low Prices’
revealing that Price Perfection enables Perpetual Growth.
Case Study 2: McDonald’s Cost Leadership Strategy

The restaurant industry is known for yielding low margins that can make it difficult to compete with a cost
leadership marketing strategy. However, McDonald’s - the near-eighty-year-old restaurant chain - has been
extremely successful with Cost Leadership Strategy by offering basic fast-food meals at low prices.
McDonald’s has made itself to be the family friendly low-cost restaurant in the fast-food business all over the
world. McDonald’s have stuck to their core market throughout the years even through the changing times. The
term happy meal is said and begged for by children worldwide and has become a house hold name. McDonald’s
does things differently than its competitors by marketing to the exclusive family market.
The entity realizes that when a customer goes into McDonald’s he or she expects two things. They expect the
food will come out fast, and it will be inexpensive. That is what McDonald’s aim, i.e. (a) cheap and (b) fast, and
everything they do within the organization works towards these specific goals.
These two competitive advantages, cheap and fast, comply directly with the vision of the company which reads:
“McDonald’s vision is to be the world’s best quick service restaurant experience. Being the best means providing
outstanding quality, service, cleanliness, and value, so that we make every customer in every restaurant smile.”
McDonald’s strive to be cost leaders and offer their food at prices that cannot be matched by their competitors.
They ensure that their chain-stores are efficient enough to keep everyday operations costs as low as possible.
They have the most modern and technologically advanced equipment in their restaurants to make the processes
easier. The computer operated machinery allows the franchisee outlets to keep costs low by needing only a few
employees to do the work of several. The automation also enables the employees to do the job quicker. Many of
the McDonald’s have dual drive-through to decrease wait time and to increase volume of customers served.
In order to ensure that the products remain value oriented, McDonald’s make sure costs do not get out of hand,
with practices such as wage controls and ingredient standardization. While the fast-food industry experiences a
high-turnover rate, McDonald’s have learned to work with the system. They make the trade-off of an advanced
training program, with that of a simplified, pictographic, “assembly line” procedure, which ensures quality and
consistency by narrowing employees’ task scope, and therefore their required training. Such of these internal trade-
off practices have allowed McDonald’s to beat out cost competition effectively.
All of the activities of McDonald’s work towards cutting costs. Instead of buying high grade meat and ingredients,
McDonald’s settle for a standard grade meat that fits exactly into their needs. Also, they keep employee wages low,
and training costs minimal. They are able to keep wages low through a division of labour that allows it to hire and
train inexperienced employees rather than trained cooks. It also relies on a few numbers of managers who typically
earn higher wages. These two characteristics, viz. low-cost materials and low wages, go a long way in keeping
McDonald’s food cheaper than many of its competitors.
Another important competitive advantage they aim at McDonald’s is the speedy delivery of the food. In order
to maintain this advantage over other fast-food chains, the processes of cooking food are made simple for all
employees at the restaurants. They target a low failure rate to ensure the quick production and delivery of food.
The speedy service fits well throughout McDonald’s organization and is very convenient to the customer. They
built on this idea of convenience by building a McDonald’s store everywhere.
History and prestige give McDonald’s an advantage against other chains. Prices have remained low due to their
enormous wealth’s ability to take a hit on price margins and the international expansion making up for the declining

U.S. sales. The numerous stores also satisfy consumers on convenience. Being in the industry for so long has
allowed McDonald’s to lock in certain suppliers at beneficial prices.
McDonald’s are, thus, able to maintain their edge on cost leadership through a meticulously systematised cost
management activities comprising:
a. Process Automation & Simplification
b. Standardisation of Ingredients
c. Achieving lower Employee Costs
d. Chain of Convenient Stores
e. Low price margins driving High Volumes
The synergic impact of McDonald’s Cost Leadership is that of maintaining its position as one of the Multinational
Industry Leaders!
Case Study 3: Apple earns its pie through Product Differentiation

Apple Inc. is an American multinational corporation headquartered in Cupertino, California. The company
designs, develops, and sells consumer electronics, computer software, online services, and personal computers. Its
best-known hardware products are the Mac line of computers, the iPod media player, the iPhone smartphone, etc.
Apple is the world’s second-largest information technology company by revenue after Samsung Electronics, and
the world’s third-largest mobile phone maker.
The markets for the Apple’s products and services are highly competitive and the Company is confronted by
aggressive competition in all areas of its business. These markets are characterized by frequent product introductions
and rapid technological advances. Principal competitive factors important to the Company include price, product
features, relative performance, product quality and reliability, design innovation, software and peripherals,
marketing and distribution capability, service and support, and corporate reputation.
The Company’s business strategy, therefore, leverages on its unique ability to design and develop its own operating
systems, hardware, application software, and services to provide its customers new products and solutions with
superior ease-of-use, seamless integration, and innovative design.
Apple became the most valuable consumer-facing brand in the world In June 2011. Apple Inc. reported that the
company sold 51 million iPhones in the Q1 of 2014 (an all-time quarterly record), compared to 47.8 million in the
year-ago quarter. Apple also sold 26 million iPads during the quarter, also an all-time quarterly record, compared
to 22.9 million in the year-ago quarter. The Company sold 4.8 million Macs, compared to 4.1 million in the year-
ago quarter.
Apple’s high level of brand loyalty is considered unusual for any product. Fortune magazine named Apple the
most admired company in the United States in 2008, and in the world from 2008 to 2012. On September 30, 2013,
Apple surpassed Coco-Cola to become the world’s most valuable brand in the Omnicom Group’s “Best Global
Brands” report. Boston Consulting Group has ranked Apple as the world’s most innovative brand for a number of
years since 2005.
Apple attempts to increase market demand for its products through differentiation, which entails making its
products unique and attractive to consumers. The company’s products have always been designed to be ahead
of the curve compared to its peers. Despite high competition, Apple has succeeded in creating demand for its
products, giving the company power over prices through product differentiation, innovative advertising, ensured
brand loyalty, and hype around the launch of new products. By focusing on customers willing to pay more and
maintaining a premium price at the cost of unit volume, Apple also set up an artificial entry barrier to competitors.

The renowned Steve Jobs is stated to have built the strategy for Apple on four pillars, viz.
1. Offer a small number of products
2. Focus on the high-end
3. Give priority to profits over market share
4. Create a halo effect that makes people starve for new Apple products
Jobs’ vision for Apple was always to create a premier product and charge a premium price. Apple’s cheapest
products are usually priced in the mid-range, but they ensure a high-quality user experience with their features.
Drawing an example from the mobile market, as in May 2015 Apple charges `46,000/- for its iPhone6 whereas
Galaxy S5 mini a compatible product of Samsung is priced at `21,000/-. Apple is able to collect a premium of
119% for its carefully carved out characteristic of unique Product Differentiation.
The reading is that carefully carved out Product Differentiation holds the key for the success story of Apple Inc.;
Thus, Apple earns its pie through the strategy of Product Differentiation.
Case Study 4: Yield Management in Indian Railways

Rail vs Air: Captain Gopinath dreamt of bringing air travel within the reach of the common man and conceived
Air Deccan which became the first low-cost airline to fly pan-India in 2003. Air Deccan took to the strategy of Yield
Management and gradually pioneered the concept of low-cost travel. Air travel was offered at peanut prices as low
as one rupee per ticket. The market was taken by storm, and air travel was perceived as an affordable comfort. By
2006 Air Deccan was perceived to have converted air travel into a mass commodity and thus changed the face of
aviation sector in India. For the first time, train travellers started shifting from rail journey to flight journey.
It was in 2006 that Indian Railways decided to introduce a Dynamic Pricing Policy for freight as well as passenger,
for peak and non-peak seasons, premium and non-premium services, and for busy and non-busy routes. As per
this policy the rates for non-peak season, non-premium service and empty flow directions would be less than the
general rates and the rates for peak season and premium services could be higher than normal. For the freight the
non-peak season would be 1st July to 31st October. For the passenger segment this period would be 15th January
to 15th April and 15th July to 15th September.
The tricky issue in dynamic pricing is to figure out how high the tariff can go and to what extent a passenger will
pay higher rail tariffs, given that one can get an air-ticket at around the same price. A smart-pricing formula had
been developed to compete with airways and increase fares as per the demand curve. The formula has a floor price
equivalent or more than the Tatkal Rajdhani/Mail tariff. The price will further increase in tune with the demand
curve – the rate at which the tickets are booked. The prices of air tickets at that time will be monitored and thus
keep the ticket price for premium trains lower than airfares.
The revenue managers of Indian Railways had perceived the market threat posed by the low-cost air carriers to
the rail traffic in a proper perspective and have gone forward in adopting the technique of yield management to
optimise its capacity utilisation and counter the switchovers.
Reservation Against Cancellation (RAC): As a corollary to its governmental and social obligations, Indian
Railway earmarks considerable portion of its accommodations towards various categories of passengers such as
Government Exigencies, Defence, Foreign Tourist, Specially Abled, Women, Senior Citizens, etc. The quota is
kept open till the last moment and the unfilled seats and berths are allotted to accommodate the passengers from
the general wait list. However, the risk of some of the seats and births remaining vacant would always remain.
Similarly, last minute cancellations and no shows add up to the idle berths and seats.
The concept of Reservation Against Cancellation (RAC) was evolved with a view to fill up vacant berths and

seats that go idle due to passenger cancellations, quota vacancies, no shows, etc. Each train is given a fixed number
of RAC allocations by splitting some of the berths into seats. RAC passengers are offered confirmed sitting
accommodation with the assurance of providing berths against probable vacancies arising from any sort of quota
lapses or cancellations. The system facilitates assured accommodation to the travellers while, at the same time,
yielding additional earnings to the Railways. RAC is a practical example of programmed overbooking towards
enabling better capacity utilisation.
Auto Up-gradation: In case of upper-class seats remaining vacant, lower-class passengers are upgraded to
higher class travel whereby more lower-class vacancies can be offered to waitlisted passengers. It is reported that
on the average there are two upgrades for every wait listed upgraded confirmation. Impliedly, whenever an upgrade
does happen, then at least two passengers are happy, viz. the one who is upgraded to the higher class and as also
the one who is confirmed in the lower class. The process of auto up-gradation, certainly, maximises the passenger
capacity utilisation. In addition, this is one measure that had generated a lot of good will and proved to be a brand
builder for the Indian Railways.
Tatkal: Tatkal is an example of demand driven differential pricing wherein the last-minute passengers are offered
tickets at a premium. Tatkal bookings start a day before the scheduled journey. The tatkal charges are levied as a
percentage of the basic fare, i.e., at the rate of 10% for second class and 30% for all other classes, subject to certain
minimum and maximum limits. No refunds are granted on cancellation of confirmed tatkal tickets. The tatkal
scheme has gained popularity amongst the rail travellers, eventually leading to Premium Tatkal. Premium Tatkal
is an advancement of tatkal wherein dynamic pricing has been introduced by increasing the fare for the subsequent
bookings.
Premium special train are being run by Indian Railways with dynamic fare pricing, where dynamic fare stands
for the fare component that may be increased with the subsequent bookings. Advance Reservation Period (ARP)
of this train will be a maximum of 15 days. Only E-tickets will be permitted for booking. No concession shall
be applicable in this train. Vacant berths left at the time of charting will be offered for current booking at current
booking counters of train originating stations. Cancellation is not allowed.
Slack Season: Towards addressing the supply driven constraints, Indian Railways have implemented the concept
of differential pricing by offering lower train fares during the non-peak travel periods. The slack season fares are
kept marginally lower than the normal, the objective being to attract more customers for the rail travel, and thereby
minimise capacity losses.
Clone Trains: Clone trains are run on high-demand routes within an hour of a scheduled train’s departure to
accommodate those on its waiting list. The idea behind such real-time demand-driven trains is to ensure that the
wait listed passengers reach their destination around the same time they had originally envisaged. A premium train
would automatically get announced on the net/ on the system whenever waitlisted passengers went up beyond a
point - one way or both ways. The passengers would have to pay a ‘premium’ if they want to avail of it.
Add On Revenue: Add On Revenue (AOR) is the Revenue generated by any of the idle resources. Post Budget
2016-17, Indian Railways has initiated several measures to make use of its idle resources and double up its revenues
from non-tariff during the next five years. The spread of the activities, spelt out by the railway minister in his
budget speech, included:
i. Monetization of land and buildings through commercial exploitation of vacant land and space rights over
station buildings;
ii. Leasing out huge tracks of land available adjacent to rail network to promote horticulture and tree plantation;
Exploring the possibility of using this track for generating solar energy;
iii. Monetizing data, software and some of the free services provided by IR such as PNR enquiry, currently
being commercially exploited by other players;

iv. Exploiting advertising potential of stations, trains and land adjacent to tracks outside of big stations with a
focused target of increasing the advertising revenues by more than four times the current level;
v. Liberalizing the current parcel policies including opening the sector to container train operators to effect a
quantum jump in IR’s share of the national CEP (Courier, Express and Parcel) market; and
vi. Augmentation of revenues from manufacturing activity
Such of these Add On Revenue initiatives do focus on enhancing the existing avenues by putting the idle and
dormant resources to demand oriented utilisation in line with the market trend. The propositions are quite innovative
and appealing. They would certainly shore up the revenues substantially when implemented.
Surge Pricing: Surge Pricing is the latest adoption of Indian Railways. Rajdhani Express models introduced
in 1985, Durontos of 2010 and Shatabdis of the present day - all of them can be construed as demand driven &
need warranted premium trains. Effective from 9th September 2016, i.e., exactly ten years after the introduction of
dynamic pricing, IR has gone for Surge Pricing on an experimental basis. Ticket prices of Rajdhani, Duronto and
Shatabdi trains will keep increasing by ten percent of the basic fare with every ten percent of the tickets sold. The
fares will keep raising progressively as the tickets are sold out. Of course, the surging is subject to maximum ceiling.
Being a Social Enterprise, Indian Railways do adopt the concept of ‘’cap’’ on fares for each class of travel. A
sleeper fare would only increase to one and a half times its base fare and then remain constant; and so also for other
classes. Pricing is linked to the rate of sale of tickets, read in buckets, and capped to a maximum for each class of
travel.
Overnight Tangle: Wherever the train travel is overnight such that by many a Rajdhani or Duronto, for example
Mumbai to Delhi, full travel cost is the key factor that impacts the choice of the mode of journey of a regular
passenger. Full cost, here, implies the travel cost and the hoteling cost added together. The traveller starts from
home the previous evening, reaches the destination early in the morning, checks into a hotel for the daily chores,
completes the day’s work, vacates the hotel, takes the evening train and is home the next day morning.
In case of air, the traveller can start from home in the morning, catch the flight in the early hours, attend to the
work during the day, board a return flight in the evening and be home by night. The journey having been from to
home on the same day, the air traveller does not have to incur any hoteling cost. Therefore, an air traveller would
opt for train travel only if the to & fro train fare and hoteling cost put together are less than the to & fro air fare.
If a train traveller is extended the facility of having a bath and resting for an hour in an exclusive room in the
railway station on marginal rents, Rajdhanis and Durontos can pose fierce competition to the airlines. Designated
special rest rooms at the Railway Stations can make huge difference to the Class Travel being offered by the IR.
The challenging equation, however, is “To & Fro Train Fare + Rest Room Tariff” should be less than “To & Fro Air
Fare”. This is an idea that can be toyed with by the railways in a true perspective.
Learning Track: The capacity for every train trip remains fixed; once the train is scheduled the seats and berths
acquire the nature of perishability; trip based marginal costs are practically nil; the demand for travel can be
influenced by the pricing mechanism; passenger market is segmented with different categories of travellers; and
the facility of advance booking exists. All the major features of yield management are, thus, visible in the Indian
Railway Model.
General wait list for the reserved accommodation is an age-old tradition of the Indian Railways and reflects
a chance overbooking whereas RAC is a programmed overbooking, both the measures being in the direction of
augmenting the passenger capacity utilisation. Differential pricing strategy is put to use by IR through the medium
of demand driven tatkal and real time-based clone trains. Both of these measures are premium revenue propellers.
Auto up-gradation and lower fares during slack season and are aimed at improving the capacity utilisation and

generating marginal revenues. Non fare revenue is a movement towards next best utilisation of the idle resources.
Surge Pricing is a market prone approach.
The endeavours are good, but it is still a long journey for the Indian Railways because of its social and economic
limitations. These are the endeavours that can provide the Indian Railways a competitive posture towards perfecting
affordable passenger fares and compatible goods tariff; These are the endeavours that shall be pursued for effective
and efficient implementation; And these are the endeavours that can make Indian Railways a role model Cost
Leader! In the entire process, Yield Management could be the cutting edge for the Indian Railways.
Illustrative Examples: The illustrative examples provided in preceding section (i.e., Decisions involving
alternative choices) covers the specimens relating to pricing decisions and strategies as well. Hence, no additional
illustrative examples are furnished in this section.
3.3 Transfer Pricing

Transfer Price (TP) is the notional value of goods and services transferred from one division to the other division
of an organisation. In other words, when internal exchange of goods and services take place between the different
divisions of a firm, they have to be expressed in monetary terms. The monetary amount for those interdivisional
exchanges is called as ‘Transfer Price’. Transfer price is, thus, the price that one segment (sub unit, department,
division etc.,) of an organization charges for a product or services supplied to another segment of the same
organization.
Transfer prices are used when individual entities of a larger multi entity firm are treated and measured as
separately run entities. The determination of transfer prices is an extremely difficult and delicate task as lot of
complicated issues are involved in the same. Inter division conflicts are also possible.
‘Transfer Pricing’ is needed to monitor the flow of goods and services among the divisions of a company and to
facilitate the divisional performance measurement. The primary utility of transfer pricing is to measure the notional
sales of one division to another division. Thus, the system of transfer prices adopted in the organization will have
a significant effect on the performance evaluation of various divisions. It becomes very vital when there is internal
transfer of goods or services and it is required to appraise the distinct performances of the divisions/ departments
involved.
If profit centers are to be used, transfer prices become necessary in order to determine the separate performances
of both the ‘buying’ and ‘selling’ profit centers. If transfer prices are set too high, the ‘selling center’ will be
favoured. On the other hand, if transfer prices are set too low, the ‘buying center’ will receive an unwarranted
proportion of the profits.
In the current era of globalization, the transfer pricing practice extends to cross-border transactions as well as
domestic ones. Multi-National Corporations (MNC) are legally allowed to use the transfer pricing method for
allocating earnings among their various subsidiary and affiliate companies that are part of the parent organization.
However, companies at times can also use this practice for planning their taxable income and reducing their overall
taxes. The transfer pricing mechanism is a way that companies can shift tax liabilities to low-cost tax jurisdictions.
The tax impact of transfer pricing on tax liabilities can be explained by means of the example that follows.
Let’s say that an automobile manufacturer has two divisions: Division A, which manufactures software, and
Division B, which manufactures cars. Division A sells the software to other carmakers as well as its parent company.
Division B pays Division A for the software, typically at the prevailing market price that Division A charges other
carmakers. Let’s say that Division A decides to charge a lower price to Division B instead of using the market
price. As a result, Division A’s revenues get reduced and profits dip correspondingly. On the other hand, Division
B’s costs of goods sold become lower and increase its profits. In short, Division A’s revenues and profits are lower
by the same amount as of Division B’s reduction in costs and hence, there is no financial impact on the company
as a whole.
Assuming that Division A is located in a high-tax country and Division B in a low-tax country, the company can
save on taxes by making Division A less profitable and Division B more profitable. By making Division A charge
lower prices and passing on the savings to Division B, the tax liability of A is reduced. As Division B will be taxed
at a lower rate, there would be consequential reduction in the overall tax-outflow and the company would be able
to bring down its overall tax liability. In short, by charging below or above the market price, companies can use
transfer pricing to transfer profits and costs to other divisions internally and reduce their overall tax burden.
Methods of Transfer Pricing

There are several methods of fixation of ‘Transfer Price’ some of which are mentioned below:
i. Pricing based on Cost: In these methods, “cost” is the base and following methods fall under this category
a. Actual cost
b. Cost Plus
c. Standard Cost
d. Marginal Cost
ii. Market price as transfer price: Under this method, transfer price will be determined according to the
prevailing market price
iii. Negotiated pricing: Under this method, the transfer prices are fixed through negotiations between the selling
and buying divisions.
iv. Pricing based on opportunity cost: This pricing recognizes the minimum price that the selling division is
ready to accept and the maximum price that the buying division is ready to pay.
The benefits of Transfer Pricing Policy may be listed as under:

i. Divisional performance evaluation is made easier.
ii. It will develop healthy inter-divisional competitive spirit.
iii. Management by exception is possible.
iv. It helps in co-ordination of divisional objectives in achieving organizational goals.
v. It provides useful information to the top management in making policy decisions like expansion, sub-
contracting, closing down of a division, make or buy decisions, etc.,
vi. Transfer Price will act as a check on supplier’s prices.
vii. It fosters economic entity and free enterprise system.
viii. It optimizes the allocation of company’s financial resources based on the relative performance of various
profit centres, which in turn, are influenced by transfer pricing policies.
ix. Transfer pricing plays a vital role in strategic tax planning too. In that, the transfer pricing mechanism
provides a means whereby companies can shift tax liabilities to low-cost tax jurisdictions and gain cost
advantages.
The benefits and advantages of transfer pricing can be understood and appreciated better while going through the
illustrative examples furnished hereafter.

Illustrative Examples
Illustration 17
Your company fixes the inter-divisional transfer prices for its products on the basis of cost, plus a return on
investment in the division. The Budget for Division A for 2021-22 appears as under:
Particulars Rupees
Fixed Assets 5,00,000
Current assets 3,00,000
Debtors 2,00,000
Annual Fixed Cost of the Division 8,00,000
Variable Cost per unit of Product 10
Budgeted Volume 4,00,000 units per year
Desired ROI 28%
Determine the transfer price for Division A.
Answer
Budgeted Volume = 4,00,000 units per year
Variable Cost per Unit = `10.00
Fixed Cost per Unit = (8,00,000 ÷ 4,00,000) = `2.00
Desired ROI per Unit = {(10,00,000 × 28%) ÷ 4,00,000} = `0.70
Transfer Price per Unit = (VC + FC + ROI) = 10.00 + 2.00 + 0.70 = `12.70
(Explanatory Comment: The problem facilitates understanding the basic concept of transfer pricing.)
Illustration 18
Transferor Ltd. has two processes, Preparing and Finishing. The normal output per week is 7,500 units
(Completed) at a capacity of 75%. Transferee Ltd. had production problems in preparing and requires 2,000 units
per week of prepared material for their finishing processes. The existing cost structure of one prepared unit of
Transferor Ltd. at existing capacity is as follows:
Material = ` 2.00 (variable 100%)
Labour = `2.00 (Variable 50%)
Overhead = `4.00 (variable 25%)
The sale price of a completed unit of Transferor Ltd is `16 with a profit of `4 per unit.
Required:
Construct the effect on the profits of Transferor Ltd., for six months (25 weeks) of supplying units to Transferee
Ltd. with the following alternative transfer prices per unit:
(i) Marginal Cost
(ii) Marginal Cost + 25%

(iii) Marginal Cost + 15% Return on capital (assume capital employed as `20 lakhs)
(iv) Existing Cost
(v) Existing Cost + a portion of profit on the basis of {(Preparing cost ÷ Total Cost) x Unit Profit)
(vi) At an agreed market price of `8.50.
Assume no increase in fixed cost.
Answer
Evaluation of the effect of transfer of 2,000 units per week for 25 weeks on profit
Sl. Alternative TP (`) Effect on Profit (`)

Per Unit For 50,000 units
(i) Marginal Cost 4.00 (4.00 - 4.00) = 0 Nil
(Working Note 1)
(ii) Marginal Cost + 25% 4.00 + 25% = (5.00 - 4.00) = 1.00 50,000 × 1 =
(Working Note 3) 5.00 ` 50,000
(iii) Marginal Cost + 15% ROI 4.00 + 3.00 = (7.00 - 4.00) = 3.00 50,000 × 3 =
(Working Note 3) 7.00 ` 1,50,000
(iv) Existing Cost 8.00 (8.00 - 4.00) = 4.00 50,000 × 4 =

(Working Note 1) ` 2,00,000
(v) Existing Cost + Proportionate Profit 8.00 + 2.67 = (10.67 - 4.00) = 50,000 × 6.67 =
(Working Note 4) 10.67 6.67 ` 3,33,500
(vi) Agreed Market Price 8.50 (8.50 - 4.00) = 4.50 50,000 × 4.50 =
` 2,25,000
Working Note 1
Existing Cost Structure one Prepared Unit
Serial Element Workings Rupees

1 Variable (Marginal) Costs
(i) Material (100%) 2.00
(ii) Labour (50%) (2.00 × 50%) 1.00
(iii) Overheads (25%) (4.00 × 25%) 1.00
(iv) Total (i..iii) 4.00
2 Fixed Costs
(i) Labour (50%) (2.00 × 50%) 1.00
(ii) Overheads (75%) (4.00 × 75%) 3.00
(iii) Total (i..ii) 4.00
3 Total Cost 8.00

Working Note 2
Units to be Transferred in 25 weeks = 25 × 2,000 = 50,000
Working Note 3
Capital Employed = `20,00,000
ROI per annum @ 15% = 20,00,000 × 15% = `3,00,000
ROI for 6 months = {(3,00,000 ÷ 12) × 6} = `1,50,000
ROI per Unit = (1,50,000 ÷ 50,000) = `3.00
Working Note 4
Sale Price of the Completed Unit = `16.00
Profit per Unit – `4.00
Cost per Completed Unit = (16.00 – 4.00) = 12.00
Proportionate Profit for Prepared Unit = {(Preparing cost ÷ Total Cost) × Unit Profit)
={(8 ÷ 12) × 4} = `2.67
(Explanatory Comment: The problem highlights different methods of adopting the transfer price within an
organisation)
Illustration 19
A Company with two manufacturing divisions is organised on profit centre basis. Division ‘A’ is the only source
for the supply of a component that is used in Division B in the manufacture of a product KLIM. One such part is
used in each unit of the product KLIM. As the demand for the product is not steady, Division B can obtain orders
for increased quantities only by spending more on sales promotion and by reducing the selling prices. The Manager
of Division B has accordingly prepared the following forecast of sales quantities and selling prices.
Sales units per day Average Selling price per unit of KLIM (`)
1,000 5.25
2,000 3.98
3,000 3.30
4,000 2.78
5,000 2.40
6,000 2.01
The manufacturing cost of KLIM in Division B is `3,750 for first 1,000 units and `750 per 1,000 units in excess
of 1,000 units. Division A incurs a total cost of `1,500 per day for an output to 1,000 components and the total costs
will increase by `900 per day for every additional 1,000 components manufactured. The Manager of Division A
states that the operating results of his Division will be optimised if the transfer price of the component is set at `1.20
per unit and he has accordingly set the aforesaid transfer price for his supplies of the component to Division A.
(a) Prepare a schedule showing the profit at each level of output for Division A and Division B.

(b) Find the profit of the company as a whole at the output level which
(i) Division A’s net profit is maximum.
(ii) Division B’s net profit is maximum.
(c) If the Company is not organised on profit centre basis, what level of output will be chosen to yield the
maximum profit.
Answer
(a) Profit at each level of output
(i) Statement showing profit of division A
Sale per day Sale value Cost Profit/(loss)

(units) (`) (`) (`)
1000 1200 1500 (300)
2000 2400 2400 -
3000 3600 3300 300
4000 4800 4200 600
5000 6000 5100 900
6000 7200 6000 1200
(ii) Statement showing profit of division B

Other
No of Selling Price Transfer Profit /
Sales Manufacturing Total Cost
units per Unit Price (Loss)
Cost
(`) (`) (`) (`) (`) (`)
1 2 3 4 5 6 7
Derivation (1 × 2) (4 + 5) (3 – 6)
1000 5.25 5250 1200 3750 4950 300
2000 3.98 7960 2400 4500 6900 1060
3000 3.30 9900 3600 5250 8850 1050
4000 2.78 11120 4800 6000 10800 320
5000 2.40 12000 6000 6750 12750 (750)
6000 2.01 12060 7200 7500 14700 (2640)
(b) (i) Profit of the company at the output level where division A’s net profit is maximum
Profit of Division A is maximum, i.e. `1,200/- at the output level of 6,000 units
At the level of 6,000 units:
Profit of Division A = `1,200
Profit of Division B = (-) `2,640
Profit of the Company = (-) `1,440

(b) (ii) Profit of the company at the output level where division B’s net profit is maximum
Profit of Division B is maximum, i.e. ` 1,060/- at the output level of 2,000 units
At the level of 2,000 units:
Profit of Division A = ` Nil
Profit of Division B = `1,060
Profit of the Company = `1,060
(c) Profit when the company is not organized on profit centre basis
Units Division A (`) Division B (`) Total (`)

1000 (300) 300 —
2000 — 1060 1060
3000 300 1050 1350
4000 600 320 920
5000 900 (750) 150
6000 1200 (2640) (1440)
Maximum profit of `1,350 accrues at the output level of 3000 units which may be chosen.
(Explanatory Comment: The problem throws light as to how to make use of the principles of transfer pricing
for profit planning, both internally as also externally)
Illustration 20
Division A is a profit centre which produces three products X, Y and Z. Each product has an external market. The
details are as follows:
X Y Z
External market price per unit (`.) 48 46 40
Variable cost of production in division A (`.) 33 24 28
Labour hours required per unit in division A 3 4 2
Product Y can be transferred to Division B, but the maximum quantity that might be required for transfer is 300
units of Y.
X Y Z
The maximum external sales are: 800 units 500 units 300 units
Instead of receiving transfers of Product Y from Division A, Division B could buy similar product in the open
market at a slightly cheaper price of `45 per unit.
What should the transfer price be for each unit for 300 units of Y, if the total labour hours available in Division
A are?
(a) 3800 hours
(b) 5600 hours.

Answer
Computation of contribution per labour hour from external sales:
X Y Z
Market price (`.) 48 46 40
Variable cost (`.) 33 24 28
Contribution (`.) 15 22 12
Labour hours required 3 4 2
Contribution per labour hour (`.) 5 5.50 6
Ranking ΙΙΙ ΙΙ Ι
(a) Computation of transfer price when the capacity is 3800 hours:
Allocation of Hours if the capacity is 3800 labour hours
External Sales (Units) 800 500 300

Labour hours required per Unit 3 4 2
Hours needed for External Sales 2400 2000 600
Allocation of Hours if the capacity is 1200 2000 600
3800 hours (balancing)
The existing capacity is not sufficient, even, to produce the units to meet the external sales. In order to transfer
300 units of Y, 1200 hours are required in which division A has to give up the production of X to the extent of 1200
hours (400 units).
Transfer price for 300 units of Y will, therefore, work out to

Variable Cost of Y (`. 24) + [{(Contribution loss for X (`. 5 × 1200 hours = 6,000)} ÷300] = 24 + 20 = `. 44/-
(b) Computation of transfer price when the capacity is 5600 labour hours:
Allocation of Hours if the capacity is 5600 hours
External Sales (Units) 800 500 300

Labour hours required per Unit 3 4 2
Hours needed for External Sales 2400 2000 600
Balance of hours (Surplus) 600
Labour Hours needed for 300 units of Y = 300 × 4 = 1200
Surplus Labour Hours Available = 5600 – 5000 = 600
Short fall in Labour Hours = 1200 – 600 = 600
The short fall 600 hours may have to be diverted from X resulting in a contribution loss of `3,000 /- (600
hours × `5)
Transfer price for 300 units of Y will, therefore, work out to

Variable Cost of Y (`24) + [{Contribution loss for X (`5 × 600 hours = 3,000)} ÷ 300] = `24 + `10 = `34/-
(Explanatory Comment: The problem is a good example to make use of transfer pricing for optimum
utilisation of limited resources.)
Illustration 21
P.H. Ltd. has two manufacturing departments organised into separate profit centres known as the Basic unit and
Processing unit. The Basic unit has a production capacity of 4,000 tonnes per month of Chemvax but at present its
sales are limited `2,000 tonnes to outside market and 1,200 tonnes to the Processing unit.
The transfer price for the year 2021 was agreed at ` 400 per tonne. This price has been fixed in line with the
external wholesale trade price on 1st January 2021. However due to heavy competition the Basic unit has been
forced to reduce the wholesale trade price to `360 per tonne with effect from 1st June, 2021. This price however
was not made applicable to the sales made to the Processing unit of the company. The Processing unit applied for
revision of the price as applicable to the outside market buyers as from 1st June 2021 but the same was turned
down by the basic unit.
The Processing unit refines Chemvax and packs the output Known as Colour-X in drums of 50kgs each. The
selling price of colour-X is ` 40 per drum. The Processing unit has a potential of selling a further quantity of 16,000
drums of colour-X provided the overall price is reduced to `32 per drum. In that event it can buy the additional 800
tonnes of Chemvex from the basic unit whose capacity can be fully utilised. The outside market will not however
absorb more than the present quantity of 2,000 tonnes. The cost data relevant to the operations are:
Basic Unit (`) Processing Unit (`)

Raw Materials /tonne 70 Transfer price
Variable Cost /tonne 140 170
Fixed Costs /month 3,00,000 1,20,000
Required:
(i) Prepare statement showing the estimated profitability for June 2021 for each unit and the company as a
whole on the following bases:
(a) At 80% and 100% capacity utilisation of the Basic unit at the market price and transfer price to the
Processing unit of `400 per tonne.
(b) At 80% capacity utilisation of the basic unit at the market price of `360 per tonne and the transfer price
to the Processing unit of `400 per tonne.
(c) At 100% capacity utilisation of the Basic unit at the market price and transfer price to the Processing unit
of `360 per tonne.
(ii) Comment on the effect of the company’s transfer pricing policy on the profitability of the Processing Unit.
Answer
(a) (i) Statement showing computation of profit at 80% capacity when transfer price is ` 400/- ton:
Basic unit Processing unit Total
Production (Tonnes) 2000 + 1200 = 3200 1200 4400

Selling Price per Tonne (`) 400 (`40 ÷ 50 kgs) × 1000 = 800

Variable Cost per Tonne (`) 70+140 = 210 400 +170 = 570
Contribution per Tonne (`) 400-210 = 190 800 – 570 = 230
Total contribution (`) 6,08,000 2,76,000 8,84,000
Fixed cost (`) 3,00,000 1,20,000 4,20,000
Profit (`) 3,08,000 1,56,000 4,64,000

(a) (ii) Statement showing computation of profit at 100% capacity when transfer price is ` 400/- ton:
Production (Tonnes) 3200 ÷ 80% = 4000 1200 + 800 = 2000 6,000

Selling Price per Tonne (`) 400 (`.32 ÷ 50 kgs) × 1000 = 640
Variable Cost per Tonne (`) 70 + 140 = 210 400 + 170 = 570
Contribution per Tonne (`) 400 - 210 = 190 640 – 570 = 70
Fixed cost (`) 3,00,000 1,20,000 4,20,000
Profit (`) 4,60,000 20,000 4,80,000
(b) Computation of profit at 80% capacity utilisation of the basic unit at the market price of `360 per
tonne and the transfer price to the Processing unit of `400 per tonne.
Basic unit
Processing
Outside Internal Total
unit
sale transfer
Capacity (Tonnes) 2000 1200 1200 4400
Selling Price per Tonne (`) 360 400 800
Variable Cost per Tonne (`) 210 210 570
Contribution per unit (`) 150 190 230
(`) 5,28,000 2,76,000 8,04,000
(iv) Fixed cost (`) 3,00,000 1,20,000 4,20,000
(v) Profit (`) 2,28,000 1,56,000 3,84,000

(c) Computation of profit at 100% capacity utilisation of the Basic unit at the market price and transfer
price to the Processing unit of `360 per tonne

Capacity (Tonnes) 4000 2000 6000
Selling Price per Tonne (`) 360 640
Variable Cost per Tonne (`) 210 360 + 170 = 530
Fixed cost (`) 3,00,000 1,20,000 4,20,000
Profit (`) 3,00,000 1,00,000 4,00,000
(d) Comments
Overall profit is more at 100% capacity of basic unit with a transfer price of `400/- per ton being the market
price. If individual interests are not considered this may be adopted. However, from the view point of the
processing unit, it will not be interested to buy more than 1200tonnes from the basic unit, because its profit
gets reduced when it takes additional units.
(Explanatory Comment: The aspects of capacity utilisation and profit planning are two dimensions that are
worth learning from the problem)
Illustration 22
SV Ltd. Manufactures a product which is obtained basically from a series of mixing operations. The finished
product is packaged in the company made glass bottles and packed in attractive cartons. The company is organized
into two independent divisions viz. one for the manufacture of the end product and the other for the manufacture of
glass bottles. The Product manufacturing division can buy all the bottle requirements from the bottle manufacturing
division.
The General Manager of the bottle manufacturing division has obtained the following quotations from the outside
manufacturers for the empty bottles.
Volume Purchase Value
Empty bottles Total (`)
8,00,000 14,00,000
12,00,000 20,00,00
A cost analysis of the bottle manufacturing division for the manufacture of empty bottles reveals the following
production costs:
Volume Purchase Value
Empty bottles Total (`)
8,00,000 10,40,000
12,00,000 14,40,000

The production cost and sales value of the end product marketed by the product manufacturing division are as
under.
Volume Total cost of end product* Sales Value
(Bottle of end product) (Packed in bottles)
8,00,000 ` 64,80,000 ` 91,20,000
12,00,000 ` 96,80,000 ` 1,27,80,000
There has been considerable discussion at the corporate level as to the use of proper price for transfer of empty
bottles from the bottle manufacturing division to product manufacturing division. This interest is heightened
because a significant portion of the Divisional General Manager’s salary is in incentive bonus based on profit centre
results. As the corporate management accountant responsible for defining the proper transfer prices for the supply
of empty bottles by the bottle manufacturing division to the product manufacturing division, you are required to
show for the two levels of volume of 8,00,000 and 12,00,000 bottles, the profitability by using
i. Market price and
ii. Shared profit relative to the cost involved basis for the determination of transfer prices.
The profitability position should be furnished separately for the two divisions and the company as a whole under
each method. Discuss also the effect of these methods on the profitability of the two divisions.
* (Excluding cost of empty bottles)
Answer
(i) Profitability on the basis of Market Price
Description Amount (`) Amount (`)

Output (Units) 8,00,000 12,00,000
Bottle manufacturing division
Sale value 14,00,000 20,00,000
Cost 10,40,000 14,40,000
Profit 3,60,000 5,60,000
Product manufacturing division
Sale value 91,20,000 1,27,80,000
Costs
Product manufacturing division 64,80,000 96,80,000
Bottle manufacturing division 14,00,000 20,00,000
Total 78,80,000 1,16,80,000
Profit 12,40,000 11,00,000
Total profit 16,00,000 16,60,000
Transfer Price per Bottle 1.75 1.67

(ii) Statement showing Computation of Transfer Price on the basis of Profit shared on Cost Basis:

Output (Units) 8,00,000 12,00,000
Sales 91,20,000 1,27,80,000
Costs
Total 75,20,000 1,11,20,000
Profit 16,00,000 16,60.000
Apportionment of Profit in the ratio of Costs
Total 16,00,000 16,60.000
Transfer Price of Bottle manufacturing division
Costs 10,40,000 14,40,000
Share in Profit 2,21,276 2,14,964
Total Transfer price 12,61,276 16,54,964
Transfer price per bottle 1.5766 1.379
(iii) Statement of Comparative Profits

Product manufacturing division
Market Price Basis 12,40,000 11,00,000
Profit shared on Cost Basis 13,78,724 14,45,036
Bottle manufacturing division
Market Price Basis 3,60,000 5,60,000
Profit shared on Cost Basis 2,21,276 2,14,964
Observations
(a) Share of Profit of Product manufacturing division is higher when Transfer Price is worked out on Profit
shared on Cost Basis.
(b) Share of Profit of Bottle manufacturing division is higher when Transfer Price is worked out on Market Price
Basis.
(c) Overall Profit of the Company remains the same under both the alternatives.

Illustration 23
XYZ Ltd which has a system of assessment of Divisional Performance on the basis of residual income has two
Divisions, Alfa and Beta. Alfa has annual capacity to manufacture 15,00,000 numbers of a special component that
it sells to outside customers, but has idle capacity. The budgeted residual income of Beta is ` 1,20,00,000 while
that of Alfa is `1,00,00,000.
Other relevant details extracted from the budget of Alfa for the current year were as follows.
Particulars
Sale (outside customers) 12,00,000 units @ 180 per unit
Variable cost per unit 160
Divisional fixed cost 80,00,000
Capital employed 7,50,00,000
Cost of Capital 12%
Beta has just received a special order for which it requires components similar to the ones made by Alfa. Fully
aware of the idle capacity of Alfa, beta has asked Alfa to quote for manufacture and supply of 3,00,000 numbers
of the components with a slight modification during final processing. Alfa and Beta agree that this will involve
an extra variable cost of `5 per unit. Calculate the transfer price which Alfa should quote to Beta to achieve its
budgeted residual income.
Answer
Contribution required at Budgeted Residual Income
Fixed cost 80,00,000
Return on 7,50,00,000 × 12 % 90,00,000
Residual Income 1,00,00,000
Total Contribution required. 2,70,00,000
Contribution derived from existing units = 12,00,000 × 20 = ` 2,40,00,000
Contribution (Residual) required on 3,00,000 units = 2,70,00,000 – 2,40,00,000 = ` 30,00,000
Contribution per unit = 30,00,000 ÷ 3,00,000 = ` 10
Increase in Variable cost = `5
Transfer price = V.C + Desired Residual Contribution + Increase in VC = 160 + 10 + 5 = `175
3.4 Relevant Cost Analysis
Relevant Costs
The costs which should be used for decision making are often referred to as “relevant costs”. CIMA defines
relevant costs as ‘costs appropriate to aiding the making of specific management decisions’. Relevant costs are
costs which are relevant for a specific purpose or situation. In the context of decision making, only those costs are
relevant which are pertinent to the decision at hand.
Relevant costs and revenues are those, that are influenced by the decisions. Relevant costs are those expected

future costs that are essential but differ for alternative courses of action. It is a future cost that would arise as a
direct consequence of the decision under review. The concept of relevant cost is used to eliminate unnecessary data
that could complicate the decision-making process.
Relevant Cost Analysis enables mangers to choose between alternative choices in situations such as:
i. Accept or reject an order when there is excess capacity
ii. Accept or reject an order when there is no excess capacity
iii. Outsource a product or service
iv. Add, drop a product, service or department
v. Sell or process further
vi. Optimization of limited resources or working under constraint.
Relevant cost analysis is an incremental analysis which considers only relevant costs i.e., the costs that differ
between alternatives and ignores sunk costs i.e., costs which have been incurred, which cannot be changed and
hence are irrelevant to the situation.
In order to influence a decision a cost must be:
(a) Futuristic: Past costs are irrelevant, as we cannot change them by current decisions and they are common
to all alternatives that we may choose.
(b) Incremental: Expenditure which will be incurred or avoided as a result of making a decision. Any costs
which would be incurred whether or not the decision is made are not said to be incremental to the decision.
(c) Cash flow: Expenses such as depreciation are not cash flows and are therefore not relevant. Similarly, the
book value of existing equipment is irrelevant, but the disposal value is relevant.
Illustration 24
Company A manufactures bicycles. It can produce 1,000 units in a month for a fixed cost of `3,00,000 and
variable cost of ` 500 per unit. Its current demand is 600 units which it sells at `1,000 per unit. It is approached by
Company B for an order of 200 units at `700 per unit. Should the company accept the order?
Answer
A layman would reject the order because he would think that the order is leading to loss of `100 per unit
assuming that the total cost per unit is `800 (fixed cost of ` 3,00,000 ÷1,000 = `300 and variable cost of `500 as
compared to revenue of ` 700).
On the other hand, a management accountant will go ahead with the order because in his opinion the special order
will yield a contribution of `200 per unit. He knows that the fixed cost of `300,000 is irrelevant because it is going
to be incurred regardless of whether the order is accepted or not. Effectively, the additional cost which Company
A would have to incur is the variable cost of `500 per unit. Hence, the order will yield `200 per unit (` 700 minus
`500 of variable cost).
Normally, the following categories of costs are considered as relevant Costs:
i. Differential Costs
ii. Incremental or Marginal Costs
iii. Opportunity Costs
iv. Avoidable costs

v. Replacement Costs
vi. Imputed Costs
vii. Out-of-Pocket Costs
Differential Costs: A differential cost is the difference in costs under two or more decision alternatives,
specifically, two different projects or situations. It is also the change in the cost due to change in activity from one
level to another. Where same item with the same amount appears in all alternatives, it is irrelevant. For example,
a plot of land can be used for a shopping mall or entertainment park. The plot is irrelevant since it would be used
in both the cases.
An example of differential cost would be of a company which is selling its products through distributors. It is
paying them a commission of `16 million. Any alternate which costs lesser would be considered. Let us suppose
that the company is planning to appoint salespersons to sell its products and cancels the contracts with distributors.
In this case, the selling expense is expected to be to `12 million. There is cost differential of `4 million (16 m
- 12m). This is a good sign but the risk would have to be considered for changing the channel of distribution. If
there is low risk, it would be prudent to go for own arrangements for sales. Differential costs must be compared
to differential revenues. In case, switching over to direct sales brings additional revenues of `2 million, it would
increase the net benefit to `6 million. This would provide more comfort to the decision maker while considering
a change in the distribution channel.
Incremental or Marginal Costs: Incremental or marginal cost is a cost associated with producing an additional
unit. In case of a university, it could be cost of admitting another student. Even operating a second shift is an
example of incremental cost. It would be noted that the two decisions are not independent as second shift depends
upon first shift. Incremental costs must be compared with incremental revenues to arrive at a decision.
Opportunity Costs: Opportunity cost is the cost of an opportunity foregone. Opportunity costs represent the
potential benefits an individual, investor, or business misses out on when choosing one alternative over another.
Because of the fact that opportunity costs are, by definition, unseen, they can be easily overlooked. Understanding
the potential of missed opportunities when a business or individual chooses one investment over another allows
for better decision-making. In order t o properly evaluate opportunity costs, the costs and benefits of every option
available must be considered and weighed against the others.
Examples
a. Mr. Ahmed Shah left a bank job which was paying him `15,000 per month and got admission in a university.
Monthly fee-charge in the university is `10,000 per month. For Ahmed Shah, this would mean a cost of
`25,000 per month (` 10,000 + ` 15,000).
b. Farhana is a fresh graduate from a business university. She got two offers, one of `25,000 from an investment
bank and another of `15,000 for a teaching-assistant in a university. Another of her class-fellow, Shabana
got the same offer from the same university. While Shabana would be happy to join the university, Farhana
would not be as she would lose an opportunity to serve at the bank for `25,000.
Whenever an organization is deciding to go for a particular project, it should not ignore opportunities for other
projects. It should consider:
1. What alternative opportunities are there?
2. Which is the best of these alternative opportunities?
Avoidable costs: Avoidable Costs are those which under given conditions of performance efficiency should not
have been incurred. These are costs that can be eliminated in whole or in part by choosing one alternative over
another.

Replacement Costs: Replacement cost is the cost of replacement at current market price and is relevant for
decision-making. It is the cost at which there could be purchase of an asset or material identical to that which is
being replaced. Replacement cost is used for determining the optimum time of replacement of an equipment or
machine in consideration of maintenance cost of the existing one and its productive capacity.
Imputed Costs: Imputed costs are hypothetical or notional costs, not involving cash outlay. Imputed costs are
computed only for the purpose of decision making. In this respect, imputed costs are similar to opportunity costs.
Interest on funds generated internally, payment for which is not actually made is an example of imputed cost.
When alternative capital investment projects are being considered out of which one or more are to be financed from
internal funds, it is necessary to take into account the imputed interest on own funds before a decision is arrived at.
Out-of-Pocket Costs: These are costs that entail current or near future cash outlays for the decision at hand.
Such costs are relevant for decision - making, as these will occur in near future. This cost concept is a short-run
concept and is used in decisions on fixing Selling Price in recession, Make or Buy, etc. Out-of-Pocket costs can be
avoided or saved if a particular proposal under consideration is not accepted.
Irrelevant Costs
Irrelevant costs are costs which are not relevant for a specific purpose or situation. The examples of irrelevant
costs include:
i. Sunk Costs
ii. Committed Costs
iii. Unavoidable Costs
iv. Absorbed Costs
Sunk Costs: Sunk costs are historical costs which are incurred i.e., sunk in the past and are not relevant to the
particular decision. Sunk costs are those that have been incurred for a project and which will not be recovered if
the project is terminated. While considering the replacement of a plant, the depreciated book value of the old asset
is irrelevant as the amount is sunk cost which is to be written-off at the time of replacement.
Experiments have been conducted that identify situations in which individuals, including professional managers,
incorporate sunk costs in their decisions. One common example from business is that a manager would often
continue to support a project that the manager initiated, long after any objective examination of the project seems
to indicate that the best course of action is to abandon it. A possible explanation for why managers exhibit this
behaviour is that there may be negative repercussions to poor decisions, and the manager might prefer to attempt
to make the project look successful, than to admit to a mistake.
Here is another example. Consider a student who is between her junior and senior year in college, deciding
whether to complete her degree. From a financial point of view (ignoring nonfinancial factors) her situation is as
follows. She has paid for three years of tuition. She can pay for one more year of tuition and earn her degree, or
she can drop out of school. If her market value is greater with the degree than without the degree, then her decision
should depend on the cost of tuition for next year and the opportunity cost of lost earnings related to one more year
of school, on the one hand; and the increased earnings throughout her career that are made possible by having a
college degree, on the other hand. In making this comparison, the tuition fee paid for her first three years is a sunk
cost, and it is entirely irrelevant to her decision. In fact, consider three individuals who all face this same decision,
but one paid ` 24,000 for three years of in-state tuition, one paid ` 48,000 for out-of-state tuition, and one paid
nothing because she had a scholarship for three years. Now assume that the student who paid out-of-state tuition
qualifies for in-state tuition for her last year, and the student who had the three-year scholarship now must pay
in-state tuition for her last year. Although these three students have paid significantly different amounts for three
years of college (`.0, `24,000 and `48,000), all of those expenditures are sunk and irrelevant, and they all face

exactly the same decision with respect to whether to attend one more year to complete their degrees. It would be
wrong to reason that the student who paid `48,000 should be more likely to stay and finish, than the student who
had the scholarship.
Committed Costs: Committed Costs are costs that will occur in the future, and cannot be changed. Sometimes,
accountants use the term “sunk costs” to encompass committed costs as well. A committed cost is an investment
that a business entity has already made and cannot recover by any means, as well as obligations already made that
the business cannot get out of.
For example, if a company buys a machine for `40,000 and also issues a purchase order to pay for a maintenance
contract for `2,000 in each of the next three years, all of `46,000 is a committed cost, because the company has
already bought the machine, and has a legal obligation to pay for the maintenance. A multi-year property lease
agreement is also a committed cost for the full term of the lease, since it is extremely difficult to terminate a lease
agreement.
Unavoidable Costs: Unavoidable Costs are costs that are inescapable costs, and which are essentially to be
incurred, within the limits or norms provided for.
Absorbed Costs: Absorbed costs are indirect costs that are absorbed by the product or service. Absorbed fixed
costs which do not change due to increase or decrease in activity is irrelevant to decision-making. However, if
Fixed Costs are specific, they become relevant for decision-making.
Illustration 25
A machine which originally cost `12,000 has an estimated life of 10 years and it depreciated at the rate of `1,200
per year. It has been unused for some time, however, as expected production orders did not materialise. A special
order has now been received which would require the use of the machine for two months. The current net realisable
value of the machine is `8,000. If it is used for the job, its value is expected to fall to `7,500. The net book value
of the machine is `8,400. Routine maintenance of the machine currently costs `40 per month. With use, the cost of
maintenance and repairs would increase to `60 per month. What would be the relevant cost of using the machine
for the order so that it can be charged as the minimum price for the order?
Answer
Computation of relevant cost of using the machine for the order
Narration Working Amount (`)

Fall in sale value, if used (8000-7500) 500.00
Incremental maintenance cost [(60-40) × 2] 40.00
Relevant cost of using the machine for the order 540.00
Illustration 26
X Ltd. has been approached by a customer who would like a special job to be done for him and is willing to pay
`22,000 for it. The job would require the following materials:
Book Value of Realisable Replacement

Total units Units already Value
Materials units in stock Cost
required in stock
(`)/unit (`)/unit (`)/unit
A 1,000 0 — — 6

Book Value of Realisable Replacement

Total units Units already Value
Materials units in stock Cost
required in stock
(`)/unit (`)/unit (`)/unit
B 1,000 600 2 2.5 5
C 1,000 700 3 2.5 4
D 200 200 4 6 9
(i) Material B is used regularly by X Ltd. and if stocks were required for this job, they would need to be replaced
to meet other production demand.
(ii) Materials C and D are in stock as the result of previous excess purchase and they have a restricted use. No
other use could be found for material C but material D could be used in another job as substitute for 300 units
of material which currently costs `5 per unit (of which the company has no units in stock at the moment.)
What are the relevant costs of material, in deciding whether or not to accept the contract? Assume all other
expenses on this contract to be specially incurred besides the relevant cost of material is `550.
Computation of relevant costs of Material
Material Relevant Cost Workings Amount (`)

A Replacement Cost (1000×6) 6,000.00
B Replacement Cost (1000×5) 5,000.00
C Realisable Value for 700 units and Replacement [(700×2.5) + (300×4)] 2,950.00
Cost for 300 units
D Substitution Cost (300×5) 1,500.00
Sub Total 15,450.00
Add: other expenses 550.00
Total 16,000.00
As the revenue from the order, is more than the relevant costs of `16000 the order should be accepted
Illustration 27
Chakra Ltd. manufactures Mixer Grinders. The manufacture involves an assembly of various parts which are
processed in the machine shop and purchased components. The on/off switch is presently being purchased form a
vendor at `4.50 each, annual requirement being 20,000 pieces. The production manager has put up a proposal two
months back to make the switch in the machine shop. He had suggested that the company would make profit and
save taxes on bought out switch. The costing department was asked to make an estimate of making the item which
showed that the cost of making was `4.73. The purchase department continues buying the item on the basis of
the cost estimate given to them. Recently, the Vendor has sent a letter requesting the purchase department to grant
increase in price of 10% minimum per switch as the input costs had gone up. The costing department was once
again requested to estimate cost of making the switch. The costing department re-estimated the costs using current
prices and observed that the cost of making has gone up to `5.33. Purchase department again decided to continue
buying as it was cheaper to buy than make.

The cost estimate prepared by the costing department was as under:
Annual costs
Previous (`) Current (`)
Direct Materials 40,000 48,000
Direct Labour 20,000 22,000
Overheads 30,000 31,500
Total cost at current price 90,000 1,01,500
Add: expected increase 5% 4,500 5,075
Expected manufacturing cost 94,500 1,06.575
Cost per price 4.73 5.33
Twenty-five per cent of the overheads are fixed.
Required: Do you agree with the decision of buying considering the relevant costs? If the cost of making or
buying is more or less, what factors other than cost will influence making decision?
Answer
Twenty-five per cent of the overheads are fixed and hence not relevant for decision making.
Fixed Overheads:
Previous = 25% of 30,000 = ` 7,500/-
Current = 25% of 31,500 = ` 7,875/-
Variable Overheads:
Previous = 75% of 30,000 = ` 22,500/-
Current = 75% of 31,500 = ` 23,625/-
Statement of variable costs of making on/off switch before and after price increase
Particulars Previous (`) Current (`)
Materials 40,000 48,000
Labour 20,000 22,000
Overhead 22,500 23,625
Total Variable Cost 82,500 93,625
Number of Units 20,000 20,000
Cost per Switch 4.125 4.68
(82,500/20,000) (93,625/20,000)
Cost of Buying 4.50 4.95
(4.50 × 110/100)

It is not advisable that purchase department continues to buy the switch because variable cost of making is less
than the buying cost.
Illustration 28
The Officers’ Recreation Club of a large public sector undertaking has a cinema theater for the exclusive use of
themselves and their families. It is a bit difficult to get good motion pictures for show and so pictures are booked
as and when available.
The theater has been showing the picture ‘Blood Bath’ for the past two weeks. This picture, which is strictly for
adults only has been a great hit and the manager of the theater is convinced that the attendance will continue to be
above normal for another two weeks, if the show of ‘Blood Bath’ is extended. However, another popular movie,
eagerly looked forward to by both adults and children alike, ‘Appu on the Airbus’ is booked for next two weeks.
Even if ‘Blood Bath’ is extended the theater has to pay the regular rental on ‘Appu on the Airbus’ as well.
Normal attendance at theater is 2,000 patrons per week, approximately one fourth of whom are children under
the age of 12. Attendance of ‘Blood Bath’ has been 50% greater than the normal total. The manager believes that
this would taper off during the second two weeks, 25% below that of the first two weeks, during the third week and
33 1/3 % below that of the first two weeks, during the fourth week. Attendance for ‘Appu on the Airbus’ would be
expected to be normal throughout its run regardless of the duration.
All runs at the theater are shown at a regular price of `2 for adults and `1.20 for children lower than 12. The
rental charge for ‘Blood Bath’ is `900 for one week or `1,500 for two weeks. For ‘Appu on the Airbus’ it is `750
for one week or `1,200 for two weeks. All other operating costs are fixed - `4,200 per week, except for the cost
of potato wafers and cakes, which average 60% of their selling price. Sales of potato wafers and cakes regularly
average `1.20 per patron, regardless of age.
The Manager can arrange to show ‘Blood Bath’ for one week and ‘Appu on the Airbus’ for the following week
or he can extend the show of ‘Blood Bath’ for two weeks or else he can show ‘Appu on the Airbus’ for two weeks
as originally booked.
Show by computation, the most profitable course of action he has to pursue.
Answer
Statement showing Evaluation of Alternatives
Option 1 Option 2 Option 3
Narration Blood Bath & Appu
Blood Bath Appu on the Airbus
on the Airbus
(`) (`) (`)
No. of spectators
Adults:
Third week 3,000 × 75% 2,250.00 2,250.00 1,500.00
Fourth week 3,000 × 2/3 2,000.00 1,500.00 1,500.00
4,250.00 3,750.00 3,000.00
Children:
Third week 500.00

Option 1 Option 2 Option 3

Narration Blood Bath & Appu
Blood Bath Appu on the Airbus
on the Airbus
(`) (`) (`)
Fourth week 500.00 500.00
500.00 1,000.00
Total spectators 4,250.00 4,250.00 4,000.00
Revenue
By sale of tickets
Adults 8,500.00 7,500.00 6,000.00
Children - 600.00 1,200.00
Sub Total 8,100.00 7,200.00
Add: contribution from snacks @ 2,040.00 2,040.00 1,920.00
`.0.48 (40% of 1.20) per Patron
Total Revenue 10,540.00 10,140.00 9,120.00

Less: Incremental Costs 1,500.00 900.00
9,040.00 9,240.00 9,120.00
It may be observed that the net revenue is more at the option of running blood bath and Appu on the Air bus a
week each. It must be chosen.
Explanatory Notes:
(i) The problem specifies that even if ‘Blood Bath’ is extended the theater has to pay the regular rental of
`1,200/- on ‘Appu on the Airbus’ for the two-week period under consideration and hence they become
irrelevant for the decision making.
(ii) In case of Option 1 rental of `1,500/- on Blood Bath for two weeks is the incremental cost
(iii) In case of Option 2 rental of `900/- on Blood Bath for one week is the incremental cost
Illustration 29
Tiptop Textiles manufactures a wide range of fashion fabrics. The company is considering whether to add a
further product ‘Superb’ to the range. A market research survey recently undertaken at a cost of `50,000 suggests
that demand of the ‘Superb’ will last for only one year, during which 50,000 units could be sold at `25/- per
unit. Production and sale of ‘Superb’ would take place evenly throughout the year. The following information is
available regarding the cost of manufacturing ‘Superb’.
Raw Materials: Each ‘Superb’ would require 3 types of raw materials Posh, Flash and Splash. Quantities required,
current stock levels and cost of each raw material are shown below. Posh is used regularly by the company and
stocks are replaced as they are used. The current stock of Flash is the result of over buying for an earlier contract.
The material is not used regularly by Tiptop Textiles and any stock that was not used to manufacture ‘Superb’
would be sold. The Company does not carry a stock of splash and the units required would be specially purchased.

Meters reqd.
Raw Current
per unit of Costs per meter of Raw Material
Material Stock
Superb
Current
Original Current
Replacement
Cost Resale cost
Cost
(`) (`) (`)
Posh 1.00 1,00,000 2.10 2.50 1.80
Flash 2.00 60,000 3.30 2.80 1.10
Splash 0.50 0 5.50 5.00 5.00
Labour: Production of each ‘Superb’ would require a quarter of an hour of skilled labour and two hours of
unskilled labour @ `20 per hour for unskilled labour. In addition, one foreman would be required to devote all
his working time for one year in supervision of the production of superb. He is currently paid an annual salary of
`1,50,000. Tiptop Textiles is currently finding it very difficult to get skilled labour. The skilled workers needed to
manufacture ‘Superb’ would be transferred from another job on which they are earning a contribution surplus of
`4.50 per labour hour, comprising sales revenue of `40.00 less skilled labour wages of `30.00 and other variable
costs of `5.50. It should not be possible to employ additional skilled labour during the coming year. If ‘Superb’
are not manufactured, the company expects to have available 2,00,000 surplus unskilled labour hours during the
coming year. Because the company intends to expand in the future, it has decided not to terminate the services
of any unskilled worker in the foreseeable future. The foreman is due to retire immediately on an annual pension
payable by the company of `60,000. He has been prevailed upon to stay on for a further year and to differ his
pension for one year in return for his annual salary.
Machinery: Two Machines would be required to manufacture ‘Superb’ MT 4 and MT 7. Details of each machine
are as under:
Start of the year End of the year

(`) (`)
MT 4
Replacement cost 80,000 65,000
Resale Value 60,000 47,000
MT 7
Replacement cost 13,000 9,000
Resale Value 11,000 8,000
Straight-line depreciation has been charged on each machine for each year of its life. Tiptop Textiles owns a
number of MT 4 machines, which are used regularly for various products. Each MT 4 is replaced as soon it reaches
the end of its useful life. MT 7 machines are no longer used and the one which would be used for ‘Superb’ is the
only one the company now has. If it were not used to produce ‘Superb’ it would be sold immediately.
Overheads: A predetermined rate of recovery for overheads is in operation and the fixed overheads are recovered
fully from the regular production at `3.50 per labour hour. Variable overhead costs for Superb are estimated at
`1.20 per unit produced.

For decision-making, incremental costs based on relevant costs and opportunity costs are usually computed.
You are required to compute such a cost sheet for ‘Superb’ with all details of material, labour overhead etc.,
substantiating the figures with necessary explanations.
Answer
For each of the element the relevant cost will be as follows for preparing cost sheet
(i) Market survey cost is a sunk cost and not relevant for decision making
(ii) Raw materials
(a) Raw material ‘Posh’, is used regularly and stocks are replenished and hence current replacement cost is
relevant.
Units of Posh required = (50.000 × 1) = 50,000
Cost of Posh = (50,000 × 2.5) = `1,25,000.00
(b) Current stock of ‘Flash’ is a result of over buying and will not be used for other than ‘Superb’ and hence
relevant cost is net releasable value.
Material required (50000 × 2) = 100000 units
Cost of Flash = 60,000 units from stock @ `1.10 per unit and 40,000 units @ the replacement cost of
`2.80 per unit = (60,000 × 1.1) + (40,000 × 2.8)
= `1,78,000
(c) Material ‘Splash’ has no stock and has to be bought @ the replacement cost of `5.00 per unit
Units of Splash required = (50.000 × 0.5) = 25,000
Cost of Splash = (25,000 × 5.00) = `1,25,000.00
(iii) Labour:
(a) Due to unskilled labour, no work has been suffered and so no extra cost and hence not relevant in
decision making
(b) Skilled labour is stated to be scarce. Therefore, not only the cost, but also the contribution forgone,
being opportunity cost, should be considered for decision making
Skilled Labour Hours required = (50.000 × 0.25) = 12,500
Wages of Skilled Labour @ `30/- per hour = (12,500 × 30) = `3,75,000/-
Contribution foregone @ `4.50 per hour = (12,500 × 4.50) = `56,250.00
Cost of Skilled Labour = (3,75,000 + 56,250) = `4,31,250/-
(c) Effective cost of foremen = (Salary – Pension Deferred)
= (1,50,000 - 60,000)
= `90,000/-
(iv) Machinery:
(a) MT-4 are regularly used and therefore the difference between replacement cost at the start and at the end
of the year is relevant
Cost of MT-4 = (80,000 – 65,000) = `15,000.00
(b) MT-7 is not used regularly and the difference between resale value at the start and at the end of the year
should be considered as relevant
Cost of MT-7 = (11,000 – 8,000) = `3,000.00

(v) Variable Overheads:

Variable Overheads are relevant costs.
Variables Overheads = (50,000 × 1.2) = ` 60,000.00
(vi) Fixed Overheads:
Fixed Overheads are not relevant because it is recorded fully at regular production
Cost Sheet of 50,000 units of Superb
Element Amount (`) Amount (`)
Raw material:
Posh 125,000.00
Flash 178,000.00
Splash 125,000.00 428,000.00
Labour:
Skilled 4,31,250.00
Pension 90,000.00 5,21,250.00
Machinery:
MT-4 15,000.00
MT-7 3,000.00 18,000.00
Variable overheads 60,000.00
Total Cost 10,27,250.00
Profit (b/f) 2,22,750.00
Sales (50000 × 25) 12,50,000.00
(Commentary: The problem serves as a good example for understanding the multiple dimensions of relevant
and irrelevant costs)
Illustration 30
A Company can produce any of its 4 products, A, B, C and D. Only one product can be produced in a production
period and this has to be determined at the beginning of the production run. The production Capacity is 1,000 hours.
Whatever is produced has to be sold and there is no Inventory build-up to be considered beyond the production
period. The following information is given:
Particulars A B C D
Selling Price (`. Per unit) 40 50 60 70
Variable Cost (`. Per unit) 30 20 20 30
No. of units that can be sold 1,000 600 900 600
No. of production hours required 1 hour 1 hour and 15 1 hour and 15 2 hours
per unit of product minutes minutes

What are the Opportunity Costs of A, B, C and D?
Answer
Serial Particulars A B C D
1 Contribution per unit (`.)
Selling Price 40.00 50.00 60.00 70.00
Variable Cost 30.00 20.00 20.00 30.00
Contribution (a-b) 10.00 30.00 40.00 40.00
2 Time Required per Unit (Hours) 1.00 1.25 1.25 2.00
3 Production Capacity (Hours) 1000 1000 1000 1000
4 Maximum Production (Units) = (3÷2) 1000 800 800 500
5 No. of Units that can be sold 1000 600 900 600
6 Sales lost due to production constraint (Units) Nil Nil 100 100
7 Opportunity Cost (Contribution lost due to Sales Nil Nil `.4000 `.4000
Constraint) = (6 × 1)
Illustration 31
The accountant of XYZ Ltd. has prepared the following estimate on the basis of which he has advised that a
contract should not be accepted at the price offered. The estimate (`.) was as follows:
Material X in stock at original cost 1,50,000

Material Y on order at contract price 1,80,000
Material Z to be ordered at current price 3,00,000
Skilled Labour 5,40,000
Unskilled Labour 3,00,000
Supervisory Cost 1,00,000
General Overheads 1,80,000
Total Cost 17,50,000
Price offered 14,00,000
Net Loss 3,50,000
The following details are available about the cost components listed above.
a. Material X is an obsolete material. It can be used on another product W, the material for which is available
at `1,35,000 (Material X requires some adaptation to be used which costs `15,000). It may take some time
before W’s order is confirmed. Until then storage will cost `12,000.
b. Material Y is ordered for some other product which is no longer required. It now has a residual value of
`1,55,000.

c. Skilled labour can work on other contracts which are presently operated by semi-skilled labour at a cost of
`4,00,000
d. Unskilled labour are specifically employed for this contract
e. Supervisory staff will remain whether or not the contract is accepted. Only two them can replace other
positions where the salary is `50,000.
f. Overheads are charged at 33 1/3% of skilled labour. Only `1,25,000 would be avoidable
You are required to answer the following questions using relevant cost approach:
(a) Relevant costs of material X, Y and Z
(b) Relevant cost of labour-skilled and unskilled
(c) Relevant cost of Supervisory cost and General overheads
(d) If the contract is accepted, what would be the resulting financial impact on XYZ’s profit
Answer
(a) Relevant costs of material X, Y and Z
Material X (Obsolete)
Material X in stock at original cost = 1,50,000
Reuse Value = 1,35,000
Adaptation Cost = 15,000
Storage Cost = 12,000
Relevant Cost of Material X= (1,35,000 – 15,000- 12,000) = `1,08,000/-
Material Y (No longer required)

Material Y on order at contract price = 1,50,000
Residual Value = 1,55,000
Relevant Cost of Material Y= `1,55,000/-
Material Z (To be ordered)

Material Z to be ordered at current price = 3,00,000
Relevant Cost of Material Z = `3,00,000/-
(b) Relevant cost of labour-skilled and unskilled

Skilled Labour (Can replace unskilled labour)
Cost of skilled labour = 5,40,000
Replacement Cost (in place of unskilled labour) = 4,00,000
Relevant Cost of Skilled Labour = `4,00,000/-
Unskilled Labour (Specifically Employed)

Cost of unskilled labour = 3,00,000

Relevant Cost of Unskilled Labour = `3,00,000/-
(c) Relevant cost of Supervisory cost and General overheads

Supervisory cost = 1,00,000
Replacement Value for others = 50,000
Relevant Supervisory Cost = `50,000/-
Avoidable General Overheads = 1,25,000

Relevant Costs of General Overheads = ` 1,25,000
(d) Computation of Financial Impact

A Price Offered 14,00,000
B Relevant Costs
1. Material X 1,08,000
2. Material Y 1,55,000
3. Material Z 3,00,000
4. Skilled Labour 4,00,000
5. Unskilled Labour 3,00,000
6. Supervisory Cost 50,000
7. General Overheads 1,25,000
8. Total (1...7) 14,38,000
C Financial Impact (A-B) (38,000)
Observation: The loss is much less than what the accountant has worked out. However, if the contract is
accepted, XYZ’s profit will be reduced by ` ,38,000/-.
3.5 Target Costing
Japan’s Competitive Thinking triggers Target Costing

The primary objective of Japanese Management is stated to be linking accounting practices with corporate goals
and missions. As a consequence, the Japanese Management Accountants are tuned to focus on influential roles
rather than restraining themselves as information providers. There lies the emulative spirit of Japan’s Competitive
Posture.
The Japanese believe that the key to achieving a competitive edge is simplicity. They have established that
there can be too much of good things, too much of a variety, too much of a flexibility and even too much of

customer satisfaction. Deriving it from the thought of continuously improving costing, in their stride to maintain
the competitive edge, Japanese organisations have moved on to the radical approach being referred to as ‘Target
costing’. Target costing is market-driven system of cost reduction, focused on managing costs at the developmental
and design stages of a product.
In the early of 1990s, three major events occurred in Japan that contributed to significant changes in target
costing. The first and the most significant was the bursting of the economic bubble in 1990 and 1991, which caused
many companies to struggle to meet customers’ expectations of lower prices.
The second event was the rise of the Japanese yen against the U.S. dollar, which started in 1993. By 1995, the
Japanese yen had appreciated as much as 50 per cent against the dollar. It moved from a stabilized exchange rate
of 130–140 yen per dollar in 1992 onto a record 84 yen per dollar in 1995. As a consequence, both the exports and
the profit margins of Japanese companies plummeted. The survival instinct of the Japanese companies forced them
to intensify their use of target costing.
The long recession in Japan caused by a crisis in the financial sector was the third major event that forced many
Japanese companies to squeeze out costs to meet their profitability requirements. Target costing paved the way for
survival of the fittest as also to reinvent the upbeat.
The Target Philosophy

Effective cost management systems are developed in response to changing competitive conditions. Target costing
is an example of such a system that has a special relevance to companies in the process and assembly industries.
In these industries, firms are no longer able to achieve a sustainable competitive advantage by pursuing either a
low-cost or differentiation strategy. Rather, firms realize that any competitive advantage they achieve is likely to
be short-lived as their competitors move quickly to match new product offerings at competitive prices. Moreover,
competitors will often supply their new products with more advanced features, providing further challenges that
require a firm to respond.
Rather than attempting to create a sustainable competitive advantage based on either low cost or commanding
price premiums through product differentiation, firms become involved in continual head-on competition. And
there arises the need for Target Costing.
Target costing focuses on searching for opportunities for cost reduction at the product planning stage, as well as
providing continuous cost reductions once a product commences manufacture. In a competitive economy, product
markets influence the determination of the price of the product and the financial markets influence the determination
of the cost of capital. Cost of the capital infused by the enterprise sets the benchmark for the quantum of the profit
to be achieved. Thus, price of the product as also the quantum of the profit are market driven. The end result is that
the product cost boundaries are set by the difference between the price and the profit.
Target Costing is considered as a philosophy in
which product development is based on what the
customer wants and is willing to pay for and not what
it costs to produce. Hence it starts with the market TARGET PRICE
determined price; then deducts the desired profit TARGET COST MINUS TRAGET
margin; and works back the target cost. Peter Drucker PROFIT
calls this “price-led costing.” And that is how the
formulation: “Target Cost = Target Price – Target
Profit” in place of the traditional approach of “Cost +
Profit = Selling Price”.
An illustrative example assumes the following situations. ABC Limited finds a market niche to an innovative

kitchen grinder at a market driven price of `3,000/- per piece. The estimated sales volume at that price would
work out to 40,000 pieces per annum aggregating to `12 crores. The projected investment towards designing,
developing, producing, marketing and servicing these grinders is estimated to be `8 crores; and the desired return
on investment is 15% per annum. Given the afore said data, the target cost to design, develop, produce, market
and service the kitchen grinder of ABC Limited may be formulated as shown in the table that follows.
Target Cost of Kitchen Grinder
Serial Item Workings Amount in `

1 Projected Sales 40,000 pieces @ `.3,000/- per piece 12,00,00,000
2 Desired Profit 15% ROI on `.8,00,00,00 of Investment 1,20,00,000
3 Target Cost Projected Sales – Desired Profit 10,80,00,000
4 Target Cost per grinder Target cost / 40,000 pieces 2,700

The target cost of `1080 lakhs per annum which computes to `2,700/- per grinder would further be broken down
function-wise for the designing, developing, producing, marketing, servicing, and so on. Each of the functional
areas would be made responsible to achieve the actual costs in line with the targets.
Process of Target Costing
The stages in the process of target costing may be enumerated by means of the following eleven vital steps.
Step1- Identification of the Market Needs: The first step consists of identifying the market requirements as
regards design, utility and need for a new product or improvements of existing product. The customer requirements
as to the functionality and quality of the product is of prime importance. The design specification of the new
product is based on customer’s tastes, expectations and requirements. Competitor’s products and the need to have
extra features over competitor’s products are also considered. However, the need to provide improved products,
without significant increase in prices, should be recognized as charging a higher price may not be possible in
competitive conditions.
Step 2 – Establishment of Selling Price: The second step in target costing is the establishment of a selling price
for the new product by adopting market driven approach. The Target Selling Price is determined using various
sales forecasting techniques. The price is also influenced by the offers of competitors, product utility, prices,
volumes and margins. In view of competition and elasticity of demand, the firm has to forecast the price volume
relationship with reasonable certainty. Hence the Target Selling Price is market driven and should encompass a
realistic reflection of the competitive environment.
Step 3 - Establishment of Target Production Volumes: Next comes the establishment of Target Production
Volumes which is closely related to Target Selling price, given the relationship between price and volume. Target
Volumes are also significant in computation of unit costs, in particular, Capacity Related Costs and Fixed Costs.
Product Costs are dependent upon the production levels over the life cycle of the product.
Step 4 - Target Profit: The fourth step is that of visualising a target profit by means of investment driven
considerations. Since profitability is critical for survival, a Target Profit Margin is established for all new products.
The Target Profit Margin is derived from the company’s long term business plan, objectives and strategies. Each
product or product line is required to earn at least the Target Profit Margin.

Step 5 -Target Cost: The fifth step relates to determining the target cost by subtracting the target profit from the
established selling price. The difference between the Target Selling Price and Target Profit Margin indicates the
“Allowable Cost” for the product. Ideally, the Allowable Cost becomes the “Target
Cost for the product”. However, the Target Cost may exceed the Allowable Cost,
Market Needs
in the light of the realities associated with existing capacities and capabilities.
Step 6 - Estimating Current Costs: The sixth step relates to estimating the
current costs for the product on the basis of functional cost analysis and value Selling Price
engineering of individual components and processes. The estimation of Current
Cost is based on existing technologies and components, taking into account
the functionalities and quality requirements of the new product. Direct Costs
Production Volume
are determined by reference to design specifications, materials prices, labour
processing time and wage rates. Indirect Costs may be estimated using Activity
Based Costing Principles.
Target Profit
Step 7 - Cost Reduction Targets: Then follows the exercise of comparing
the current costs with the target costs. The difference between Current Cost and
Target Cost indicates the required cost reduction. This amount may be divided into Target Cost
two constituents namely – (a) Target Cost - Reduction Objective and (b) Strategic
Cost - Reduction Challenge. The former is viewed as being achievable (yet still a
very challenging target) while the latter acknowledges current inherent limitations. Estimating
After analyzing the Cost Reduction Objective, a Product-Level Target Cost is set Current Costs
which is the difference between the current cost and the target cost -reduction
objective. Cost Reduction
Step 8 - Identifying Cost Reduction Opportunities (Iteration): After the Targets
Product-Level Target Cost is set, a series of analytical activities, commence to
translate the cost challenge into reality. These activities continue from the design Iteration
stage until the point when the new product goes into production. The total target
is broken down into its various components, each component is studied and
opportunities for cost reductions are identified. Target, or allowable, costs are Lauching the
identified for individual components or processes and cost improvement teams Product
keep on working to reduce the estimated costs to match the target. However,
cost-reduction requirements are not usually applied uniformly across all the Product Cost
components and subsystems of the product, but based on an informed assessment Management
of how much cost can be removed from each component based on value to
the customer, historical trends and other data. There may also be a process of
Consumption
negotiation between different production departments and between the company
Cost Management
and its suppliers to arrive at final target costs for the individual components. This
process of cost reduction is an iterative one which continues until the target cost
is reached or it is concluded that the overall target cost cannot be reached and a decision is made not to launch the
product.
Step 9 - Launching the Product: The product is on for launching after the cost estimate is on target.
Step 10 - Product Cost Management: Once the target costs have been determined, actual costs can be monitored
and managed against the targets using the usual budgeting and costing methods such as standard costing.
Step 11 - Consumption Cost Management: A consumer friendly post sale support service should be oriented
towards cost management during the consumption cycle of the product.

Advantages
Target costing offers a range of advantages as follows:
i. Innovation: It reinforces top-to-bottom commitment to process and product innovation, and is aimed at
identifying issues to be resolved.
ii. Competitive Advantage: It enables a firm to achieve competitive advantage over other firms in the industry.
The firm which achieves cost reduction targets realistically stands to gain in the long run.
iii. Market Driven Management: It helps to create a Company’s competitive future with market-driven
management for designing and manufacturing products that meet the price required for market success.
iv. Real Cost Reduction: It uses management control systems to support and reinforce manufacturing strategies,
and to identify market opportunities that can be converted into real savings to achieve the best value rather
than simply the lowest cost.
Key Features
Here follow the Seven Key Features that encompass Target Costing.
1. Price-Led Costing: Target costing sets the target cost by first determining the price at which a product can
be sold in the marketplace. Subtracting the target profit margin from this target price yields the target cost,
that is, the cost at which the product must be manufactured. Notice
that in a target costing approach, the price is set first, and then the
target product cost is determined. This is opposite from the order in Price-Led
which the product cost and selling price are determined under Costing
traditional cost-plus pricing. Focus on the
Key Derivation: Cost = (Price – Profit) Customer
2. Focus on the Customer: To be successful at target costing, Focus on
management must listen to the company’s customers. What Product Design
products do they want? What features are important? How much
Focus on
are they willing to pay for a certain level of product quality?
Process Design
Management needs to aggressively seek customer feedback, and
then products must be designed to satisfy customer demand and be Cross-Functional
sold at a price they are willing to pay. In short, the target costing Teams
approach is market driven.
Life-Cycle
Key Derivation: Customer is the Philosopher Costs
3. Focus on Product Design: Design engineering is a key element in Value-Chain
target costing. Engineers must design a product from the ground Orientation
up so that it can be produced at its target cost. This design activity
includes specifying the raw materials and components to be used
as well as the labour, machinery, and other elements of the production process. In short, a product must be
designed for manufacturability.
Key Derivation: Manufacturable Product Design forms the Base
4. Focus on Process Design: Every aspect of the production process must be examined to make sure that
the product is produced as efficiently as possible. The use of touch labour, technology, global sourcing in
procurement and every aspect of the production process must be designed with the product’s target cost in
mind.
Key Derivation: Efficient Process Design is the Pillar

5. Cross-Functional Teams: Manufacturing a product at or below its target cost requires the involvement of
people from many different functions in an organisation, i.e., market research, sales, design engineering,
procurement, production engineering, production scheduling, material handling and cost management.
Individuals from all these diverse areas of expertise can make key contributions to the target costing process.
Moreover, a cross-functional team is not a set of specialists who contribute their expertise and then leave;
they are responsible for the entire product.
Key Derivation: Team Work does the Trick
6. Life-Cycle Costs: In specifying a product’s target cost, analysts must be careful to incorporate all of the
product’s life-cycle costs. These include the costs of product planning and concept design, preliminary
design, detailed design and testing, production, distribution and customer service. Traditional cost-
accounting systems have tended to focus only on the production phase and have not paid enough attention
to the product’s other life-cycle costs.
Key Derivation: Life Cycle Perception is the Approach
7. Value-Chain Orientation: Sometimes the projected cost of a new product is above the target cost. Then
efforts are made to eliminate non-value-added costs to bring the projected cost down. In some cases, a close
look at the company’s entire value chain can help managers identify opportunities for cost reduction.
Key Derivation: Value Addition is the Crux
Cost Management Techniques and Target Costing

Many organisations have found that the real strength of target costing lies in its overall framework for cost
improvement and efficiency within which a range of different techniques are used. The choice of technique or
combination of techniques may vary from one company to another. Important techniques that fit into the framework
of target costing include:
●● Value Analysis
●● Value Engineering
●● Just-In-Time (JIT)
●● Total Quality Management (TQM)
●● Materials Requirements Planning (MRP)
●● Kaizen
●● Lean Manufacturing
●● Activity Based Costing and Management (ABCM)
●● Cause-Effect Analysis (Fishbone Diagrams)
Implementation of these techniques, in an overall framework, is a team effort. Given that perspective, target
costing paves the way for the cost accounting professionals to look beyond, move onto shop floors and work hand
in hand with the cross functional teams.
Target costing is as relevant to the service sector as is for the manufacturing sector. Cooper and Chew (1996)
identify ways in which target costing can be applied to service-oriented businesses. For process businesses, the focus
of target costing shifts from the product to the process, and for service businesses the focus is the service delivery
system. All through, the key issues – understanding the needs of the market, customers and users, and ensuring
satisfactory financial performance at a given cost or price which does not exceed the target cost – do remain.

Kaizen Costing
One of the most influential changes in the practice of management to emerge is kaizen – the philosophy of
continuous improvement. Originally a Japanese idea, it has been adapted around the world as an integral part of
management strategy. An advancement of the concept of kaizen is that of ‘kaizen costing’ in which the emphasis
is on gradual ongoing cost reduction.
Kaizen costing refers to the ongoing continuous improvement program that focuses on the reduction of waste in
the production process, thereby further lowering costs below the initial targets specified during the design phase. it
is a Japanese term for a number of cost reduction steps that can be used subsequent to issuing a new product design
to the factory floor.
Activities in kaizen costing include elimination of waste in production, assembly, and distribution processes, as
well as the elimination of unnecessary work steps in any of these areas. Thus, kaizen costing is intended to repeat
many of the value engineering steps, continuously and constantly refining the process, thereby eliminating out
extra costs at each stage.
Cost reductions resulting from kaizen costing are much smaller than those achieved with value engineering. But
these are still significant 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. Target Costing is considered
to be an off spring of Kaizen Costing.
Toyota aggressively pursues kaizen costing to reduce costs in the manufacturing phase. In every July and January,
plant managers submit six months plan for attaining their kaizen goal. Methods for achieving these goals include
cutting material costs per unit and improvement in standard operating procedures. These are pursued based on
employees’ suggestions. For improvements involving industrial engineering and value engineering, employees
often receive support from technical staff. To draw up a kaizen plan after kaizen goals have been set by top
management, employees look for ways to contribute to kaizen in their daily work. It was reported that about two
million suggestions were received from Toyota employees in one year alone (roughly thirty-five per employee).
Ninety-seven per cent of them were adopted. This is a prime example of the concept of employee empowerment
in which workers are encouraged to take their own initiatives to improve operations, reduce costs, and improve
product quality and customer service.
Case Study 1: Target Costing at Caterpillar

The application of target costing is best illustrated by Dan Swenson, Shahid Ansari, Jan Bell, and IL Woon Kim,
in their research article ‘Best Practices in Target Costing’ (Management Accounting Quarterly, Winter 2003) by
drawing a practical example from Caterpillar. The illustration runs as follows.
Caterpillar offers a good illustration to highlight the target costing process as was applied to one of its new
products. For this particular vehicle, management set the target cost at 94.6% of a comparable model, creating an
initial gap of 5.4%. The cost of the comparable model is based on current manufacturing capabilities. Therefore, to
achieve the target, costs must be reduced by 5.4%.
A cost improvement team is then formed comprising representatives from product design, manufacturing
engineering, production, marketing, and purchasing to determine how to close the gap. Initially, the group evaluates
component part substitutions that would reduce costs but still provide the product features and benefits necessary
to satisfy customer requirements. The group also considers opportunities to reduce costs through efficiency
improvements. Table 1 shows the outcome from the team evaluations.

Table 1
Modification of Current Product: Known Adjustments
Projected Adjusted
Current Costs Savings
Activity Explanation of Known Adjustments
Costs (%)
(%) (%)
Assembly 5.4 3.9 1.5 Efficiency improvements due to redesigning sheet
metal, as documented on current production models.
Cab 7.9 7.1 0.8 Replace current cab with the “Classy Cab.” PF quote
already received.
Engine 8.6 7.9 0.7 Cost estimate from Engineering for switching to
different configuration.
Hydraulics 19.1 17.5 1.6 New pump design
Power Train 12.0 12.0 0
Structures 20.0 20.0 0
Linkage 18.0 18.0 0
Others 9.0 9.0 0
Total 100.0 95.4 4.6
As may be observed from the table, the cost improvement team identified 4.6% in “known” savings through an
initial evaluation of cost savings opportunities. Having reduced the gap by 4.6%, the team must find an additional
0.8% in savings to achieve the 5.4% cost reduction target.
At this stage, the cost improvement team surveys the operational groups, through a questionnaire, to identify
potential cost savings opportunities. The responses to the questionnaire do not recommend specific solutions,
but they do identify where improvement opportunities are more likely to be successful (see Table 2). Each “yes”
response on the questionnaire indicates an opportunity for cost reduction, and the component part category (cab,
engine, hydraulics, etc.) that has the largest number of positive responses is viewed as having the greatest potential
for saving money.
Table 2
Modification of Current Product: Sample Questionnaire
(Yes = 1, No = 0)
Hydraulics
Structures
Assembly
Linkage
Engine
Others
Power
Train
Total
Cab
1. Are there more than five suppliers from 0 0 0 1 1 1 1 0

whom you can purchase materials?
2. Are you costlier than best-in-class supplier 0 0 0 1 0 0 0 0
(either Caterpillar or non-Caterpillar)?

Hydraulics
Structures
Assembly
Linkage
Engine
Others
Power
Train
Total
Cab
3. Do you plan to survey your supplier cost 0 0 0 1 0 0 1 0
breakdown?
4. Is the current manufacturing process 0 0 0 1 0 0 0 0
younger than two years?
5. Does labour represent more than 40% of 0 0 1 1 0 0 1 0
your total cost?
6. Is your “unit setup cost/total unit cost” ratio 0 0 1 1 0 0 0 0
greater than 5%?
7. Do you see potential for material 0 0 0 1 0 0 0 0
specification changes?
8. Do you see potential for tolerance loosening? 0 0 0 1 0 0 1 0
9. Does the current family of parts contain 0 0 0 1 0 1 1 0
nonapproved parts?
10. Can the current design or manufacturing 0 0 0 1 0 0 0 0
processes be subjected to emerging
innovative technologies?
Total 0 0 2 10 1 2 5 0 20
Distribution of 0.8% in Cost Reduction (%) 0 0 10 50 5 10 25 0 100
Table 2 highlights a sample questionnaire, and a tally of the responses indicates the extent to which each part
category will be targeted for cost reduction. In this case, hydraulics will be responsible for achieving the highest
percentage (50%) of the cost savings that are needed. Therefore, the cost of hydraulics must be reduced by 0.4%
(0.50 × 0.08). Table 3 illustrates the final step in the process. It takes the adjusted costs column from Table 1 and
subtracts the additional savings that are required for each component part category. The right-hand column in Table
3 illustrates the target cost for the new vehicle, broken down to the component level.
Table 3
Modification of Current Product: Final Target Cost Assignments
Adjusted Distribution of 0.8% in Target Cost for

Activity
Costs (%) Cost Reduction (%) New Product (%)
Assembly 3.90 0.00 3.90
Cab 7.10 0.00 7.10
Engine 7.90 0.08 7.82
Hydraulics 17.50 0.40 17.10

Adjusted Distribution of 0.8% in Target Cost for

Activity
Costs (%) Cost Reduction (%) New Product (%)
Power Train 12.00 0.04 11.96
Structures 20.00 0.08 19.92
Linkage 18.00 0.20 17.80
Others 9.00 0.00 9.00
Total 95.40 0.80 94.60
To recap, Caterpillar began with current costs for a comparable product (100%) and, after deducting known
savings based on existing technology (Table 1) and potential savings based on an analysis of the questionnaire
(Table 2), established cost targets for each component of the new vehicle whereby the target cost is brought down
to 94.60% of the current costs.
The researchers observe that target costing is being adopted in some key industries, namely the transportation
and heavy equipment industries. Intensive competition, extensive supply chains, and relatively long product
development cycles characterize these industries. The best practice companies were relatively consistent in the
way in which they applied target costing. The other companies follow a similar approach to the target costing steps
at Caterpillar.
All of the best practice companies employ a cross-functional organizational structure, listen to the “voice of the
customer,” emphasize cost reduction during the new product development cycle, and are very effective at removing
costs throughout the supply chain. For these companies, target costing has proven to be a very effective means of
cost control and profit enhancement.
Case Study 2: Using Target Costing to Increase Value

Here under is an interesting field story on ‘Using Target Costing to Increase Value’ posted in February, 2004, by
Brian H. Maskell, President BMA Inc.
The Opportunity: In order to capture an OEM business, Major-Cable quoted a very low price and bagged an
opportunity. The Target Costing project was designed to improve the profitability of these cables to this customer
and other OEM customers.
The Issue: The exercise began with one of the key steps in Target Costing where the customer’s needs were
nailed down by specifying them exactly. One need from this customer was to have the cable with a minimum
of 20 meters length. This has been a problem for Major Cable because delivery is made from their centralized
distribution center which cuts the cable to the customers required length and they cannot always guarantee to have
the right quantity of 20-meter lengths. The plant provides the distribution center with much longer lengths, but the
specific 20-meter length is difficult to maintain.
The Solution: The initial solution to this problem was for the production plant to create a new product number for
20-meter lengths and manufacturing them specially for the OEM customer. The team then asked the question; “Why
does the customer need 20-meter minimum lengths?” It turned out that the machines the customer manufactures
require several pieces of cable and the total amount of cable for any machine never exceeds 20 meters. They
wanted the cables in 20-meter lengths so that they can issue them to the manufacturing location who in turn can
then cut the cables into the lengths they require for the specific machine they are currently manufacturing.
Major Cable’s plant has “off-cuts” of cable that are too short to be sent to the distribution center. These off-cuts
are stored as finished goods in case there is occasional demand for a short length; but these off-cuts are mostly

scrapped at the year-end. The customer’s need for short lengths interested the production manager. He suggested
that instead of supplying the product from the distribution center, they can deliver directly to the customer. Instead
of delivering 20-meter lengths, they can deliver the cable cut to the precise lengths required by the customer that
day. Instead of supplying the product on large round spools, they can place the cut pieces into production kits in
cardboard tubes or boxes to suit the customer’s needs.
After this was discussed and agreed with the customer, the result was:
●● he customer is delighted to have just-in-time deliveries of cable kits. This has reduced their manufacturing
T
costs.
●● The customer is paying a higher price because they are receiving kits instead of spooled cable.
●● any of the cable lengths can be provided from the off-cuts that were being scrapped most of the time
M
previously. The cost of these pieces is effectively zero.
●● he cardboard boxes or tubes are much less expensive than the previously used spools and the overall cost
T
of the packed product has turned out to be less.
The sales people were also delighted. They did not know the production plant could supply cut pieces. They
were under the impression that the production plant would only make long lengths (economic order quantities) on
large spools.
The Power of Target Costing: Without Target Costing Major Cable would not have had the opportunity to
bring together the cross-functional teams needed to understand the customer’s needs and find manufacturing,
logistics, and marketing methods to create more value for the customer. In the process, everybody has “won”. The
customer has reduced their costs, their inventory, and their production lead time. The production plant has reduced
its material costs and scrap. The company’s revenues have increased owing to the higher price of the cut piece
kits. It is the power of Target Costing in practical action. Put it rightly, it is a focus on increasing value as well as
reducing cost.”
(Resource: www.maskell.com/lean_accounting/field_stories/target_costing.html, 1.11.2013).
Case Study 3: Unveiling the Indian Nano

Talking of the Indian scenario, no other car launch in the history of Indian auto industry has received as much
global press as the “people’s car”, the “Tata Nano”. No other car promised to revolutionise motoring as the Nano
has. Clever marketing apart, some frugal and out-of-the-box engineering has gone into the making of Nano. Nano
modelled Indian Target Costing too.
Much like what Henry Ford had in the beginning of the 20thcentury with his Model T in 1908 at a price of $825,
exactly 100 years after Ratan Tata unveiled Nano, the Indian ultra-low-cost car. At ` one lakh, the Nano was the
world’s cheapest car and makes motoring affordable to millions of Indians. Even its deluxe models, featuring
air-conditioning and power windows, are fairly cheaper than the then cheapest car in the country, the Maruti 800.
Every component in the Nano is stated to have been studied from a functionality, cost and performance
requirements as there was no other way to reduce costs. From an outsourcing perspective, the company put in
place an Early Vendor Integration Programme. The company had a lot of design inputs from vendors that either
facilitated manufacturing or brought the cost down. This could be for lamps, seats or for any other component.
The Nano is completely indigenised. At the same time over 85 per cent of the Nano is sourced from outside
vendors. Vender parks have been put in place with the objective of ensuring that the components between vendors
and the assembly line move smoothly and just in time. Keeping costs down was a major problem for vendors, and
they found innovative ways to achieve it. The initial effort was towards cost prevention, which involved selecting
a design concept with the least cost. Later on, it is a perpetual cost-reduction effort.

When Ratan Tata addressed an Automotive Component Manufacturers’ Association (ACMA) meeting saying
that “Can we all get together to produce an Asian peoples’ car?”; the response was lukewarm – as in the case of
Henry Ford. Tata too encountered considerable amount of ridicule from certain close quarters. Even the vendors
took it to be a hypothetical project. But, Ratan Tata didn’t budge; he went ahead and did it. The initial idea was to
come up with a low-cost car that Malaysia, Indonesia and India could produce jointly. As it turned out, it was left
to Ratan Tata to respond to the FT Reporter at Geneva Motor show to commit an Indian Nano at about 1,00,000
rupees. The news got flashed, and it happened. Nano has restructured the dynamics of the car manufacturers all
over the world.
As Ratan Tata put it in his interview to the Economic Times in January 2008; “The real challenge is when you
have some strength and you really choose to throw out the gauntlet that you can do X. And it ought to be the kind
of challenge which somebody says that can’t be done because then that really becomes the engine of innovation.
…. We haven’t said we will send a man to Mars, we may put landers on Mars, but we have not done those kinds of
things. It is those areas which really create the innovation that we need”.
Illustration 32
A Company requires ` 85,00,000 in sales to meet its target net profit. Its contribution
margin is 30% and the fixed costs are `15,00,000. What is the target net profit?
Answer
Sales = `85,00,000
Contribution = 30% of Sales = (85,00,000 × 30%) = `25,50,000/-
Fixed Costs = `15,00,000
Target Net Profit = (Contribution – Fixed Costs) = (25,50,000 – 15,00,000)
= `10,50,000/-
Illustration 33
Marketing department of an organisation estimates that 40,000 of new mixers could be sold annually at a price
of `6,000/- each. To design, develop and produce these new mixers an investment of `40,00,00,000 would be
required. The company desires a 15% return on investment (ROI). What should be the target cost to manufacture,
sell, distribute and service one mixer?
Answer
Projected sales = (40,000 mixers × 6000 per mixer) = ` 24,00,00,000
Desired profit = (15% of 40,00,00,000) = `6,00,00,000
Target Cost for 40,000 mixers = Projected Sales – Desired Profit
= 24,00,00,000 – 6,00,00,000
= `18,00,00,000
Target cost per mixer = (18,00,00,000 ÷ 40,000 mixers) = `4,500/-
Illustration 34
T Ltd. produces and sells a product. The company expects the following revenues and costs in 2020:
Revenues (400 sets sold @ `600 per product) = `2,40,000

Variable costs = ` 1,60,000

Fixed costs = ` 50,000
What amount of sales must T Ltd. has to earn a target net income of `63,000 if they have a tax rate of 30%?
Solution
Sales = `2,40,000
Variable Costs = `1,60,000/-
Contribution = (2,40,000 – 1,60,000) = `80,000/-
C/S Ratio = (80,000 ÷ 2,40,000) = 1/3
Target Net Income (Net Profit) = `63,000/-
Tax Rate = 30%
Profit Before Tax = {(Net Profit ÷ (1-Tax Rate)}
= {63,000 ÷ (1-30%)} = `90,000/-
Fixed Costs + `50,000/-
Target Contribution = (PBT + FC) = 90,000 + 50,000
= `1,40,000/-
Target Sales = (Target Contribution ÷ C/S Ratio)
= (`.1,40,000 ÷ 1/3) = `4,20,000/-
Illustration 35
Desktop Co. manufactures and sells 7,500 units of a product. The full cost per unit is `100. The Company has
fixed Its price so as to earn a 20% return on an Investment of ` 9,00,000. What will be the Target selling price?
Answer
Serial Particulars Workings (`)
1 Investment Given 9,00,000
2 Expected Return on Investment 20% of 900000 1,80,000
3 Number of Units Given 7,500
4 Expected Return on Investment per unit 1,80,000 ÷ 7500 24.00
5 Full cost per unit Given 100.00
6 Target Selling Price (24 +100) 124.00
Illustration 36
‘B’ manufacturing Company sells its product at `1,000/- per unit. Due to competition, its competitors are likely
to reduce the price by 15%. B wants to respond aggressively by cutting down its price by 20% and expects that the
present volume of 1,50,000 units p.a. will increase to 2,00,000. B wants to earn a 10% target profit on sales. What
should be the Target cost per unit of the product?

Answer
1 Selling Price at Present Given 1,000.00
2 Proposed Reduction 20% of 1000 200.00
3 Target selling price (1 – 2) 800.00
4 Target profit margin 105 of 800 80.00
5 Target costs per unit (3 – 4) 720.00
Illustration 37
You, the manager of a paper mill (XYZ Ltd.), 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 being charged by your own mill.
The value chain for one of MT of such paper for ABC Ltd is follows:
“ABC Ltd. ----- Merchant ------ Printer ------ Customer”.
ABC Ltd sells this particular paper to the merchant at the rate of `30,400 per MT. ABC Ltd pays for the freight
which amounts to `600 per MT. Average sales returns and allowances amount to 4% of sales and approximately
equal to `1200 per MT.
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 receives the paper from a huge
distribution center maintained by your company at Haryana. Shipment costs from the mill to the Distribution
Center amount to `200 per MT while the operating costs in the Distribution Center have been estimated to be `125
per MT. The return on investments required by the Distribution Center for the investments made amount to an
estimated ` 120 per MT.
You are required to compute the “Mill Manufacturing Target Cost” for this particular paper for your company.
You may assume that the return on the investment expected by your company equals ` 120 per MT of such paper.
Answer
Serial Particulars Workings `. per MT
1 ABC Ltd’s selling price to the merchant Given 30,400

2 Post Sales Expenses Given
Freight paid by ABC Ltd 600
Normal sales returns and allowances 1,200
Sub Total 1,800

3 Net Selling Price of ABC Ltd (1 – 2) 28,600
4 XYZ Ltd’s Expected Return on Investment Given 120
5 Target cost for XYZ Ltd (3 – 4) 28,480

Serial Particulars Workings `. per MT
6 Post Manufacturing Expenses Given

Shipment costs to the Distribution Center 200
Operating cost in the Distribution Center 125
Expected Return on Investment of the Distribution Center 120
Sub Total 445

7 Target manufacturing cost of the Mill (3 – 4) 28,035
Illustration 38
CELO 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 for every reduction of `10 in Selling Price,
the demand is doubled.
Required:
a. What should be the Target Cost at full capacity, if Profit Margin on Sale is 25%?
b. What should be the Cost Reduction Scheme at full capacity if at the present level 40% of the cost is variable
and Total Fixed Cost is `36 lakhs?
c. If Rate of Return desired is 16%, what will be the maximum investment at full capacity?
Answer
a. Target Cost at Full Capacity
Projected Demand
Selling Price
Demand (Units) Capacity Utilisation
(`. Per Unit)
100 20,000 25%
90 (20,000 × 2) = 40,000 50%
80 (40,000 × 2) = 80,000 100%
Selling Price at Full Capacity = `80.00

Target Profit = 25% on Sales = `20.00
Target Cost at Full Capacity = (80 – 20) = ` 60.00 per unit
b. Cost Reduction Scheme
(i) Computation of Variable Cost per unit
At the Present Capacity of 20,000 units
Selling Price = `100.00 per unit
Profit Margin = 25% on Sales = `25.00
Total Cost = (100 – 25) = ` 75.00
Variable Cost = 40% of total cost = 40% of 75 = `30.00

(ii) Existing Projections of Total Cost at full capacity

Total Variable Cost = (30 × 80000) = `24.00 lakhs
Total Fixed Cost = `36.00 Lakhs
Total Cost = (24.00 + 36.00) = 60.00 lakhs
(iii) Target Cost = (60 × 80000) = 48.00 lakhs
(iv) Cost Reduction Scheme
Cost Reduction Needed = (Existing Cost – Target Cost) = (60.00 – 48.00) = ` 12.00 lakhs
c. Maximum Investment at full capacity
(i) Target Profit at full Capacity
Sales = 80.00 × 80,000 units = `64.00 lakhs
Target Cost = `48.00 lakhs
Target Profit = (64.00 – 48.00) = `16.00 lakhs
(ii) Rate of Return on Investment = 16%
(iii) Minimum Investment
Investment Needed = (Target Profit ÷ Target Return on Investment) = (16.00 ÷ 16%) = ` 100.00 lakhs
Illustration 39
K & Co. manufactures and sells 15,000 units of a product. The Full Cost per unit is `200. The Company has fixed
its price so as to earn a 20% Return on an Investment of `18,00,000.
Required:
(i) Calculate the Selling Price per unit from the above. Also, calculate the Mark-up % on the Full Cost per unit.
(ii) If the Selling Price as calculated above represents a Mark-up of 40% on Variable cost per unit, calculate the
Variable cost per unit.
(iii) Calculate the Company’s Income if it had increased the Selling Price to `230. At this price, the company
would have sold 13,500 units. Should the Company have increased the Selling price to `230?
(iv) In response to competitive pressures, the Company must reduce the price to `210 next year, in order to
achieve sales of 15,000 units. The Company also plans to reduce its investment to `16,50,000. If a 20%
Return on Investment should be maintained, what is the Target Cost per unit for the next year?
Answer
(i) Target Sale Price per unit

1 Full Cost per unit Given 200.00
2 Target profit per unit (18,00,000 × 20%) ÷ 15,000 units
= 3,60,000 ÷ 15,000 24.00
3 Target Sale Price (Full Cost + Target Profit) 224.00
4 Mark up on Full Cost (24 ÷ 200)/100 12%

(ii) Variable Cost per Unit

1 Selling Price As computed above 224.00
2 Variable Cost (224 ÷ 140) × 100 160.00
Note: Sale price includes 40% of mark up on Variable cost and hence equals to 140% on variable cost.
(iii) Company’s income at a Selling Price of `230

a. Existing Contribution
Existing Number of Units = 15,000
Selling Price = `224.00
Variable Cost = ` 160.00
Contribution = (224-160) = `64 per unit or (64 × 15,000) = `9,60,000
b. Revised Contribution
Revised Number of Units = 13,500
Selling Price = `230.00
Variable Cost = ` 160.00
Contribution = (230-160) = `70 per unit or (70 × 13,500) = `9,45,000
c. Observation
Revision of Selling Price from `224/- to `230/- brings down the contribution by `15,000/- i.e., from
`9,60,000/- to `9,45,000/- and hence not beneficial.
(iv) Target Cost for Next Year

1 New Sale Price Given 210.00
2 Target profit per unit (16,50,000×20%) ÷ 15,000 units 22.00
= 3,30,000÷ 15,000
3 Target Cost per unit (New Sale Price - Target Profit) 188.00
Illustration 40
ABC Enterprises has prepared a draft budget for one of its products for the next year as follows:
Quantity 10,000 units

Sales price per unit 300
Variable costs per unit:
Direct materials 80
Direct labour (2 hrs × 30) 60
Variable overhead (2 hrs × 5) 10

Contribution per unit 150

Budgeted contribution 15,00,000
Budgeted fixed costs 14,00,000
Budgeted profit 1,00,000
The Board of Directors is dissatisfied with this budget, and asks working party to come up with alternate budget
with higher target profit figures.
The working party reports back with the following suggestions that will lead to budgeted profit of `2,50,000. The
company should spend `2,46,000 on advertising, & set the target sales price up to `316.75 per unit. It is expected
that the sales volume will also rise, in-spite of the price rise, to 12,000 units.
In order to achieve the extra production capacity, however, the workforce must be able to reduce the time taken
to make each unit of the product. It is proposed to offer a pay and productivity deal in which the wage rate per
hour is increased to `40. The hourly rate for variable overhead will be unaffected. Ascertain the target labour time
required to achieve the target profit.
Answer
(i) Target Conversion Cost per unit

1 Target profit Given 2,50,000
2 Add Given
Additional Advertisement 2,46,000
Sub Total 16,46,000
3 Total contribution (1 + 2) 18,96,000
4 Sales volume 12,000
5 Contribution per unit (18,96,000÷12,000) 158.00
6 Target Selling price per unit Given 316.75
7 Target variable cost per unit (5 – 6) 158.75
8 Material cost per unit Given 80.00
9 Target Conversion Cost per unit (7 – 8) 78.75
(i.e. Labour + Variable overhead)
(ii) Target Labour Time

Let Target Labour Time per unit be x hours
Revised Labour Rate being `40/- per hour, Total Labour Cost = 40x
Variable Overhead Rate being `5/- per hour, Total Variable Cost = 5x
Thus, Total Conversion Cost = 40x + 5x = 45x

We also have Total Conversion Cost = 78.75 × 12,000 units = `9,45,000

Therefore, 45x = 9,45,000 or x = 21,000 hours
Target Labour Time per unit = 21,000 ÷ 12,000 = 1.75 hours
(iii) Target Reduction in Labour Time
Budgeted Labour Time per unit = 2.00 hours
Target Labour Time per unit = 1.75 hours
Target Reduction in Labour Time = (2.00 – 1.75) = 0.25 hours per unit
Hence, target labour time per unit, required to achieve the target profit, is 1.75hours and target reduction in
labour time is 0.25 hours per unit.
3.6 Product Life Cycle Costing
Product Life Cycle

Product Life Cycle is a pattern of expenditure, sale level, revenue and profit over the period beginning from new
idea generation to the deletion of product from product range. Product Life Cycle spans the time from initial R&D
on a product to when customer servicing and support is no longer offered for the product. For products like motor
vehicles, this time-span may range from 5 to 7 years. For some basic pharmaceuticals, the time-span be 7 to 10
years.
Many a product are observed to possess a distinctive life cycle comprising six clearly defined phases, each phase
having its own characteristics. Older, long-established products eventually become less popular, while in contrast,
the demand for new, more modern goods usually increases quite rapidly after they are launched. The time line
commencing from the innovation of a new product and ending with its degeneration into a common product and
the eventual extinction is termed as the life cycle of a product.
(i) Development Phase: The cycle begins with the identification of a new consumer need and the invention of
a new product. This is often followed by patent protection and further
development to make it saleable. Research and engineering skills enable
product development. The costs incurred are termed as developmental. No Development
revenues accrue during this phase.
(ii) Introduction Phase: During this phase, the product is introduced to the
market. Efforts are towards spreading awareness about the product, the Introduction
target being achieving market acceptance. Promotional costs will be high,
sales revenue low and profits probably negative. The skill that is exhibited
in testing and launching the product will rank high in this phase as the Growth
critical factor in securing success and initial market acceptance. Sales of
new products usually rise slowly at first.
(iii) Growth Phase: As the product gains market acceptance a rapid expansion Maturity
follows leading to the growth. This phase is characterized by product
penetration into the market and increase in sales & profits. Benefits of
economies of scale would start pouring in leading to cost reduction. It Decline
now becomes vital to secure wholesaler and retailer support as also to
ensure consumer satisfaction. If the product is successful, growth usually
accelerates at some point, often catching the innovator by surprise. Extinction
(iv) Maturity phase: This stage begins after sales cease to rise exponentially

indicating market saturation. Eventually most potential customers have tried the product and sales settle at
a rate governed by population growth and the replacement rate of satisfied buyers. In addition, there were
no new distribution channels to fill. This is usually the longest and the most competitive stage in the cycle.
Most of the popular products are in this stage. The period over which sales are maintained depends upon the
firm’s ability to stretch the cycle by means of market segmentation and finding new uses for it.
(v) Decline phase: Eventually most products and brands enter a period of declining sales. This may be caused
by: technical advances leading to product substitution, fashion and changing tastes, exogenous cost factors
reducing profitability until it reaches zero at which point the product’s life is commercially complete. The
speed of degeneration differs from product to product.
(vi) Extinction Phase: This is the tail end of the decline phase where after the product exits from the market.
The Revenue, Cost and Profit Matrix of the Product Life Cycle is summarised in the table that follows.
Revenue, Cost and Profit Matrix of the Product Life Cycle
Serial Phase Revenue Costs Profit

1 Development Nil Developmental Nil
2 Introduction Low Promotional Negative
3 Growth Increasing Declining Growing
4 Maturity Stable Stable Stable
5 Decline Declining Increasing Declining
6 Extinction Nil End Life Negative
The product can sustain viability only if the total revenue arising from the product during its life cycle exceeds
the total costs incurred during all the phases of its life.
Life cycle costing is a system that is evolved to track and accumulate the costs and revenues attributable to a
product or service from the stage of development to the stage of extinction. In essence, Life Cycle Costing is a
means of estimating all the costs involved in procuring, operating, maintaining and ultimately disposing a product
throughout its life. Eventually, the process involves tracing costs and revenues of the product over several calendar
periods.
Life cycle costing is a three-staged process. The first stage is life cost planning stage which includes planning
LCC Analysis, Selecting and Developing LCC Model, applying LCC Model and finally recording and reviewing
the LCC Results. The Second Stage is Life Cost Analysis Preparation Stage followed by the third stage of
Implementation and Monitoring Life Cost Analysis.
Characteristic of PLCC
(a) Involves tracing of costs and revenues of each product over several calendar periods throughout their entire
life cycle.
(b) Traces research, design and development costs and total magnitude of these costs for each individual product
and compared with product revenue.
(c) Assists report generation for costs and revenues.

Importance of Product Life Cycle Costing

Product Life Cycle Costing is considered important due to the following reasons:
a. Time based analysis: Life cycle costing involves tracing of costs and revenues of each product over several
calendar periods throughout their life cycle. Costs and revenues can be analysed by time periods. The
total magnitude of costs for each individual product can be reported and compared with product revenues
generated in various time periods.
b. Overall Cost Analysis: Production Costs are accounted and recognized by the routine accounting system.
However non-production costs like R&D; design; marketing; distribution; customer service etc. are less
visible on a product — by — product basis. Product Life Cycle Costing focuses on recognizing both
production and non-production costs.
c. Pre-production costs analysis: The development period of R&D and design is long and costly. A high
percentage of total product costs maybe incurred before commercial production begin. Hence; the Company
needs accurate information on such costs for deciding whether to continue with the R&D or not.
d. Effective Pricing Decisions: Pricing Decisions; in order to be effective; should include market considerations
on one hand and cost considerations on the other. Product Life Cycle Costing and Target Costing help
analyze both these considerations and arrive at optimal price decisions.
e. Better Decision Making: Based on a more accurate and realistic assessment ot revenues and costs, at least
within a particular life cycle stage, better decisions can be taken.
f. Long Run Holistic view: Product Life Cycle Costing can promote long-term rewarding in contrast to short-
term profitability rewarding. 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.
g. Life Cycle Budgeting: Life Cycle Budgeting with Target Costing principles, facilitates scope for cost
reduction at the design stage itself. Since costs are avoided before they are committed or locked in the
Company is benefited.
h. Review: Life Cycle Costing provides scope for analysis of 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.
The Three Key Factors

Three key factors should be optimised to maximise a product’s profitability over its whole life. These are:
i. Design
ii. Time to Market
iii. Length of the Lifecycle.
Design: Development activity is the most important from a sustainability perspective. Since 80% of a product’s
costs are locked in at the design stage, it’s vital that waste is minimised by design. Choices made at the design stage
should account for all stages of a product’s life, including end of life costs, which could involve handling or storing
hazardous material, and polluting activities, such as land fill or incineration.
The reduction of waste by design is usually good for profitability and also the sustainable consumption of scarce
capitals. While it may be tempting to specify cheap materials in the design of products, consider the environmental
impact and end of life requirements. Even though some financial or environmental costs accumulated in the lifecycle

of a product are not producer costs, the producer should still consider these costs carefully. Aware consumers will
often factor such costs into their purchase decisions, and thus even if the producer ignores these factors, the
consumer may calculate the total cost of ownership of the product, not just the initial acquisition cost. Known as
asset lifestyle costing, this is the other side of the coin to product lifecycle costing.
A great example is the aero engine market. The balance of power has radically shifted from producers to operators
in recent years, to the extent that producers must now guarantee operating performance across a range of factors.
They must also agree to pay operators for costs of under-performance over an engine’s whole life. Producers are
taking note of consumers’ increasing environmental awareness. As a result, they’re considering the price and
financial cost of their products. However, they’re also designing products to have a lower environmental impact
and using ‘environmental friendliness’ as a selling point to enhance product appeal. More and more producers are
adopting triple bottom line, or PPP (people, planet, profit) principles in practice.
Time to Market: Competitors watch each other to discover new products coming to market, and they seek to
develop products to keep ahead of each other. When competition is minimal, the growth phase of a product’s life
provides producers the chance to charge premium prices and invest heavily in awareness activities. The longer
a producer has before a rival product hits the market, the longer they’re able to command a price premium and
entrench their product in the consumer’s buying habits. The management accountant should be aware of the
competitive market for new products to improve accuracy of whole-life profitability.
Length of the Lifecycle: Getting to market quickly will lengthen a product’s life. However, there are other ways
of increasing a product’s life and, ideally, consideration should be given to this at the design stage itself. Examples
include:
●● Designing the product in a modular way and conceptualising future modules to aid introducing variants after
the initial launch
●● Designing the product to satisfy as many markets as possible, even if this requires post-launch modification
●● Staggering the launch in different markets to reduce costs and prolong demand.
The management accountant should try to encourage teams involved in product conceptualisation to consider as
many of these factors as possible at the design phase. This improves estimation of whole-life profitability.
Illustration 41
Wipro is examining the profitability and pricing policies of its Software Division. The Software Division develops
Software Packages for Engineers. It has collected data on three of its more recent packages - (a) ECE Package
for Electronics and Communication Engineers, (b) CE Package for Computer Engineers, and (c) IE Package for
Industrial Engineers. Summary details on each package over their two-year cradle to grave product lives are –
Package Selling Price Number of units sold

(`) Year 1 Year 2
ECE 250 2,000 8,000
CE 300 2,000 3,000
IE 200 5,000 3,000
Assume that no inventory remains on hand at the end of year 2. Wipro is deciding which product lines to
emphasize in its software division. In the past two years, the profitability of this division has been mediocre. Wipro
is particularly concerned with the increase in R & D costs in several of its divisions. An analyst at the Software

Division pointed out that for one of its most recent packages (IE) major efforts had been made to reduce R&D
costs. Last week, Amit, the Software Division Manager, decides to use Life Cycle Costing in his own division. He
collects the following Life Cycle Revenue and Cost information for the packages -
Amount (`.)
Package ECE Package CE Package IE

Particulars
Year 1 Year 2 Year 1 Year 2 Year 1 Year 2
Revenues 5,00,000 20,00,000 6,00,000 9,00,000 10,00,000 6,00,000
Costs
R&D 7,00,000 - 4,50,000 - 2,40,000 -
Design of Product 1,15,000 85,000 1,05,000 15,000 76,000 20,000
Manufacturing 25,000 2,75,000 1,10,000 1,00,000 1,65,000 43,000
Marketing 1,60,000 3,40,000 1,50,000 1,20,000 2,08,000 2,40,000
Distribution 15,000 60,000 24,000 36,000 60,000 36,000
Customer Service 50,000 3,25,000 45,000 1,05,000 2,20,000 3,88,000
Present a Product Life Cycle Income Statement for each Software Package. Which package is most profitable
and which is the least profitable? How do the three packages differ in their cost structure (the percentage of total
costs in each category)?
Answer
Life cycle Income Statement (in ` 000s)
Particulars Package ECE Package CE Package IE

Y1 Y2 Total % Y1 Y2 Total % Y1 Y2 Total %
Revenues 500 2,000 2,500 100% 600 900 1,500 100% 1,000 600 1,600 100%
Costs
R&D 700 - 700 28% 450 - 450 30% 240 - 240 15%
Design 115 85 200 8% 105 15 120 8% 76 20 96 6%
Manufacturing 25 275 300 12% 110 100 210 14% 165 43 208 13%
Marketing 160 340 500 20% 150 120 270 18% 208 240 448 28%
Distribution 15 60 75 3% 24 36 60 4% 60 36 96 6%
Cust. Service 50 325 375 15% 45 105 150 10% 220 388 608 38%
Total Costs 1065 1,085 2150 86% 884 376 1260 84% 969 727 1696 106%
Profit 350 240 (96)

Observations
(a) Package ECE with a Life Cycle Profit of `3,50,000/- is most profitable; while package IE with a Life Cycle
Loss of `96,000/- is least profitable.
(b) As may be observed from the tabulated data, the differences in comparative percentages (of total costs to
revenues) in each category of the three packages are apparent and self-explanatory.
Illustration 42
Zenith Ltd. manufacturers tablet batteries. The company is preparing a product life cycle budget for a new type
of battery. Development on the new battery is to start shortly. Estimates for the new battery are as follows:
Life cycle units manufactured and sold 2,00,000

Selling price per battery ` 55
Life cycle costs:

R & D and design cost ` 8,00,000
Manufacturing:
Variable cost per battery ` 25
Variable cost per batch ` 300
Batteries per batch 250

Fixed costs ` 12,00,000
Marketing
Variable cost per battery ` 3.50
Distribution:
Variable cost per battery ` 140
Batteries per batch 100

Customer service cost per battery (Variable) ` 1.70
Ignore the time value of money.

Required:
(i) Calculate the budgeted life cycle operating income for the new battery.
(ii) What percentage of the budget total product life cycle costs will be incurred by the end of the R&D and
design stages?
(iii) Company’s market research department estimates that reducing price by ` 2.50 will increase life cycle unit
sales by 8%. If unit sale increases by 8%, the company plans to increase manufacturing and distribution
batch sizes by 8% as well. Assume that all variable costs per battery, per batch and fixed costs will remain
the same. Should the company reduce battery price by ` 2.50?
Show your calculations.

Answer
(i) Statement of Budgeted Life Cycle Revenue and Costs
(a) Revenue (2,00,000 × 55) = `1,10,00,000
(b) Costs:
Element (`)
Research and design 8,00,000
Manufacturing costs:
Variable costs (25 × 200000) 50,00,000
Batch cost{300 × (200000÷250)} 2,40,000
Marketing costs:
Variable costs (3.5 × 200000) 7,00,000
Fixed cost 8,00,000
Distribution costs:
Batch cost {140 × (200000÷100)} 2,80,000
Fixed cost 4,60,000
Customer service [Variable](1.7 × 200000) 3,40,000
Total cost 98,20,000
(c) Operating Income = 1,10,00,000 - 98,20,000 = `11,80,000/-
(ii) Total product life cycle costs by the end of the R&D and design stages
Budgeted product life cycle costs for R&D and design ` 8,00,000
Total budgeted life cycle product costs ` 98,20,000
Percentage of budgeted product life cycle cost incurred (8,00,000 ÷ 98,20,000) × 100 = 8.15%
till the R&D and design
(iii) Statement of Revised Budgeted Life Cycle Revenue and Costs

(a) Revenue (2,16,000 × 52.50) = 1,13,40,000
(b) Costs
Element (`)
Research and design 8,00,000
Manufacturing costs:
Variable costs (25 × 216000) 54,00,000
Batch cost {300 × (216000÷270)) 2,40,000

Element (`)
Marketing costs:
Variable costs (3.5 × 216000) 7,56,000
Fixed cost 8,00,000
Distribution costs:
Batch cost {140 × (216000÷108)) 2,80,000
Fixed cost 4,60,000
Customer service [Variable](1.7 × 216000) 3,67,200
Total cost 1,03,03,200
Operating Income 10,36,800
(c) Operating Income = 1,13,40,000 – 1,03,03,200 = ` 10,36,800/-

Suggestion: Since profit is lower, price should not be reduced.
Illustration 43
SRM Ltd. has developed a new product ‘Kent’ which is about to be launched into the market and anticipates
to sell 80,000 of these units at a sale price of ` 300 over the product’s life cycle of four years. Data pertaining to
product ‘Kent’ are as follows:
Costs of Design and Development of Moulding ` 10,25,000

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 @ ` 10 per part, 1

visit per 500 units (cost ` 500 per visit)
Required:
(i) Compute the product Kent’s Life Cycle Cost.
(ii) Suppose SRM Ltd. can increase sales volume by 25% through 15% decrease in selling price, should SRM
Ltd. choose the lower price?
Answer
(i) Statement showing Kent’s Life Cycle Cost (80,000 units)
Particulars Amount (` )

Costs of Design and Development of Moulding Dies and Other tools 10,25,000

Particulars Amount (` )

Manufacturing costs (125 × 80,000 units) 1,00,00,000
Selling costs (` 100 × 80,000 units + ` 12,500 × 4 years) 80,50,000
Administration costs (` 50,000 × 4 years) 2,00,000
Warranty expenses
Replacement costs: {(80,000 units ÷ 25 units) × 5 parts × ` 10)} 1,60,000
Visit costs: {(80,000 units ÷ 500 units × 1 visit × ` 500)} 80,000
Total Cost 1,95,15,000
(ii) Statement showing Kent’s Life Cycle Cost (1,00,000 units)
Particulars Amount (`)

Costs of Design and Development of Moulding Dies and Other tools 10,25,000
Manufacturing costs (125 × 1,00,000 units) 1,25,00,000
Selling costs (` 100 × 1,00,000 units + ` 12,500 × 4 years) 1,00,50,000
Administration costs (` 50,000 × 4 years) 2,00,000
Warranty expenses
Replacement costs: {(1,00,000 units ÷ 25 units) × 5 parts × ` 10)) 2,00,000
Visit costs: {(1,00,000 units ÷ 500 units) × 1 visit × ` 500)) 1,00,000
Total Cost 2,40,75,000
Statement showing Kent’s Life Time Profit

Particulars ` at the level of 80,000 units ` at the level of 1,00,000 units
Sales (80,000 × 300) = 2,40,00,000 (1,00,000 × 255) = 2,55,00,000

Total cost 1,95,15,000 2,40,75,000
Profit 44,85,000 14,25,000
Observation: Reducing the, price by 15% will decrease profit by ` 30,60,000/-. Therefore, SRM Ltd. should
not cut the price.
3.7 Asset Life Cycle Costing

CIMA defines Life-Cycle Costing as ‘Maintenance of physical asset cost records over entire asset lives, so that
decisions concerning the acquisition, use or disposal of assets can be made in a way that achieves the optimum
asset usage at the lowest possible cost to the entity. The term may be applied to the profiling of cost over a product’s
life, including the pre-production stage (terotechnology), and to both company and industry life cycles.
Life Cycle Cost (LCC) may, thus, be stated as “The total cost throughout the life of an asset including planning,
design, acquisition and support costs and any other costs directly attributable to owning or using the asset”. Life
Cycle Cost (LCC) of any item represents costs of its acquisition, operation, maintenance and disposal.

Life Cycle Cost Analysis is used to examine and assess the total cost of resource ownership and takes into
account expenses related to buying, maintaining, operating and disposing of a project or an object. It is used
especially to select the best project when
there are multiple projects that satisfy
the same performance requirements, Operation Maintenance
but differ in terms of operating costs
and initial costs which must be
Acquistion Disposal
compared for selecting the method for
maximization of net savings. Asset Life
Cycle Costs
The purpose of LCC analysis is
the estimation of the overall cost of
project options and then to select the
designs which can ensure the facility to provide the overall lowest cost of ownership constant with the function and
its quality. The analysis should be performed at an early stage so that there will be chances of refining the design
to ensure the reduction in life cycle total cost. The most challenging assignment of this analysis or any economic
evaluation technique is to ascertain the economic effects of alternate designs of a building system and quantify
these effects in the monetary terms. The process involves assessing cost arising from the assets of the company
over some time and evaluating alternatives which impact on the cost ownership.
Life Cycle cost analysis appropriately weighs the money spent today as compared to money spent in the future.
The basic formula is:
LCC = C + PV Recurring – PV Residual Value
Where:
●● LCC is the life cycle cost
●● C is the 0-year acquisition cost
●● PV recurring is the present value of all recurring costs
●● PV residual value is the present value of residual-value at the end of the life of the asset.
Life Cycle Costs of an Asset
●● Acquisition
●● Installation
●● Operating
●● Maintenance
●● Financing (e.g., interest)
●● Depreciation
●● Disposal
Example of Life Cycle Cost of a printer
●● Purchase: The price is `20,000.
●● Installation: `500 for setting up and delivery purposes.
●● Operating: `2,000 for ink cartridges and paper for it. Cost of electricity is expected at `300.
●● Maintenance: Repairs will cost `500.

●● Financing: Interest rate of 9% per annum.
●● Depreciation: Value will be reduced by `2,000 each year.
●● Disposal: Estimation of hiring a contractor to remove the printer is ` 150.
Even though the price of the printer is `20,000, the life cycle cost of the printer will end up costing the business
much more.
Case Study: LC Margin for an Orange Plantation Project

The application of LCC can be universal across the multiple sectors of the economy. Here follows the summarised
(basic) computations of LCC relating to an Orange Plantation Project. These computations have been carried out
on the basis of inputs provided by a couple of farmers.
Annual Cash Outflow

The annual cash outflow budget for the said plantation would be as follows:
Annual cash outflow Budget of Orange Plantation Project

Year 2 to Year 6 to
Serial Item Year 1
Year 5 Year 18
(`) (`) (`)
A Month wise Details
1 April
Land Acquisition 40,00,000
Levelling & Dressing 1,00,000
Fencing 96,000
Pits 10,000
Nutrients in Pit 50,000
Attached Labour 7,000 7,000 7,000
Hired Labour 6,000
Organic Manure @ 2 trolleys per acre 32,000
Transport and Labour Charges 8,000
Sub Total 42,63,000 7,000 53,000
2 May
Dug Well (10ft dia × 50ft deep) 2,45,000
Sub Total 2,52,000 7,000 7,000


Year 2 to Year 6 to
Serial Item Year 1
Year 5 Year 18
(`) (`) (`)
3 June
Dug Well (10ft dia × 50ft deep) 1,05,000
Electric Connection 25,000
Motor (5HP) 30,000
Cables & Other Equipment 10,000
Piping 50,000
Drip System 2,40,000
Misc. Works 25,000
Electricity 4,000 4,000 4,000
Interest on Working Capital 4,617
Sub Total 4,96,000 11,000 15,617
4 July
Plants (125 per acre × 8) 50,000
Hired Labour 4,000
Sub Total 61,000 7,000 7,000
5 August
Nutrients 14,000 14,000 10,700
Misc. Works 7,500 7,500
Sub Total 28,500 28,500 17,700
6 September
Interculture & Weed Control 7,500 7,500 5,075


Year 2 to Year 6 to
Serial Item Year 1
Year 5 Year 18
(`) (`) (`)
Pesticides 7,500 7,500 10,500
Plant Support Wood 10,000
Electricity 4,000 4,000 4,000
Hired Labour 5,000 5,000 9,000
Sub Total 31,000 31,000 50,192
7 October
Replacement Plants 10,000
Nutrients 14,000 14,000
Pesticides 10,500
Misc. Works 7,500 7,500
Hired Labour 3,000 3,000
Sub Total 41,500 31,500 17,500
8 November
Interculture & Weed Control 7,500 7,500 5,075
Pesticides 7,500 7,500
Hired Labour 4,000 4,000 3,000
Sub Total 26,000 26,000 15,075
9 December
Nutrients 12,000 12,000
Pesticides 9,000


Year 2 to Year 6 to
Serial Item Year 1
Year 5 Year 18
(`) (`) (`)
Misc. Works 3,750 3,750
Electricity 4,000 4,000 4,000
Hired Labour 2,000 2,000 3,000
Sub Total 28,750 28,750 27,617
10 January
Misc. Works 3,750 3,750
Hired Labour 2,000 2,000 3,000
Sub Total 12,750 12,750 10,000
11 February
Misc. Works 3,750 3,750
Hired Labour 2,000 2,000 3,000
Sub Total 12,750 12,750 10,000
12 March
Misc. Works 3,750 3,750
Electricity 4,000 4,000 4,000
Hired Labour 2,000 2,000 3,000
Sub Total 16,750 16,750 18,617


Year 2 to Year 6 to
Serial Item Year 1
Year 5 Year 18
(`) (`) (`)
B Summary
April 42,63,000 7,000 53,000
May 2,52,000 7,000 7,000
June 4,96,000 11,000 15,617
July 61,000 7,000 7,000
August 28,500 28,500 17,700
September 31,000 31,000 50,192
October 41,500 31,500 17,500
November 26,000 26,000 15,075
December 28,750 28,750 27,617
January 12,750 12,750 10,000
February 12,750 12,750 10,000
March 16,750 16,750 18,617
Total 52,70,000 2,20,000 2,49,318
The total cash outflow during the first year would aggregate to `52.70 lakhs, consisting of `50.50 lakhs of initial
investment and annual nurturing cost of `2.20 lakhs. The nurturing outflow would continue at the rate of `2.20
lakhs per year till the 5th year. The annual operating outflow would work out to `2.49 lakhs from the 6th year
to the 18th year. Such of these annual cash budgets would go a long way in facilitating the farmers in planning,
coordinating and controlling their cash outflows.
Life Cycle Margin

The computations relating to Life Cycle Margin of the above project are as follows:
LC Margin per Plant of Oranges
A Quantitative Data
Plantation Area (Acres) 8
Number of Plants per Acre 125
Number of Plants per 8 Acres 1000
Life (Years) 18
Nurturing Period (Years) 5

Cropping Period (Years) 13

Life Cycle Yield per Plant (Kg) 940
Selling Price (` Per Kg) 31
B Investment (` Lakhs)
1 Land 41.96
2 Water Distribution Systems 7.30
3 Plantation 1.24
4 Nurturing Cost for the first 5 years 11.00
5 Total 61.50
C Means of Finance (` Lakhs)
1 Own Funds 21.80
2 Subsidies 2.80
3 Loan Funds 36.90
4 Total 61.50
D Life Time Plantation Cost
1 Plantation Cost per Anum (`)
i. Nutrients 50,700
ii. Interculture & Weed Control 10,150
iii. Pesticide Spray 30,000
iv. Plant Support Wood 10,000
v. Electricity 16,000
vi. Labour 1,14,000
vii. Interest on Working Capital 18,468
viii. Total 2,49,318
2 Plantation Cost for 13 Years (` Lakhs) 32.41
E Life Cycle Cost (` Lakhs)
1 Investment 61.50
2 Interest on Term Loan 25.99
3 Plantation Cost from year 6 to year 18 32.41
4 Life Cycle Cost (1 + 2 + 3) 119.90

F Life Cycle Margin per Plant (` )

1 Life Cycle Revenue per Plant (940 kg × ` 31) 29140
2 Life Cycle Cost per Plant (1,19,90,000 ÷ 1000) 11990
3 Life Cycle Margin per Plant (1-2) 17150
4 Average Margin per Plant per annum (3 ÷ 18) 953
As could be seen from the computations, a model farmer would be able to earn a Life Cycle Margin `17,150/- per
plant of oranges over a period of 18 years which works out to `953/- per plant per year. Thus, the margin computes
to `1,19,125/- per acre (of 125 plants) per annum which is quite attractive and competitive apparently. A note of
caution, however, is that the case study under reference is demonstrative in nature and does not consider time value
of money.
It is also relevant to observe that there are no revenues during the first five years of the plantation which is the
nurturing period. The revenue flow starts from the 6th year and continues upto the 18th. Thus, the adoption of the
principles of Life Cycle Costing to any horticulture project would not only facilitate ‘Overall Cost Analysis’, but
also would bring out an ‘Holistic View’.
Illustration 44
A2Z plc. supports the concept of tero technology or life cycle costing for new investment decisions covering its
engineering activities. The financial side of this philosophy is now well established, and its principles extended
to all other areas of decision making. The company is to replace a number of its machines and the Production
Manager is torn between the Exe Machine, a more expensive machine with a life of 12 years, and the Wye machine
with an estimated life of 6 years. If the Wye machine is chosen it is likely that it would be replaced at the end of
6 years by another Wye machine. The pattern of maintenance and running costs differs between the two types of
machine and relevant data are shown below:
Exe (`) Wye (`)

Purchase Price 19,000 13,000
Trade-in value/breakup/scrap 3,000 3,000
Annual repair costs 2,000 2,600
Overhaul costs (at year 8) 4,000 (at year 4) 2,000
Estimated financing costs averaged over machine life 10%p. a - Exe; 10% p.a. – Wye.
You are required to: recommend with supporting figures, which machine to purchase, stating any assumptions
made.
Answer
Computation of present value of outflows and equivalent annual costs
(`) Exe machine (`) Wye machine
Initial cost 19,000.00 13,000.00
Less: Present Value of Scrap at the (3000 × 0.319) 957.00 (3000 × 0.564) 1,692.00
end of the life

(`) Exe machine (`) Wye machine

Net Cost 18,043.00 11,308.00
Present value of total annual repair (2000 × 6.812) 13,624.00 (2600 × 4.354) 11,320.00
costs
Overhaul costs (4000 × 0.466) 1,864.00 (2000 × 0.683) 1,366.00
Total Cost 33,531.00 23,994.00
Capital recovery factor (1÷6.812) 0.1468 (1÷4.354) 0.2297
Equivalent annual cost 4,922.35 5,511.42
Recommendation: As the equivalent annual cost is less for exe machine, it is better to purchase the same.
Working Note
1. Present Value Factors @ 10%: Year4 =0.683; Year6 =0.564; Year8=0.466; Year12=0.319
2. Compounded Present Value @ 10%: 8 years = 4.354; 12 years = 6.812
Illustration 45
Company X is forced to choose between two machines A and B. The two machines are designed differently but
have identical capacity and do exactly the same job. Machine A costs ` 1,50,000 and will last for 3 years. It costs `
40,000 per year to run. Machine B is an ‘economy’ model costing only ` 1,00,000, but will last only for 2 years, and
costs ` 60,000 per year to run. These are real cash flows. The costs are forecasted in rupees of constant purchasing
power. Ignore tax. Opportunity cost of capital is 10%.
Which machine Company X should buy?
Answer
Compounded present value of 3 years @ 10% 2.486
P.V. of running cost of Machine A for 3 years ` 40,000 × 2.486 ` 99,440
Compounded present value of 2 years @ 10% 1.735

P.V. of running cost of Machine B for 2 years ` 60,000 × 1.735 ` 1,04,100
Statement Showing Evaluation of Machine A and B (`)
Particulars Machine A Machine B

Cost of purchase 1,50,000 1,00,000
Add: P.V. of running cost 99,440 1,04,100
P.V. of Cash outflow 2,49,440 2,04,100
Equivalent present value of annual cash 2,49,440 ÷ 2.486 = 1,00,338 2,04,100 ÷ 1.735 = 1,17,637
outflow
Suggestion: Since the annual cash outflow of Machine B is higher, purchase of Machine A is recommended.

Illustration 46
(Computation of Equivalent Annual Cost and Identification of Year to Replace the Machine)
A & Co. is contemplating whether to replace an existing machine or to spend money on overhauling it. A & Co.
currently pays no taxes. The replacement machine costs ` 90,000 now and requires maintenance of ` 10,000 at the
end of every year for eight years. At the end of eight years, it would have a salvage value of ` 20,000 and would
be sold. The existing machine requires increasing amounts of maintenance each year and its salvage value falls
each year as follows:
Amount (`)
Year Maintenance Salvage

Present 0 40,000
1 10,000 25,000
2 20,000 15,000
3 30,000 10,000
4 40,000 0
The opportunity cost of capital for A & Co. is 15%.
When should the company replace the machine?
(Notes: Present value of an annuity of `1 per period for 8 years at interest rate of 15%: 4.4873; present value of
` 1 to be received after 8 years at interest rate of 15%: 0.3269)
Answer
Step1: Calculation of Equivalent Annual Cost of New Machine
Particulars Working Amount (`)

Cost of New Machine 90,000
Add: Present value of annual maintenance cost for 8 years (` 10,000 × 4.4873) 44,873
1,34,873
Deduct: Present value of salvage value at the end of 8 year
th
(` 20,000 × 0.3269) 6,538
Total present value of life cycle cost of new machine 1,28,335
Equivalent annual cost of New Machine = ` 1,28,335÷4.4873 = ` 28,600
Step2: Calculation of Present Value of Maintenance & Salvage of Existing Machine
Maintenance (`) Salvage Value (`)
Year PVF @ 15%
Annual Value Present Value Annual Value Present Value
0 0 0 40,000 40,000
1 0.870 10,000 8,700 25,000 21,750
2 0.756 20,000 15,120 15,000 11,340

Maintenance (`) Salvage Value (`)

Year PVF @ 15%
Annual Value Present Value Annual Value Present Value
3 0.658 30,000 19,740 10,000 6,580
4 0.572 40,000 22,880 0 0
Step 3: Calculation of Equivalent Annual Cost of Existing Machine
Deduct: PV of
PV of Opening Add: PV of Equivalent
Year Closing Salvage
Salvage Value Maintenance Cost Annual Cost
Value
1 40,000 8,700 21,750 26,950
2 21,750 15,120 11,340 25,530
3 11,340 19,740 6,580 24,500
4 6,580 22,880 0 29,460
Step 4: Comparison of Equivalent Annual Cost
Year New Machine (`) Existing Machine (`) (New – Existing)

1 28,600 26950 1,650
2 28,600 25,530 3,070
3 28,600 24,500 4,100
4 28,600 29,460 (860)
Suggestion: Equivalent Annual Cost of New Machine is higher for the first 3 years and is lower by `860/- in the
4th year. Therefore, it is desirable to replace the existing machine after the third year.
Illustration 47
A company is considering the purchase of a machine for ` 3,50,000. It feels quite confident that it can sell the
goods produced by the machine as to yield an annual cash surplus of ` 1,00,000. There is however uncertainly as to
the machine working life. A recently published Trade Association Survey shows that members of the Association
have between them owned 250 of these machines and have found the lives of the machines vary as under:
No. of year of Machine life 3 4 5 6 7 Total

No. of machines having given life 20 50 100 70 10 250
Assuming discount rate of 10% the net present value for each different machine life is follows:
Machine life 3 4 5 6 7
NPV (`) (1,01,000) (33,000) 29,000 86,000 1,37,000
You required to advice whether the company should purchase a machine or not.

Answer
Computation of NPV of an asset considering the probability of life of machine.
Year Probability (a) (`) NPV (b) (`) Expected Value (a × b)

3 20/250 (1,01,000) (8,080)
4 50/250 (33,000) (6,600)
5 100/250 29,000 11,600
6 70/250 86,000 24,080
7 10/250 1,37,000 5,480
26,480
The advice, therefore, is for purchasing the machine.
3.8 Decision Making Using Probability
Introduction
Strategic Cost Management Techniques both use and depend on the information probability distributions provide.
A probability distribution establishes a statistical relationship between two or more variables and the chances of
each occurring. For business enterprises, which often experience volatility, probability distributions are useful
decision-making tools for both maximizing profits and controlling associated costs. Using probability distribution,
instead of making an informed best guess, is a way to reduce some of the uncertainties inherent in a subjective
planning or cost management decision.
Probability Distribution
A probability distribution is a statistical function that describes all the possible values and likelihoods that a
random variable can take within a given range. This range will be bounded between the minimum and maximum
possible values, but precisely where the possible value is likely to be plotted on the probability distribution depends
on a number of factors. These factors include the distribution’s mean (average), standard deviation, skewness, and
kurtosis. Perhaps, the most common probability distribution is the normal distribution, or “bell curve,” although
several distributions exist that are commonly used. The term “bell curve” originates from the fact that the graph
used to depict a normal distribution consists of a symmetrical bell-shaped curve. A probability distribution, thus, is
a statistical tool that shows the possible outcomes of a particular event or course of action as well as the statistical
likelihood of each event. For example, a company might have a probability distribution for the change in sales
given a particular marketing campaign. The values on the “tails” or the left and right end of the distribution are
much less likely to occur than those in the middle of the curve.
Applications
Scenario Analysis: Probability distributions can be used to create scenario analyses. A scenario analysis uses
probability distributions to create several, theoretically distinct possibilities for the outcome of a particular course
of action or future event. For example, a business might create three scenarios: worst-case, likely and best-case.
The worst-case scenario would contain some value from the lower end of the probability distribution; the likely
scenario would contain a value towards the middle of the distribution; and the best-case scenario would contain a
value in the upper end of the scenario

Forecasting: One practical use for probability distributions and scenario analysis in business is to predict future
levels of sales and costs. It is essentially impossible to predict the precise value of a future sales level or cost
movements; however, businesses still need to
be able to plan for future events. Using a
scenario analysis based on a probability
distribution can help a company frame its Forecasting
Scenario Risk
possible future values in terms of a likely
Analysis Evaluation
sales level, cost estimations and a worst-
case and best-case scenario. By doing so,
the company can base its business plans on
the likely scenario but still be aware of the
alternative possibilities. PROBABILITY
Risk Evaluation: In addition to

predicting future sales levels, probability
distribution can be a useful tool for evaluating risk. Consider, for example, a company considering entering a new
business line. If the company needs to generate `5.00 crore in revenue in order to break even and their probability
distribution tells them that there is a 10 percent chance that revenues will be less than `5.00, the company knows
roughly what level of risk it is facing if it decides to pursue that new business line.
Case Study: SCM can boost up the Benefits from IQF
Introduction
SA Limited is a moderate MSME located in rural Maharashtra. It is engaged in the business of processing of raw
vegetables through the technique of Individual Quick Freezing (IQF). IQF enhances the shelf-life of vegetables to
about 18 to 24 months from the date of the packing. The frozen vegetables are to be stored below minus twenty
degrees centigrade. Fresh vegetables of various kinds are the raw material. The capacity of the unit is 600 MT of
vegetables per month.
IQF process is continuous and, broadly, consists of:
i. Raw Material Preparation
ii. Blanching
iii. Freezing
iv. Primary Packing
v. Cold Storage
vi. Secondary Packing
Raw Material Preparation involves cleaning, washing, peeling, cutting, slicing, etc. of the fresh vegetables;
which are then taken up for blanching wherever necessary; and processed through the freezing machinery. Primary
packing consists of bulk packing for cold storage and secondary packing consists of custom packing made to
orders. The frozen vegetables can be sold in domestic market and exported to various developed countries all over
the world. Refrigerated containers are used for the carriage of finished goods.
Lucrative aspects of the business include:
1. Increasing Demand: Vegetables are essential commodities. Demand is ever increasing with the increase
in population and change in consumption pattern i.e., more inclination towards the vegetarian food. As a
consequence, the demand and supply gap has also been increasing.

2. Cheap Labour: The unit is located in a rural area. Cheap and trained labour is available locally.
3. Export Potential: Export market exists to absorb the 100% production capacity of the plant.
4. Strong Bottom Line: The industry is quite profitable and the bottom line is very strong.
The company posted the following financial results for the year 2020-21:
SA Limited: Financial Results for 2020-21
Serial Item ` Lakhs
A Revenue
1. Sales (5400 MT at an average price of ` 45,000 per MT) 2430.00
2. Increase in Stocks (600 MT @ ` 40,000 per MT) 240.00
3. Total 2670.00
B Variable Costs
1. Raw Material 1075.00
2. Variable Conversion Expenses 400.00
3. Other Variable Expenses 275.00
4. Total 1750.00
C Contribution 920.00
D Fixed Expenses
1. Fixed Conversion Expenses 250.00
2. Other Fixed Expenses 200.00
3. Total 450.00
E EBITA 470.00
F Interest 160.00
G Depreciation 60.00
H Profit Before Tax 250.00
I Tax 75.00
J Profit After Tax 175.00
Key Features
Seasonal Raw material: Vegetables are agri season specific. Sowing schedule and harvesting calendar differs
from vegetable to vegetable. For example, bitter gourd is sown in April–May and comes up for harvesting in
August–September: Beans are sown in October-November and are harvested in January–February; and so on. Fresh
vegetables are, therefore, to be processed in the season in which they are available. Carrying out the production
as per the season of the raw material is the first key feature of the industry. Off-season procurement of any fresh
vegetable is very costly and unviable. The previous experience is that the company has to resort to off season
buying to the extent of 25% of its procurements.
Yearlong Assorted Demand: The demand, local as also the export, is for that of assorted mix of the vegetables
yearlong. For example, a health-conscious consumer would like to have beans in the morning and bitter gourd in

the evening once a week yearlong. Further, as tastes and habits differ from region to region and country to country,
different categories of customers keep demanding different compositions of order mix. Impliedly sale-mix varies
from customer to customer and from order to order.
Considering the facts of seasonal raw materials and assorted yearlong demand, it turns out that only 35% of the
vegetables can be supplied from the current production whereas substantial quantities are to be supplied from the
stored-stocks. The resultant impact is that product-stock is build up on the basis of availability of raw material and
product-disposal takes place on the basis of yearlong demand.
Maintaining adequate stock of finished goods in anticipation of the yearlong assorted requirements of the
customers warrants building up sufficient stock of every item of frozen vegetable round the year. The financial
implications are:
a. Huge investments in working capital which works out to six months holding of finished products; and
b. High carrying costs on account of cold storage.
Strategic Plan
Cost Managers of SA Ltd analysed the situation and observed that seasonal availability of raw materials is the
primary bottleneck. Yearlong demand, no doubt, is a strong point; but assorted sales mix is the weak connection.
The strategy should address the issue of continuous and assured supply of raw materials at viable prices throughout
the year. The company has, therefore, designed a backward integration methodology by means of a tie-up with a
local Farmer Producer Organisation (FPO). To start with, vegetable wise annual demand and the farm land needed
for the exclusive cultivation of these vegetables have been computed as detailed in table 1.
Table 1: Annual Demand
Fresh Vegetables Yield per Acre Farm Land

Serial Vegetable
(MT) (MT) (Acres)
1 Beans 1000 8 125
2 Bitter Gourd 480 15 32
3 Bottle Gourd 330 15 22
4 Cauliflower 1080 20 54
5 Carrot 324 18 18
6 Chillies 260 20 13
7 Ivy Gourd 378 18 21
8 Onion Red 828 18 46
9 Onion white 900 18 50
10 Okra 820 10 82
11 Pumpkin 400 20 20
12 Yam 216 18 12
13 Total 7016 495
As may be observed from table 1, it is estimated that sowing in 495 acres of dedicated land can fulfill the demand

of 7016 MT for fresh vegetables and help optimum utilisation of production facilities by the company. After taking
into account the local agricultural practices and the productivity factors; the Company and the FPO, together,
compiled the feasible sowing season time table and the harvesting season calendar for the vegetables as detailed
in table 2.
Table 2: Sowing Season Time Table and Harvesting Season Calendar
Sowing Season Harvesting Season

Serial Vegetable
Time Table Calendar
1 Beans Oct – Nov Nov-Feb
2 Bitter Gourd April – May July - Oct
3 Bottle Gourd Jul – Sep Oct – Dec
4 Cauliflower Oct - Nov Jan - Mar
5 Carrot Jan – Feb Apr - May
6 Chillies Jul – Aug Oct - Dec
7 Ivy Gourd Jun – Jul Jul – Nov
8 Onion Red Nov – Dec Apr - June
9 Onion white Nov – Dec Apr -June
10 Okra Feb – Mar Apr-July
11 Pumpkin Jan – Feb Aug - Nov
12 Yam May – Jun Aug – Oct
The sowing and harvesting schedules were then synchronized and a sowing plan as in table 3 and a harvesting
plan as in table 4 were prepared. The target was the marginal and small farmers located within a radius of 30km
from the plant.
Table 3: Sowing Plan
(Figures in Acres)
Sl. Vegetable Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Total
1 Beans 65 60 125
2 Bitter Gourd 16 16 32
3 Bottle Gourd 6 8 8 22
4 Cauliflower 27 27 54
5 Carrot 9 9 18
6 Chillies 6 7 13
7 Ivy Gourd 10 11 21
8 Onion Red 23 23 46

9 Onion white 25 25 50
10 Okra 40 42 82
11 Pumpkin 10 10 20
12 Yam 6 6 12
13 Total 16 22 16 23 15 8 92 135 48 19 59 42 495
Table 4: Harvesting and Procurement Plan

(Figures in MT)
1 Beans 100 350 350 200 1000
2 Bitter Gourd 120 120 120 120 480
3 Bottle Gourd 120 30 180 330
4 Cauliflower 235 245 380 220 1080
5 Carrot 162 162 324
6 Chillies 160 100 260
7 Ivy Gourd 130 135 113 378
8 Onion Red 207 207 187 227 828
9 Onion white 100 125 225 40 285 125 900
10 Okra 125 100 175 170 250 820
11 Pumpkin 160 150 90 400
12 Yam 150 66 216
13 Total 594 594 587 557 555 596 595 583 585 595 580 595 7016
In view of the tie up with the FPO, the harvesting plan of the farmers becomes the procurement plan for the
company. Proforma Cultivation Cost Sheets were developed for each of the vegetables on the basis of a model
plot. Considering the insights provided by these cost sheets as the base, farmers were offered predetermined prices
formulated at cost plus 100% model.
Farmers were also encouraged to undertake collective buying of the inputs through the FPO. The executives of
the FPO, in coordination with the cost controllers of the company, kept on guiding the farmers in adhering to the
pre-framed time schedules and agri cost controls on a concurrent and continuous basis.
Expected Advantages
The implementation of the afore stated strategy is expected to bring forth the following advantages over the
ensuing couple of years.

A. Benefits exclusive to the Farmers

Farming income for the locals is visualised to increase at least by 50% because of the following factors:
(i) The productivity of the cultivation is expected to go up by 20%.
(ii) The cost of cultivation is expected to come down by 15%.
(iii) Farmers are expected to receive 20% higher prices than the market.
(iv) Sales being assured, farmers are totally protected from the risk of distress selling.
B. Benefits exclusive to the Company

The bottom line (profit) of the company is assumed to prop up by thirty percent on account of the
following advantages:
(i) The company is assured of smooth supply of raw materials at predetermined prices leading to
smoothened production schedule throughout the year.
(ii) Off-season buying having been prevented; the buying costs can be reduced by five to ten percent.
(iii) Despatches from current stock can be increased to beyond 50% in place of the existing quantum
of 35%. Consequently, the stock holding can be reduced by 600 MT and carrying costs can be
reduced by 15%.
(iv) Reduction in stocks is expected to bring down the working capital needs by ` 200 lakhs with a resultant
interest saving of ` 24 lakhs per annum.
(v) Increased quantum of despatches from current stocks would minimise the bulk packing with a
consequential reduction in bulk packing cost to the extent of at least 20%.
(vi) Procurements having been synchronized with vegetable seasons; process wastages of raw materials
can be brought down by 20%.
(vii) Quality measures of the product can be initiated at the farming level itself with specific focus on
customers’ tastes and preferences.
C. Integration of Value Chain

Data Modeling and Budgetary controls can be introduced and applied throughout the integrated value chain comprising
agri activities and processing activities. Eventually, farming community can be taught to implement the techniques of
marginal costing and target costing for achieving higher crop productivity.
Learning Pack
The following ground realities are worth learning from the strategic exercise of SA Limited.
●● Identification of the bottleneck is the first step for any strategic maneuver.
●● Designing a sustainable backward integration can provide a winning edge to an agro based industry.
●● volving feasible sowing and harvesting plans are the key success decisions that have mutually benefited the
E
farmers and the company.
●● Execution of the plans with care and caution is vital for the ultimate competitive advantage.
●● Steering towards the targeted margin generation is the SCM (Strategic Cost Management) forte.
Everything said, IQF is an agro based industry that can be instrumental in augmenting farmers’ income, enhancing
the industrial productivity and strengthening the export potential of the country. The benefits drawn from such an
industry can be bolstered by means of Strategic Cost Management Systems and Techniques.

Case Study: Cost Optimisation of Indian Sugar Sector

1. Indian Sugar Industry
With an annual production capacity of over 350 lakh metric tonnes, the Indian Sugar Industry is the second
largest producer of sugar in the world. Sugar can be produced from sugarcane, sugar-beet or any other crop
having sugar content. But in India, sugarcane is the main source of sugar. At present, this is the second
largest agro-based industry of India after cotton textiles.
Indian Sugar industry contributes significantly to socio-economic development of the rural population
as well. It is a source of livelihood for about 6 crores of farmers and their families; and provides direct
employment to over 5 lakh skilled and semi-skilled human resources in sugar mills and allied industries
across the country.
As of date, Indian sugar industry’s annual output approximates to 85,000 crores of rupees with about 530
sugar factories in operation (installed mills being 735). The industry contributes about ` 4,000 crores to the
central exchequer, apart from giving about ` 1,500 crores to the State Governments. The annual consumption
of sugar in India has been in the range of 250 lakh tones.
2. Sugarcane Prices
The prices of sugarcane in India are government driven through the mechanism of ‘Fair and Remunerative
Price’ (FRP).
The FRP announced by the Central Government, every year, is decided on the basis of the recommendations
of the Commission for Agricultural Costs and Prices (CACP) and in consultation with the State Governments.
CACP takes into account the following factors while fixing the FRP:
i. Cost of production of sugarcane;
ii. Return to the growers from alternative crops and the general trend of prices of agricultural commodities;
iii. Availability of sugar to consumers at a fair price;
iv. Selling Price of sugar;
v. Recovery rate of sugar from sugarcane;
vi. Revenue from sale of by-products viz. molasses, bagasse and press mud or their imputed value; and
vii. Reasonable margins, reportedly 50%, for the growers of sugarcane on account of risk and profits.
The specific stipulation is that FRP is the minimum price that shall be paid to the cane growers. In order to
ensure that higher sugar recoveries are adequately rewarded, the FRP is linked to a basic recovery rate of
sugar, with a premium payable to farmers for higher recoveries of sugar from sugarcane. Some of the state
governments go a step further and tend to implement a State Advised Price (SAP) by fixing cane price over
and above the FRP. The system is, obviously, designed to assure adequate and attractive margins to farmers.
3. Sugar Pricing Policy
Sugar prices are market determined. However, the concept of Minimum Selling Price (MSP) of sugar has
been introduced with effect from 07.06.2018 so that the industry may get at least the minimum cost of
production of sugar, and also to enable them to make time bound cane payments to the farmers. It has been
stated by the policy formulators that MSP takes into account the components of Fair & Remunerative Price
(FRP) of sugarcane and minimum conversion cost of the most efficient sugar mills.
4. Cane Margin
Cane Margin reflects the excess of ‘Operating Revenue’ (i.e. the revenue arising from the sale of sugar and

its by-products) over the ‘Landed Cost’ of sugar cane. In other words, Cane Margin is the throughput margin
available to the sugar manufacturer to defray the conversion expenses and also, thereafter, to generate due
profits for the risk-bearing shareholders.
As such, ‘Throughput (Cane) Margin’ is of utmost importance from the perspective of viable sugar
manufacturing and more so in the context of regulated pricing environment prevailing in India
The applicable FRP mechanism for sugar season 2021-22 in relation to cane is ` 290/- per quintal linked to
a basic sugar recovery of 10% subject to a premium of ` 2.90 per quintal for each 0.1% increase of recovery
over and above 10% and reduction in FRP at the same rate for each 0.1% decrease in the recovery rate till
9.5%. There shall not be any further deduction in case where recovery is below 9.5%. The MSP for sugar has
been fixed at ` 31/- per kg with effect from 14.02.2019.
In accordance with the said mechanism of cane pricing and sugar pricing, sensitivity of throughput margin
per MT of cane at 9.50%, 10.00%, 10.50%, and 11.00% levels of recovery rates of sugar are computed and
furnished in a tabular form.
The computations consider recovery of by-products of molasses @ 4%, bagasse @ 30% and press mud @
4% of the cane crushed. By-product pricing is done at ` 6,000/- per MT of molasses, ` 2,000/- per MT of
bagasse and ` 100/- per MT of press mud.
Sensitivity of Throughput Margin per MT of Cane
Sl Particulars Workings
1 Sugar Recovery % 9.50 10.00 10.50 11.00
2
a. Sugar 95 100 105 110
b. Molasses @ 4% 40 40 40 40
c. Bagasse @30% 300 300 300 300
d. Press Mud @4% 40 40 40 40
3 Operating Revenue (`)
a. Sugar @ ` 31/- per Kg 2945 3100 3255 3410
b. Molasses @ ` 6/- per Kg 240 240 240 240
c. Bagasse @ ` 2/- per Kg 600 600 600 600
d. Press Mud @ ` 0.10- per Kg 4 4 4 4
e. Sub Total 3789 3944 4099 4254
4 Landed Cost of Cane (`)
a. Basic Price @ ` 2900/- per MT 2900 2900 2900 2900
b. Premium @ ` 29/- per 0.1% of
-145 0 145 290
Recovery
c. Sub Total 2755 2900 3045 3190

Sl Particulars Workings
5 Throughput Margin (`) 1034 1044 1054 1064
6 Percentage to Operating Revenue
a. Landed Cost of Cane 72.71 73.53 74.29 74.99
b. Throughput Margin 27.29 26.47 25.71 25.01
The following are the facts that may be evidenced from the table:
(i) Sugar revenue increases in direct proportion to the sugar recovery percentage; i.e., higher the sugar
recovery %, higher the sugar revenue and vice versa.
(ii) By-product revenue remains constant in absolute figures irrespective of changes in sugar recovery
percentage.
(iii) Landed cost of sugar cane increases in more than direct proportion to the sugar recovery percentage;
i.e. higher the sugar recovery %, still higher the landed cost of sugar cane and vice versa. At the
point where the sugar recovery rate is 9.50%, landed cost of sugar cane works out to ` 2755/- and
computes to 72.71% of operating revenue. When the sugar recovery rate climbs up to 11.00%, i.e.
by two percentage points, the landed cost also goes up-to ` 3190/- in absolute terms, but increases to
74.99%, i.e. by 2.28 points when expressed as percentage to operating revenue.
(iv) Throughput Margin increases in less than direct proportion to the sugar recovery percentage; i.e.,
higher the sugar recovery %, partly higher the throughput margin and vice versa. At the point where
the sugar recovery rate is 9.50%, throughput margin works out to ` 1034/- and computes to 27.29% of
operating revenue. When the sugar recovery rate climbs up to 11.00%, i.e. by two percentage points,
the throughput margin goes up-to ` 1064/- in absolute terms, but falls down to 25.01%, i.e. by 2.28
points when expressed as percentage to operating revenue.
The striking realisation is that the percentage of throughput margin with reference to the operating revenue
keeps on coming down with the progressive increases in the sugar recovery rate.
It may be reiterated that Operating Revenue is the aggregate of the realizations from the sale of sugar
which ranges between 77.72% and 80.16% and the balance being by-product revenue. Sugar realizations do
increase or decrease in direct proportion to the recovery rate; but the by-product realizations either remain
constant or more practically may fall down marginally at higher recovery rates of sugar. The premium
formulation of ‘Rs. 2.90 per quintal for each 0.1% increase of recovery over and above 10%’ does not
consider the behaviour of by-product inflows; and assumes proportionate increase in the entire operating
revenue; and hence anomalous behaviour.
5. Target Conversion Cost
As has been highlighted earlier, Indian Sugar Industry is characteristic to the specific feature of predetermined
sugar as also cane prices. Hence, it is only conversion cost that is amenable to control by the sugar producer.
The cost boundaries for the industry are, thus, set by the Throughput Margin wherein:
Throughput Margin = (Operating Revenue) – (Landed Cost of Cane)
Moving further, as is the case with every enterprise, Profit After Tax (the bottom-line of performance) is
preset by the opportunity cost of equity, i.e., the expected Return on Investments in relation to the capital
expenditure incurred towards acquiring fixed and other manufacturing assets by the equity shareholders.

Conversion cost of sugar shall, therefore, be limited to the excess of throughput margin over the preset profit
after tax or in other words opportunity cost of equity. The relevant iteration may, thus, be formulated as:
Conversion Cost ≤ (Throughput Margin) – (Opportunity Cost of Equity)
It means that, it is just the conversion cost that any sugar manufacturer can play with and control. For instance,
at a sugar recovery rate of 10.50%, the throughput margin of 25.71% as reduced by the preset opportunity
cost of equity determines the maximum ceiling for the conversion cost. All the rest, both revenues as also the
costs, are beyond the controlling periphery of the manufacturer. The cost management formula for Indian
Sugar Industry is, thus, to be scripted as:
Target Conversion Cost ≤ (Operating Revenue) - (Landed Cost of Cane + Opportunity Cost of Equity)
Going back to our example, and assuming an Opportunity Cost of Equity of ` 60/- per MT of Cane, the target
conversion cost may be worked out as:
Target Conversion Cost ≤ {(4059) - (3045 + 60)} = 4059 - 3105 = ` 954/-
The mill should, therefore, limit its conversion cost to the affordable level of ` 954/-. And, this is where the
adoption of time tested systems of Target Cost Management comes handy and relevant in relation to the cost
optimisation efforts of Indian Sugar Industry.
Further, it is relevant to note that elements of conversion cost, in this context, include: power, steam, chemicals,
plant operation expenses, other manufacturing expenses, wages, salaries, administrative expenses, interest
and depreciation. Point to remember is that some of these elements are variable, some are semi-variable
and the remaining are fixed. Therefore, the methods and techniques of control need to be a mix of multifold
applications, i.e., by means of pre-determined standards, concurrent variance analysis, incessant target
monitoring and so on. For example, consumption of power and steam can be optimized through continuous
production; chemicals consumption can be minimized by monitoring the dosages; other plant operation
expenses can be minimized through physical supervision; all the fixed expenses can be controlled by means
of administered budgets and optimum utilization of the production facilities and so on.
6. Cost Optimisation
Indian sugar industry is known to have adopted well entrenched cost management systems relevant for the
industry such as process costing, marginal costing, budgetary control and so on. Further, several sugar mills
are covered by statutory cost audit. The strength lies in visualizing the significance of the audit data and using
it for routine cost management to tune up the existing systems and contain the costs with a synergic impact.
It could be the daily manufacturing production report, weekly key performance indicators, monthly cost
evaluations or season-end performance report – everything can be synchronized with cost audit data whereby
the existing resources can be deployed and utilised in a better manner, thus, facilitating cost optimisation.
The illustrative examples that follow demonstrate the utility of probability in relation to decision making.
Illustration 48
A company has a choice among three products A, B and C for which the following estimates are available:
Estimated profits based on demand forecast (` ‘000)
Market X Market Y Market Z

Product A 380 100 30

Market X Market Y Market Z

Product B 300 280 220
Product C 220 400 320
Probabilities are: X = 0.60. Y = 0.20, Z = 0.20
Which project should be undertaken by the company?
Answer
In order to answer the question, it is desirable to take the help of a pay-off matrix which in turn demands the
identification of the elements. e.g.; profits, events (demand), probabilities, actions (products A, B or C), outcomes
represented by Expected Values (EVs).
Profit (` ‘000) Probability Expected Value (` ‘000)

Product A X 380 0.6 228
Y 100 0.2 20
Z 30 0.2 6
Total 254
Product B X 300 0.6 180
Y 280 0.2 56
Z 220 0.2 44
Total 280
Product C X 220 0.6 132
Y 400 0.2 80
Z 320 0.2 64
Total 276
From the above matrix it is evident that Product B having the maximum EV of ` 2,80,000 should be selected.
Illustration 49
You are given the following estimates for next year’s budgeted sales and costs of a single product produced by
Bee Ltd.:
Selling Price ` 12/- per unit

Sales Demand: Units Probability
3200 0.50
4000 0.30
5000 0.20
Variable Cost per unit (`) Probability

5.00 0.30
6.00 0.50
7.00 0.20
Fixed Cost for the period ` 20,000
Required:
(i) Expected value of sales for the period.
(ii) Expected variable cost and contribution for the period.
(iii) Expected profit or loss for the budgeted period.
Answer
(1) Expected Value of Sales:

Expected Sales × Profitability
3,200 × 0.5 = 1,600
4,000 × 0.3 = 1,200
5,000 × 0.2 = 1,000 3,800 @ `12 45,600
(2) Expected Variable Cost:
Unit Variable Costs × Probability
` 5 × 0.3 = 1.5
` 6 × 0.5 = 3.0
` 7 × 0.2 = 1.4 5.9 × 3,800 22,420
(3) Expected Contribution 23,180
(4) Expected Profit:

Expected Contribution 23,180
(-) Fixed Cost 20,000
Expected Profit ` 3,180
Illustration 50
A company has estimated the following demand level of its product:
Sales Volume (units) 10000 12000 14000 16000 18000

Probability 0.10 0.15 0.25 0.30 0.20
It has assumed that the sales price of ` 6 per unit, marginal cost of ` 3.50 per unit, and fixed costs of ` 34,000.

What is the probability that:

(a) The company will break-even in the period?
(b) The company will make a profit of at least ` 10,000?
Answer
(a) Probability of Break-even for the period
In order to break-even, the company must earn enough total contribution to cover its fixed costs. The
contribution is ` 2.50 per unit (i.e. 6 - 3.5).
Break-even Sales = (Fixed Cost ÷ Contribution per Unit)
= (34,000 ÷ 2.50) = 13,600 units
Contribution required/ Contribution per unit = ` 34,000/Rs. 2.50 = 13600 units
∴The probability that sales will equal or exceed 13,600 units is the probability that sales will be 14,000,
16,000 or 18,000 units which is (0.25 + 0.30 + 0.20) = 0.75 or 75%.
(b) Probability of earning Profit of `10,000/-

Contribution Needed = (Profit Needed + Fixed Cost)
= (10,000 + 34,000) = `44,000/-
Desired Sales = (Contribution Needed ÷ Contribution per Unit)
= (44,000 ÷ 2.50) = 17,600 units
∴The probability that sales will equal or exceed 17,600 units is the probability that sales will be 18,000 units
which is 0.20 or 20%
Illustration 51
A company has estimated the unit variable cost of a Product to be ` 10, and the selling price is ` 15 per unit.
Budgeted sales for the year are 20,000 units. Estimated fixed costs are as follows:
Fixed Cost p.a. (`) 50,000 60,000 70,000 80,000 90,000

Probability 0.1 0.3 0.3 0.2 0.1
What is the probability that the company will equal or exceed its target profit of ` 25,000 for the year?
Answer
The different outcomes for fixed cost are mutually exclusive events. If fixed costs are ` 50,000 for example, they
can’t be anything else as well.
Budgeted sales = 20,000 units
Budgeted Contribution per Unit = 15 - 10 = ` 5
Budgeted total contribution (20,000 × 5) 1,00,000

Target profit 25,000
Maximum fixed costs if target is to be achieved 75,000

The probability that fixed costs will be ` 75,000 or less is:

= P (50,000 or 60,000 or 70,000)
= P (50,000) + P (60,000) + P (70,000)
= 0.1+ 0.3 + 0.3
= 0.7 or 70%
Illustration 52
The Managing Director of Y Ltd. has evolved some decision making to the operating division of the firm. He is
anxious to extend this process but first wishes to be assured that decisions are being taken properly in accordance
with group policy. As a check on existing practice, he has asked for an investigation to be made into a recent
decision to increase the price of the sole product of Z division to ` 14.50 per unit but to rising costs. The following
information and estimates were available for the management of Z division:
Last year 75,000 units were sold at ` 12 each with total units cost of ` 9 of which ` 6 were variable costs. For the
year ahead the following cost and demand estimates have been made:
Variable costs:
Pessimistic Probability 0.15 ` 7.00 per unit
Most likely Probability 0.65 ` 6.50 per unit
Optimistic Probability 0.20 ` 6.20 per unit
Total fixed costs:
Pessimistic Probability 0.3 Increase by 50%

Most likely Probability 0.5 Increase by 25%
Optimistic Probability 0.2 Increase by 10%
Demand estimates at various prices
Particulars Probability Rs. 13.50 per unit Rs. 14.50 unit

Pessimistic 0.30 45,000 35,000
Most likely 0.50 60,000 55,000
Optimistic 0.20 70,000 68,000

(Unit variable costs, fixed costs and demand estimates are statistically independent)
For this type of decision the group has decided that the option should be chosen which has the highest expected
outcome with at least an 80% chance of breaking even.
You are required:
(a) to assess whether the decision was made in accordance with group guidelines,
(b) to obtain what is the group attitude to risk as evidenced by the guidelines

Answer
Cumulative
Contribution Total Joint
Demand Probability Probability Joint
per unit Contribution Probability
Probability
Selling Price ` 13.50
45,000 0.3 6.50 0.15 2,92,500 0.045 0.045
7.00 0.65 3,15,000 0.195 0.240
7.30 0.20 3,28,500 0.060 0.300
60,000 0.5 6.50 0.15 3,90,000 0.075 0.375
7.00 0.65 4,20,000 0.325 0.700
7.30 0.20 4,38,000 0.100 0.800
70,000 0.2 6.50 0.15 4,55,000 0.030 0.830
7.00 0.65 4,90,000 0.130 0.960
7.30 0.20 5,11,000 0.040 1.000
Selling Price ` 14.50
35,000 0.3 7.50 0.15 2,62,500 0.045 0.045
8.00 0.65 2,80,000 0.195 0.240
8.30 0.20 2,90,500 0.060 0.300
55,000 0.5 7.50 0.15 4,12,500 0.075 0.375
8.00 0.65 4,40,000 0.325 0.700
8.30 0.20 4,56,500 0.100 0.800
68,000 0.2 7.50 0.15 5,10,000 0.030 0.830
8.00 0.65 5,44,000 0.130 0.960
8.30 0.20 5,64,400 0.040 1.000
Last year’s fixed costs = 75,000 units × ` 3 = ` 2,25,000
Estimated Fixed Costs (`)

` 2,25,000 × 1.10 × 0.2 49,500
` 2,25,000 × 1.25 × 0.5 1,40,625
` 2,25,000 × 1.50 × 0.3 1,01,250
2,91,375

To break-even the contribution must be greater than ` 2,91,375. It is noticed from the above tables that at selling
price of ` 13.50 there is 100% chance to break-even. However, at selling price of ` 14.50 there is 70% (0.075 +
0.325 + 0.1 + 0.03 + 0.13 + 0.04) chance of break-even. The selling price of ` 14.50, therefore, contravenes group
guidelines.
Attitude to Risk: The group seeks to minimize the downside risk whilst maximizing its return. It is to some
extent risk averse, but it is prepared to take some risk i.e., 20% risk of loss. It is always sought maximize its returns,
ignoring the probability of failure, it would be risk neutral.
Terms to Master
Decision Making: Decision making is the outcome resulting from the process of evaluation of the available
alternatives and choosing the best.
Cost Behaviour: Cost Behaviour refers to the changes in input costs in relation to the level of production.
Contribution: Contribution is excess of the Sales Value over the Variable Cost.
Break Even Point (BEP): Break Even Point is the point where ‘Total Revenues’ equal ‘Total Costs’.
Margin of Safety: Sales above the breakeven level reflect the Margin of Safety.
Product Differentiation: Product Differentiation is the process of distinguishing a product or service from
others, to make it more attractive to a particular target market.
Cost Leadership: Cost Leadership Strategy aims at the firm winning market share by appealing to cost-
conscious or price-sensitive customers.
Yield Management: Yield Management is a set of revenue maximization strategies and tactics meant to improve
the business profitability. It is a technique that determines the best pricing policy for optimising profits. It is the art
and science of price-driven and capacity-based profit maximization.
Transfer Price: Transfer price is the notional value of goods and services transferred from one division to the
other division of an organisation.
Relevant Costs: Relevant Costs are costs which are relevant for a specific purpose or situation.
Irrelevant Costs: Irrelevant costs are costs which are not relevant for a specific purpose or situation.
Target Costing: Target Costing is considered as a philosophy in which product development is based on what
the customer wants and is willing to pay for and not what it costs to produce.
kaizen Costing: kaizen Costing refers to the ongoing continuous improvement program that focuses on the
reduction of waste in the production process, thereby further lowering costs below the initial targets specified
during the design phase.
Product Life Cycle: Product Life Cycle is a pattern of expenditure, sale level, revenue and profit over the period
beginning from new idea generation to the deletion of product from product range.
Life Cycle Costing: Life Cycle Costing is a system that is evolved to track and accumulate the costs and
revenues attributable to a product or service from the stage of development to the stage of extinction.
Probability Distribution: A probability distribution is a statistical function that describes all the possible values
and likelihoods that a random variable can take within a given range.

1. Define and discuss decision making process.
2. State the relevance of cost behavior in the context of choosing the best alternative.
3. Write a note on key factor analysis.
4. What are the key pricing strategies? Elaborate with examples.
5. List the merits and de-merits of product differentiation.
6. Explain the concept of cost leadership with the help of a case study.
7. What are the key features of Yield Management?
8. What are the key features of industries that are amenable to Yield Management?
9. What are the benefits of Transfer pricing? What are the prevalent methods in determining transfer price?
10. Distinguish between Relevant Costs and Irreverent Costs.
11. Discuss the philosophy of Target Costing. Highlight its key features.
12. Narrate the process of Target Costing.
13. Write a note on product life cycle.
14. What do you understand by life cycle costing?
15. Highlight the utility of probability in decision making.
QQ1 The break-even point of a manufacturing company is `1,60,000. Fixed cost is `48,000. Variable cost is `12
per unit. The PV ratio will be:
A. 20%
B. 40%
C. 30%
D. 25% Answer: C
Workings
PV Ratio = FC ÷ BEP = 48000 ÷ 160000 = 30%
Explanatory Comment
Please remember that PV Ratio can be worked by dividing the variable cost with sales or by dividing the fixed
cost with BEP sales.
QQ2 The higher the actual hours worked,

A. The lower the capacity usage ratio.
B. The higher the capacity usage ratio.
C. The lower the capacity utilization ratio.
D. The higher the capacity utilization ratio. Answer: D
Explanatory Comment
Capacity utilization ratio is worked out by dividing the actual hours with the budgeted hours. Therefore, higher
the actual hours, higher would be the utilisation ratio.

QQ3 XYZ Ltd. has the following alternative planned activity levels.
Level E F G
Total cost (`) 1,00,000 1,50,000 2,00,000
No. of units produced 5000 10000 15000
If fixed overhead remains constant, then fixed overhead cost per unit at Level E is:
A. ` 20
B. ` 15
C. `13.33
D. ` 10 Answer: D
Workings
Level E F G
Total cost (`) 1,00,000 1,50,000 2,00,000
No. of units produced 5000 10000 15000
Change in Total Cost (1,50,000 – 1,00,000) = 50,000 (2,00,000 – 1,50,000) = 50,000
Change in units (10000-5000) = 5000 (15000-10000) = 5000
Variable Cost per Unit (50,000 ÷ 5000) = 10 (50,000 ÷ 5000) = 10
(Change in TC ÷ Change
in Units)
Total Variable Cost 10,000 × 10 = 1,00,000 15,000 × 10 = 1,50,000
Total Fixed Cost (TC – VC) (TC – VC)
= (1,50,000 – 1,00,000) = (2,00,000 – 1,50,000)
= 50,000 = 50,000
Therefore, Fixed Cost at Level E also would be `50,000/-.
Accordingly, Fixed Cost per unit at Level E = (FC ÷ No. of units) = (50000 ÷ 5000) = `10/-
Explanatory Comment
The problem is based on the fundamental principle that variable costs tend to vary in direct proportion to the level
of activity whereas fixed costs tend to remain constant.
QQ4 T Ltd. produces and sells a product. The company expects the following revenues and costs in 2018:
Revenues (400 sets sold @ `600 per product) = ` 2,40,000
Variable costs = ` 1,60,000
Fixed costs = ` 50,000
What amount of sales must T Ltd. have to earn a target net income of `63,000 if they have a tax rate of 30%?
A. ` 4,20,000

B. ` 4,29,000
C. ` 3,00,000
D. ` 4,89,000 Answer: A
Workings
Sales = `2,40,000/-
Variable Cost = `1,60,000/-
Contribution = (2,40,000 – 1,60,000) = `80,000
C/S Ratio = (80000 ÷ 240000) = 33.33%
Fixed Costs = `50,000
Profit Before Tax = (80,000 – 50,000) = `30,000/-
Target Net Income (TNI) = ` 63,000/-
Tax Rate (t) = 30%
Therefore, Target Profit Before Tax (TPBT) = {TNI ÷ (1-t)} = {63,000 ÷ (1-0.30)} = (63,000 ÷ 0.70) = `90,000
Target Contribution = (TPBT + FC) = (90,000 + 50,000) = `1,40,000/-
Target Sales = (1,40,000 ÷ 33.33%) = `4,20,000/-
Explanatory Comment
The problem focuses on the aspects of deriving the target contribution on the basis of target profit before tax and
then working out the sales by adopting the concept of C/S Ratio.
QQ5 Excel Products Ltd. manufactures four products e.g. Product E, Product F, Product G and Product H using
same raw materials. The input requirements for Products E, F, G and H are 1kg, 2kgs, 5kgs and 7kgs,
respectively. Product-wise Selling Price and Variable Cost data are given hereunder:
Products E F G H
Selling Price (`) 100 150 200 300
Variable Cost (`) 50 70 100 125
Assuming raw material availability is a limiting factor, the correct ranking of the products would be:
A. E, F, G & H
B. E, F, H & G
C. F, E, G & H
D. F, E, H & G Answer: B
Workings
Products E F G H
Selling Price (`) 100 150 200 300
Variable Cost (`) 50 70 100 125

Contribution 50 80 100 175

Raw Material (Kg) 1 2 5 7
Contribution per Kg of Raw Material 50 40 20 25
Ranking 1 2 4 3
Therefore, correct order of ranking = E, F, H & G
Explanatory Comment
The problem demonstrates the application of the concept of contribution per unit of limiting factor while
prioritizing the product preferences.
QQ6 S Ltd. recently sold an order of 50 units having the following costs:
(`)
Direct materials 1,500

Direct labour (1000 hours @ `8.50): 8,500
Variable overhead (1000 hours @ `4.00)1: 4,000
Fixed overhead2: 1,400
Total: 15,400
1. Allocated on the basis of direct labour-hours.
2. Allocated at the rate of 10% of variable cost.
The company has now been requested to prepare a bid for 150 units of the same product. If an 80% learning
curve is applicable, S Ltd.’s total cost on this order would be:
A. ` 38,500
B. ` 37,950
C. ` 26,400
D. ` 31,790 Answer: C
Workings
Production (Units) Labour Hours for 50 units Total Hours

50 1000 1000 × 1 = 1000
100 80% of 1000 = 800 800 × 2 = 1600
200 80% of 800 = 640 640 × 4 = 2560
Therefore, Direct Labour Hours for 150 units
= (Total Hours for 200 units – Total Hours for 50 units)
= (2560 – 1000) = 1,560

Estimate for 150 units

(`)
1. Variable Cost
(i) Direct materials @ `30/- per unit: 4,500
(ii) Direct labour (1560 hours @ `8.50): 13,260
(iii) Variable overhead (1560 hours @ `4.00): 6,240
(iv) Total Variable Cost: 24,000
2. Fixed overhead (10% of 24,000): 2,400
3. Total: 26,400
Explanatory Comment
The problem addresses the application of the concepts of learning curve for cost estimation as also the marginal
costing.
QQ7 A company has a breakeven point when sales are ` 3,20,000 and variable cost at that level of sales are
` 2,00,000. How much would contribution margin increase or decrease if variable expenses are dropped by
`30,000?
A. Increase by 27.5%
B. Increase by 9.375%
C. Decrease by 9.375%
D. Increase by 37.5% Answer: B
Workings
Contribution = (Sales – Variable Costs) = (3,20,000 – 2,00,000) = `1,20,000/-
C/S Ratio = {(Contribution ÷ Sales) × 100} = {(1,20,000 ÷ 3,20,000) × 100} = 37.5%
Decrease in Variable Cost = `30,000
Revised Variable Cost = (2,00,000 – 30,000) = `1,70,000/-
Revised Contribution = (3,20,000 – 1,70,000) = `1,50,000/-
Revised C/S Ratio = {(1,50,000 ÷ 3,20,000) × 100} = 46.875%
Increase in Contribution Margin = (46.875% - 37.5%) = 9.375%
QQ8 The Tech Company has fixed costs of `400,000 and variable costs are 75% of the selling price. To realize
profits of `100,000 from sales of 5,00,000 units, the selling price per unit
A. must be `1.00
B. must be `4.80
C. must be `4.00
D. cannot be determined Answer: C
Workings
Desired Profit = 1,00,000
Fixed Costs = 4,00,000

Desired Contribution = (1,00,000 + 4,00,000) = 5,00,000

PV Ratio = 25%
Desired Sales = (Contribution ÷ PV Ratio)
= (5,00,000 ÷ 25%) = 20,00,000
Number of Units = 5,00,000
Selling Price per Unit = (20,00,000 ÷ 5,00,000) = `4/-
QQ9 A company makes components and sells internally to its subsidiary and also to external market. The external
market price is `24 per component, which gives a contribution of 40% of sales. For external sales, variable
costs include `1.50 per unit for distribution costs. This is, however not incurred in internal sales. There are
no capacity constraints. To maximize company profit, the transfer price to subsidiary should be:
A. ` 9.60
B. ` 12.90
C. ` 14.40
D. None of these Answer: B
Workings
Transfer Price = Marginal Cost – Opportunity Cost
= `24 × 60% - `1.50
= 14.40 – 1.50 = `12.90.
QQ10 H Group has two divisions, Division P and Division Q. Division P manufactures an item that is transferred
to Division Q. The item has no external market and 6000 units produced are transferred internally each year.
The costs of each division are as follows:
Division P Division Q
Variable Cost 100 per unit 120 per unit
Fixed cost each year 1,20,000 90,000
Head Office management decided that a transfer price should be set that provides a profit of ` 30,000 to
Division P. What should be the transfer price per unit?
A. ` 145
B. ` 125
C. ` 120
D. ` 135 Answer: B
Workings
For Division P
Target Profit = `30,000/-
Fixed Cost = `1,20,000/-
Target Contribution = (30,000 + 1,20,000) = 1,50,000

Target Contribution per unit = 1,50,000÷6000 = 25

Target Sale Price per unit = (Target Contribution + Variable Cost)
= (25 + 100) = `125/-
QQ11 A particular job required 800 kgs of material – P. 500 kgs. of the particular material is currently in stock.
The original price of the material – P was `300 but current resale value of the same has been determined as
`200. If the current replacement price of the material – P is `0.80 per kg., the relevant cost of the material – P
required for the job would be:
A. ` 640
B. ` 440
C. ` 300
D. None of these Answer: B
Workings:
Particulars `
500 kgs of material in stock at resale value 200

Balance 300 kgs of material at current price of ` 0.80 240
Relevant Cost of the Material 440
QQ12 What is the opportunity cost of making a component part in a factory given no alternative use of the capacity?
A. The variable manufacturing cost of the component
B. The total manufacturing cost of the component
C. The total variable cost of the component
D. Zero Answer: D
Explanatory Comment:
Opportunity Cost is the “cost” incurred by not enjoying the benefit associated with the best alternative choice. In
the instant case there is no (zero) alternative use for the capacity. Hence, answer (D) is correct.
QQ13 If project A has a net present value (NPV) of ` 30,00,000 and project B has an NPV of ` 50,00,000, what is
the opportunity cost if project B is selected?
A. ` 23,00,000
B. ` 30,00,000
C. ` 20,00,000
D. ` 50,00,000 Answer: B
Opportunity cost represents the next best alternative foregone. If B is chosen, only A is being foregone and hence
the NPV of 30,00,000 is the present value of the opportunity lost.
QQ14 X Ltd. has 1000 units of an obsolete item which are carried in inventory at the original price of `50,000.
If these items are reworked for ` 20,000, they can be sold for ` 36,000. Alternatively, they can be sold as a

scrap for ` 6,000 in the market. In a decision model used to analyse the reworking proposal, the opportunity
cost should be taken as:
A. ` 16,000
B. ` 6,000
C. ` 30,000
D. ` 20,000 Answer: B
Workings
Original price of ` 50,000/- is not relevant.
Rework income = ` 36,000/-
Less: Cost of rework = ` 20,000
Net Inflow = ` 16,000/- which is relevant.
The other alternative, relevant for cash flow, is from sale as scrap, i.e. ` 6,000/-
Hence the opportunity cost is ` 6.000/-
Next best alternative for net inflow is sale as scrap which gives an income of ` 6,000/-. Therefore, Opportunity
cost is `6,000/-
QQ15 The shadow price of skilled labour for SD Ltd. is currently ` 10 per hour. What does this mean?
A. The cost of obtaining additional skilled labour is ` 10 per hour.
B. There is a hidden cost of ` 10 for each hour of skilled labour actively worked.
C. Contribution will be increased by ` 10 per hour for each extra hour of skilled labour that can be obtained.
D. The total costs will be reduced by ` 10 for each additional hour of skilled labour that can be obtained.
Answer: C
A shadow price for a scarce resource is its opportunity cost. It is the amount of contribution that would be lost
if one unit less of that resource were available. It is similarly the amount of additional contribution that would be
earned if one unit more of that resource were available. (This is on the assumption that that the scarce resource is
available at its normal variable cost).
QQ16 A factory can make only one of the three products X, Y or Z in a given production period. The following
information is given:
Per unit ` X Y Z
Selling Price 1500 1800 2000
Variable Cost 700 950 1000
Assume that there is no constraint on resource utilization or demand and similar resources are consumed by
X,Y and Z. The opportunity cost of making one unit of Z is:
A. ` 850/-
B. ` 800/-

C. ` 1,800/-
D. ` 1,500/- Answer: A
Workings:
Serial Particulars X Y Z
1 Selling Price 1500 1800 2000
2 Variable Cost 700 950 1000
3 Contribution (1-2) 800 850 1000
4 Ranking 3 2 1
Next best alternative for Z is Y which gives a contribution of ` 850/-. Therefore, Opportunity cost of Z = ` 850/-
QQ17 A company has 2000 units of an obsolete item which are carried in inventory at the original purchase price
of ` 30,000. If these items are reworked for ` 10,000, they can be sold for ` 18,000. Alternatively, they can
be sold as scrap for ` 3,000 in the market. In a decision model used to analyse the reworking proposal, the
opportunity cost should be taken as:
A. ` 8,000
B. ` 12,000
C. ` 3,000
D. ` 10,000 Answer: C
Workings
(i) Original price is not relevant
(ii) Net Inflow from Rework
Rework Income 18,000

Deduct cost of rework 10,000
Net Inflow 8,000 It is relevant
The other alternative relevant for cash flow is from sale as scrap = ` 3,000 Hence, the opportunity cost is ` 3,000.
QQ18 TM Company can make 100 units of a necessary component part with the following costs (`.)
Direct Materials 60,000
Direct Labour 10,000
Variable Overhead 30,000
Fixed Overhead 20,000
TM Company can purchase the component externally for `1,10,000 and only `5,000 of the fixed costs can
be avoided, what is the correct make-or-buy decision?
A. Make and Save `5000
B. Buy and save `5,000

C. Make and Save `1,5000

D. Buy and save `15,000 Answer: A
Workings
Variable Costs of Making = (Direct Materials + Direct Labour + Variable Overhead)
= (60,000 + 10,000 + 30,000) = 1,00,000
Hence, cost of making = `1,00,000/-
Cost of Buying = (Buying Costs – Avoidable Fixed Costs) = (1,10,000 – 5,000)
= `1,05,000/-
Make and Save = (1,05,000 – 1,00,000) = `5,000/-
QQ19 AP Products sells product A at a selling price of `40 per unit. Ap’s cost per unit based on the full capacity of
5,00,000 units is as follows:
Direct Materials 6
Direct Labour 3
Indirect Manufacturing Exps 60% of which is fixed 10
Total 19
A one-time only special order offering to buy 50,000 units was received from an overseas distributor. The
only other costs that would be incurred on this order would be ` 4 per unit for shipping. AP has sufficient
existing capacity to manufacture the additional units. In negotiating a price for the special order, AP should
consider that the minimum selling price per unit should be
A. ` 17
B. ` 19
C. ` 21
D. ` 23 Answer: A
Workings
Relevant Costs for the Special Order
Direct Materials = 6
Direct Labour = 3
40% of Indirect Manufacturing Exps = 4
Shipping Costs = 4
Total = (6+3+4+4) = 17
QQ20 In cost plus pricing, the markup consist of

A. Manufacturing cost
B. Desired ROI
C. Selling and administrative cost
D. Total cost and desired ROI Answer: B

QQ21 MN paid ` 5,30,000 for a machine used to powder wheat. The machine can be sold for ` 1,30,000. The
sale value of wheat is ` 8,00,000 and its variable cost is ` 4,00,000. The opportunity cost of producing
wheat flour is
A. ` 530,000
B. ` 1,30,000
C. ` 3,50,000
D. ` 8,00,000 Answer: B
QQ22 A Ltd. Plans to introduce a new product and issuing the target cost approach. Projected sales revenue is
` 90,00,000 (` 45 per unit) and target costs are ` 64,00,000. What is the desired profit per unit?
A. ` 13
B. ` 17
C. ` 32
D. ` 10 Answer: A
Workings
Sales Revenue = ` 90,00,000
Price per Unit = ` 45
Number of Units = (90,00,000 ÷45) = 2,00,000
Target Costs = ` 64,00,000
Cost per Unit = (64,00,000 ÷2,00,000) = ` 32
Desired Profit per Unit = (45 – 32) = ` 13
QQ23 Target costing is the answer to

A. Market driven prices
B. Sellers’ market
C. No Profit situation
D. None of the above Answer: A
QQ24 The product of XYZ company is sold at a fixed price of ` 1,500 per unit. As per company’s estimate, 500
units of the product are expected to be sold in the coming year. If the value of investments of the company
is ` 15 lakhs and it has a target ROI of 15%, the target cost would be:
A. ` 930
B. ` 950
C. ` 1050
D. ` 1130 Answer: C
Workings
Target ROI at 15% of total investment of `15 lakhs
= `15,00,000 × 0.15 = ` 2,25,000
Expected output = 500 units

Target Profit per unit of output = ` 2,25,000/500 = `450 per unit

Target cost per unit = Selling Price – Profit per unit
= `1,500 – `450 = `1,050 per unit.
QQ25 A company has the capacity of producing 80000 units and presently sells 20000 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 if the demand is doubled at full capacity and profit
margin on sale is taken at 25%?
A. ` 75/-
B. ` 90/-
C. ` 25/-
D. ` 60/- Answer: D
Workings:
Particulars Price (`) Demand (Units)
As at present 100 20,000
Reduction of price by ` 10/- 90 40,000
Reduction of price by another ` 10/- 80 80,000 (Full Capacity)
Therefore, at full capacity of 80,000 units:
Selling Price = `80/-
Target Profit = 25% of Selling Price = 25% of 80 = `20
Target Cost = (Selling Price – Profit) = (80 – 20) = `60

Activity Based Management and Just in Time (JIT)
Activity Based Management and Just

in Time (JIT)
4

4.1 Activity Based Cost Management - Concept, Purpose, Stages, Benefits, Relevance in Decision-
making and its Application in Budgeting, Responsibility Accounting, Traditional Vs. ABC
System – Comparative analysis
4.2 JIT – introduction, Benefits, Use of JIT in measuring the Performance
4.3 Throughput Accounting
4.4 Back flush Accounting
4.5 Benchmarking

Activity Based Management and Just in Time (JIT) 4

4.1 Activity Based Cost Management: Concept, Purpose, Stages, Benefits, Relevance in Decision-
making and its Application in Budgeting, Responsibility Accounting, Traditional Vs. ABC System
– Comparative analysis
Concept & Purpose

Technology Trigger Cost Accounting: Activity Based Costing (ABC) system assumes that products consume
activities and activities consume costs. It leads to more precise allocation of manufacturing overheads amongst the
products. Activity-based costing provides a means to
collect indirect costs in multiple categories and then
applies the results individually to the products and
services. Products Activities
ABC is a Technology Trigger Cost Accounting that has consume consume
gained popularity from around the mid nineteen eighties. Activities Costs
ABC was aimed to improve the accuracies in the absorption
of overheads adapted in traditional costing systems. ABC’s
ability to overcome the inherent limitations in traditional
cost accounting systems enabled changes in strategy processes, operations and in turn improved competitive
posture. ABC is being nurtured as an ongoing technology with incessant inputs from continuous research.
Traditional Limitations: The main objective of any costing system is to determine scientifically the cost of a
product or service. Costs are of various kinds such as material, labour, utilities, consumables, financial charges,
depreciation, and many othe ` But all of them can be segregated into two distinct categories, viz. direct costs and
indirect costs.
Direct costs are the costs which are traceable to the products or the services that are being offered. Indirect costs,
which are traditionally called ‘overheads’, are not traceable to the products or services. Hence, these overheads are
first identified, classified, allocated, and apportioned to convenient service cost centres; reapportioned to production
cost centres and finally absorbed by the cost units i.e. products or services.
Direct costs have traditionally been the target of management scrutiny and evaluation. Indirect costs, on the
other hand, have not had the level of scrutiny they deserve. The problem with having only one or two categories
for pooling indirect costs is that it is very difficult to have the visibility to know what costs are truly necessary and
what are not. Also, indirect costs can impact various products or services quite differently.
Charging the direct costs to the products is comparatively simple and can be done with remarkable accuracy.
However, the absorption of indirect costs by the cost units is complex and there does exist a possibility of distortion
of costs leading to hidden and unintentional inaccuracies. Distortions in the absorption of overheads may lead to
several wrong decisions such as Errors in fixation of selling prices; Wrong decisions concerning product mix;

Ignoring customer orientation; Missing of profitable opportunities; etc. Even though the basis of charging the
overheads is quite logical, such of these limitations happen to be one of the biggest restraints for the traditional
costing systems.
The limitations can be narrated by means of a simple example. Suppose XYZ Limited, a manufacturing
company, is producing two products, A and B. The direct material cost for the products is ` 15,00,000 & ` 25,00,000
respectively, totalling to ` 40,00,000. Assuming that the total overheads are ` 20,00,000 and the company adopts
direct material cost as the basis for absorption. The rate of absorption works out 50% as shown below:
Direct Material Cost: ` 40,00,000
Overheads: ` 20,00,000
Rate of absorption: (2000000 ÷ 4000000) × 100 = 50%
Absorption by A: 1500000 × 50% = ` 7,50,000
Absorption by B: 2500000 × 50% = ` 12,50,000
Product B is loaded with higher quantum of overheads because of the fact that it consumes more of the direct
material. Assuming that in course of time, engineers have been able bring down the direct material costs of product
B to ` 22,50,000, without any change in the material costs of product A and as also the total of the overheads; the
revised cost computations would read as follows:
Direct Material Cost: ` 37,50,000
Overheads: ` 20,00,000
Rate of absorption: (2000000 ÷ 3750000) 100 = 53.3333%
Absorption by A: 1500000 × 53.3333% = ` 8,00,000
Absorption by B: 2250000 × 53.3333% = ` 12,00,000
Even though, there is no change as regards product A, the absorption of overheads by it has gone up by ` 50,000/-
from ` 7,50,000/- to ` 8,00,000/- which is an evident distortion. This misrepresentation in costs may propel wrong
decisions in several areas like make or buy, pricing, acceptance of export offer etc. As a consequence, ABC was
evolved to weed out such of these avoidable inaccuracies.
Introduction to ABC: At the initial phase, Activity Based Costing has been introduced with a view to overcome
the limitations of traditional costing systems. CIMA defines Activity Based Costing as, ‘cost attribution to cost
units on the basis of benefit received from indirect activities e.g., ordering, setting up, and assuring quality.’ One
more definition of Activity Based Costing is, ‘the collection of financial and operational performance information
tracing the significant activities of the firm to product costs.’
By using multiple overhead pools and cost drivers, activity-based costing can provide more accurate cost figures
for costing and pricing the products and services. Activity may be considered as the cost pool of convenience; and
cost driver is the factor that impacts the cost of activity.
The focus of ABC is on accurate information about the true cost of products, services, processes, activities,
distribution channels, customer segments, contracts, and projects. ABC can help managers make better decisions
about what they offer. This process also encourages continual operating improvements. Once business process costs
are known with reasonable accuracy, activity-based budgeting can set realistic goals for improving the processes
and for identifying those processes that are no longer needed or are unprofitable.
Important Terms in Activity Based Costing: The operation of the ABC system involves the use of the following
terms:

Activity: An activity means an aggregate of closely related tasks having some specific functions which are
used for completion of a goal or objective. For example; customer order processing is an activity. It includes
receiving an order from customer, interacting with production department regarding capacity to produce and
giving commitment to the customer regarding delivery time. Other activities may be assembling, packaging,
advertising etc.
Resource: Resources are elements that are used for performing the activities or factors helping in the activities.
For example; order receiver, telephone, computers etc., are resources in customer order processing activity. It may
include material, labour, equipment, office supplies, etc.
Cost: Cost is the amount paid for the resources consumed by the activity. For example; salaries, printing
stationary, telephone bill, etc. are cost of customer order processing activity. It is also known as activity cost pool.
Cost Object: Cost Object refers to an item for which cost measurement is required. e.g., a product, a service, or
a customer.
Cost Pool: A cost pool is a term used to indicate grouping of costs incurred on a particular activity which drives
them.
Cost Driver: Any element that would cause a change in the cost of an activity is cost driver. Cost drivers are
the basis of charging cost of an activity to a cost object. Cost drivers are used to trace the costs to a product or
service by using a measure of the resources consumed by each activity. For example, frequency of orders, number
of orders, etc. may be the cost drivers of customer order processing activity. A Cost Driver may be a Resource Cost
Driver or an Activity Cost Driver. A resource cost driver is a measure of the quantity of resources consumed by an
activity. An activity cost driver is a measure of the frequency and intensity of the demand placed on activities by
cost objects.
Examples of activities, resources, cost pools and cost drivers are tabulated below:
Activities Resources Cost pools Cost driver

Consulting Consultant, Employee cost, Level of consultant, Time spent
Computer Maintenance cost
Laser Printing Printing Staff, Colour cost, No. of pages printed, Font
Printer Maintenance cost,
Printing stationary
Accounting & Administration Salaries No. of times account is produced
Administration Staff
Customer Service Telephone, Staff Telephone bill, Salaries Frequency of orders, No. of orders,
Time spent in servicing, No. of service
calls
Research & Staff, Equipment, Salaries, Maintenance No. of research projects, Time spent
Development Material cost, Material cost on a project, Technical complexities of
project
The cost drivers for some of the other functional avenues such as production, marketing and customer service
may be stated as:
Production: Number of units, Number of set-ups
Marketing: Number of sales personnel, Number of sales orders

Customer Service: Number of service calls, Number of products serviced, Hours spent on servicing products
Taking forward the example of XYZ Limited, cited in the earlier paragraphs, after adopting ABC the company
has identified the activities and cost drivers, as furnished in table 1, in relation to product A and product B.
Table 1
Units of Consumption
Sl Activity Cost Driver Product Product
Total
A B
1 Mould Cleaning Direct Tracing
2 Material Inspection Number of Receipts 400 600 1000
3 Machine Set up Number of Set ups 3500 6500 10000
4 Machine Maintenance Machine Hours 15000 35000 50000
5 Quality Control Inspections 5000 10000 15000
6 Packing Orders 375 625 1000
In order to facilitate the distribution of the overheads of ` 20,00,000/- , the cost driver rates of absorption are
computed as detailed in table 2; and the apportionment of overheads to product A and product B is computed in
table 3.
Table 2
Cost Driver
Sl Activity Rupees Cost Driver Units
Rate
1 Mould Cleaning 2,50,000 Direct Tracing
2 Material Inspection 2,00,000 Number of Receipts 1000 200
3 Machine Set up 4,50,000 Number of Set ups 10000 45
4 Machine Maintenance 6,25,000 Machine Hours 50000 12.50
5 Quality Control 3,00,000 Inspections 15000 20
6 Packing 1,75,000 Orders 1000 175
7 Total 20,00,000
Note: Cost Driver Rate = (Cost of Activity ÷Units of Cost Driver)

Table 3
Product A Product B Total

Activity
Workings (`) Workings (`) (`)
Mould Cleaning Direct Tracing 1,00,000 Direct Tracing 1,50,000 2,50,000
Material Inspn. 400 @ ` 200 80,000 600 @ ` 200 1,20,000 2,00,000
Machine Set up 3500 @ ` 45 1,57,500 6500 @ ` 45 2,92,500 4,50,000
Machine Mtce. 15000 @ ` 12.5 1,87,500 35000 @ ` 12.5 4,37,500 6,25,000
Quality Control 5000 @ ` 20 1,00,000 10000 @ ` 20 2,00,000 3,00,000

Product A Product B Total

Activity
Workings (`) Workings (`) (`)
Packing 375 @ ` 175 65,625 625 @ ` 175 1,09,375 1,75,000
Total 6,90,625 13,09,375 20,00,000
The results of adoption of ABC are obvious from table 3. It has enabled XYZ Limited to refine the distribution
of costs between product A and product B, and thereby better the accuracy. In fact, the company has been able
to trace the mould cleaning costs to the extent of ` 2,50,000/- as direct costs (i.e., ` 1,00,000/- to product A and
` 1,50,000/- to product B). An activity-based costing system, thus, first traces costs to activities and then to products
and other cost objects.
The absorption rates are dependent on the cost drivers which bear a direct influence on the activities whereby
overhead rates would change only if there is a change in the relevant cost driver. Till such time there is a change
any of the activities or cost drivers; product A would continue to bear a overhead distribution of ` 5,90,625/ (i.e.,
6,90,625 reduced by direct costs of 1,00,000 relating to mould cleaning); and product B would be loaded with
` 11,59,375/- (i.e.,1309375 reduced by direct costs of 1,50,000 relating to mould cleaning).
Technological advancements in Information Technology facilitated convenient application of the ABC in a cost-
effective manner. New methods are evolved that reduced the cost of implementation and operation of ABC systems.
ERP systems and BI tools made it easier to build and modify advanced ABC models and report the information to
management. Enhanced functionality and reduced cost opened up entirely new applications for ABC.
ABC has emerged as an integral component of a new generation of business performance management solutions.
These new solutions include profitability management, performance measurement, financial management,
sustainability and human capital management. Today, ABC is considered as the foundation of performance
management.
CIMA, London, goes on to assert that ABC is not a method of costing, but a technique for managing the
organisation better. It is a one-off exercise which measures the cost and performance of activities, resources,
and the objects which consume the resources in order to generate more accurate and meaningful information for
decision-making.
Stages
There are eight vital stages (steps) to the implementation of ABC.
1. Identification of Cost Objects: The process to ABC starts with the identification of the cost objects. The
cost objects of any organization are the products or services.
2. Identification of Activities: Identification of the activities is the next step. Identification of the main
activities can be done by carrying out an in-depth analysis of the operating processes of each responsibility
segment. Usually, the number of activities in ABC will be much more as compared to traditional overhead
system. The exact number will depend on how the management subdivides the organizations activities.
3. Tracing the Direct Costs: The third step relates to identification of Direct Costs. The direct costs of products
or objects may comprise direct material cost, direct labour cost and direct expenses. Classification of as
many of the total costs as direct costs as is economically feasible should be made. Classification as direct
costs reduces the amount of costs to be classified as indirects.
4. Relating the Indirect Costs to the Activities: The fourth step is relating the indirect costs to activities.
Here, various items of indirect costs are related to activities, viz. both support and primary, which caused
them. As a result of relating the items of indirect costs to various activities, cost pools or cost buckets are
created.

5. Distribution of Support Activities: Then comes the distribution of support activities. The spreading of
support activities (i.e., activities which support or assist manufacturing) across the primary activities
(correlated to the number of units produced) is done on some suitable
base which reflects the use of support activity. The base is the cost driver Identication of
and is a measure of the support activities that are used. Cost Objects
6. Determining the Activity Cost Drivers: The determination of the
activity cost drivers is done in order to relate the overheads collected in Identication of
cost pools to the cost objects of products. It is done on the basis of the Activities
factor that drives the consumption of the activities.
7. Calculating the Activity Cost Driver Rates: The activity cost driver Tracing the Direct
rates for each activity are calculated in the way in which overhead Costs
absorption rates would be calculated under the traditional system. It can
be formulated as: Activity Cost Driver Rate = (Total Cost of Activity Relating the Indirect
÷ Activity Driver). These activity cost driver rates are to be used for Costs to the Activities
ascertaining the amount of overhead chargeable to various cost objects or
products. Distribution of
8. Computing the Total Cost: The last step is computing the total cost. Support Activities
The total costs of the products shall be computed by adding all direct and
indirect costs assigned to them. The amount of overhead chargeable to a Determining the
product or cost object shall be calculated by multiplying the respective Activity Cost Drivers
activity cost driver rate by the quantum of the activity that the product or
other cost object consumes. Calculating the Activity
The introduction of ABC system in an organization can be either Cost Driver Rates
supplementary to the traditional cost accounting system as an offline system
or it can be fully integrated with the decision support systems such as ERP. Computing the
Management practices and methods have changed a lot over the last decades and Total Cost
will continue to change. Organisations are moving from managing vertically to
managing horizontally. It is a move from a function orientation to a process orientation. Total quality management
(TQM), just-in-time (JIT), benchmarking and business process reengineering (BPR) are all examples of horizontal
management improvement initiatives. These initiatives are designed to improve an organisation’s work processes
and activities to effectively and efficiently meet or exceed changing customer requirements. ABC continues to
maintain the momentum of change.
Benefits
The benefits and advantages attributable to ABC are manifold. The following list reflects the results of several
surveys of practice in the United States, the United Kingdom, and Canada to determine why companies choose
ABC.
●● Cost Reduction: ABC measures how much costly are the activities and then takes steps to reduce their costs
by changing the productions process or outsourcing those activities.
●● Product Pricing: ABC implementers generally believe that ABC provides more accurate cost information
than conventional costing does. Management can use this information to negotiate price increases with
customers or to drop unprofitable products.
●● Budgeting: Management can use more accurate cost information to improve budgets and measures of
department and division performance.
A research work on “Activity-Based Cost Management Practices in India: An Empirical Study” by Dr Manoj
Anand, Dr B S Sahay, and Subhashish Saha revealed that the firms who have adopted ABC were significantly more
successful in capturing accurate cost information for value chain analysis and supply chain analysis vis-à-vis the
firms who had not adopted ABC. The need for customer profitability analysis and budgeting led the corporate India
to extend their ABC-systems from basic level to advanced level, extending it to facility level and customer level
activities.
Product, customer, and business-unit profitability are the objectives of the activity-based cost systems. The top
management support, ABCM-linked performance valuation and compensation plans, number of applications of
ABCM in the organization and time-in-use of application have been found to be ABCM success determinants by
Foster and Swanson (1997).
The firms using activity-based costing systems are found to be more successful in capturing:
1. Accurate cost and profit information for:
a. product pricing;
b. customer profitability;
c. inventory valuation;
d. value chain analysis;
e. supply chain analysis; and
f. outsourcing decisions
2. Accurate profit analysis by product, process, department, and customer
3. Better insight for benchmarking and budgeting
4. Better insight about manufacturing performance
5. Linking up cause and effect relationship
Application of activity-based costing has resulted in changes in various management decision areas; prominent
among them being focus on profitable customers, pricing strategies, and sourcing decisions.
Application of ABCM has impact not only on the decisions within the firm but also on the decisions beyond
the boundaries of the firm. The decision areas beyond the boundaries of the firm include focus on the profitable
customers, sourcing decisions, elimination of redundant activities, distribution channel, and strategic focus. The
product mix, process simplification, and product pricing are included in decisions within the boundaries of firm.
Actual costs could consist of intrinsic costs and legacy costs. Intrinsic costs refer to the normal costs at normal
capacity. Legacy costs refer to tangible and intangible costs attributable to the policies and procedures being
inherited by the enterprise. The legacy costs do not add any value to the deliverables. Most of the avoidable costs
could fall under this category. Implementation of ABC is reported to have enabled pruning down the legacy costs
inherited by the U.S. shipyards from decades of building ships for the U.S. government.
The benefits drawn from ABC may be summed up as follows:
i. It provides more accurate product costing information by reducing arbitrary cost allocations.
ii. It improves the quality of information available for decision making by answering the questions such as what
activities and events are driving cost and where should the efforts be made to control cost?
iii. It is the easiest way to allocate overheads to the product.
iv. It helps to identify the activities that can be eliminated.
v. It links up the cause-and-effect relationship.

vi. It helps to identify the value-added activities (that increase the customer’s satisfaction) and non-value-added
activities (that creates problems to customer’s satisfaction)
vii. ABC translates costs in to a language that people can understand and that can be linked up to business
activities.
Activity-based costing has equal opportunities in both the manufacturing as well as service sectors and the
motivations are uniform over the stages of adoption. However, the major difficulties faced by the ABCM-user firms
while designing activity-based cost systems are developing activity dictionary & cost drivers and lack of review
of ABCM implementation initiative.
Relevance in Decision-Making and Application in Budgeting

Convenient Enabler: ABC is a convenient means of Cost Management. ABC enables to Unbundle the Costs &
Break them to pieces for better and easier controls. The key to using activity-based costing, as a philosophy outside
of operational realms, is by means of focusing on the relevant steps in business process that add better value as
compared to their cost.
Assuming that a purchasing department has a set of steps: receiving the purchase requisition, obtaining approval,
making the purchase order and ordering the material in question, sending payment, receiving the object and
recording the receipt. Activity-based costing philosophy would create a cost for each step, based on the salaries of
employees involved and the time each step takes to be completed, and then would look at the costs of each step to
determine where value is being wasted. For example, while approval of a purchase requisition may only take each
manager a few seconds, if the entire approval process takes two weeks, that’s a significant amount of cost to the
company in time wasted waiting for the order to be made. Or, as an alternate example, if the receiving process has
to be done manually while everything else is automated, it might make sense for the company to look into the cost
of automating that step as well, if ABC calculations show it as a significant expense.
Overall, activity-based costing allows a company to better break down the elements of their business process
that actually add cost, be it operational costs like machinery and manufacturing, or more administrative costs like
interpersonal processes or company policies. The success of the process, however, depends on how the company
evaluates and uses the data that comes out of this type of accounting calculation.
Activity Based Management: Activity Based Management is a tool of
management that involves analysing and costing activities with the goal of
improving efficiency and effectiveness. Activity Based Management is a set of Cost Driver
actions that management can take, based on information from an Activity Analysis
Based Costing system, to improve profitability. Towards a continuous
improvement, Activity Based Management keeps on attempting Cost Driver Activity
Analysis, Activity Analysis, and Performance Analysis, on a continuous basis. Analysis
Cost Driver Analysis: The factors that cause activities to be performed need
to be identified in order to manage activity costs. Cost driver analysis identifies Performance
these casual facto ` For example, in a stores department, it may be observed Analysis
that slow moving and obsolete stock is not disposed of in time, the reason
being the staff in the stores is not trained properly in this area. Managers have
to address this cost driver to correct the root cause of this problem and take
proper action.
Activity Analysis: Activity Analysis identifies value added and non-value-added activities and efforts are made
to eliminate the non-value adding activities.
Performance Analysis: Performance analysis involves the identification of appropriate measures to report the

performance of activity centers or other organizational units consistent with each unit’s goals and objectives.
Performance Analysis aims to identify the best ways to measure the performance of factors that are important to
organizations in order to stimulate continuous improvement.
Managers and employee teams are seeking more transparency and visibility of their costs. Just reliably knowing
ABCM’s per-each-unit costs of their outputs of work is useful for benchmarking to search for best practices or
monitor trends to measure performance improvement. ABCM removes the illusion that support overhead (i.e.,
indirect) expenses are necessary and, therefore, appear to be free—they are not free.
The costs of an output, product, or service (i.e., a final cost object) can be reduced by:
~~ Reducing the quantity, frequency, and/or intensity of the activity driver (e.g., fewer inspections reduce the
“inspect product” activity cost);
~~ Lowering the activity driver cost rate by productivity improvements (e.g., shorten the time for each “inspect
product” event); and
~~ Understanding the sources and causes of waste leading to nonvalue-adding activities to reduce or eliminate
them (e.g., solve the problem that requires an inspection in the first place).
These three are examples of how ABCM data leads to cost management for productivity improvement. The idea
is to do more with less (or at least with the same). That is, produce more outputs with the same amount of resources
or the same amount of outputs with fewer resources. Note how these actions support the continuous improvement
principles of the Six Sigma quality and lean management initiatives that are embraced by the operations and quality
communities.
Activity Based Budgeting (ABB): A budget is defined as a statement expressed in quantitative and monetary
terms prepared prior to a defined period of time for the policy to be pursued during that period for the purpose of
achieving a given objective. In other words, a budget is always prepared ahead of time; it is expressed either in
quantitative terms or monetary terms or both; it reflects the objective to be achieved during that period and hence
the policy to be followed during that period is put in the budget.
Budget helps in planning for the future. It also helps in controlling as there is a continuous comparison of actual
with budget. Any deviation between the two is identified for taking suitable action. In simple terms, budget is a plan
of action expressed in terms of money.
The traditional budgeting is based on traditional cost accounting whereas the activity-based budgeting is based
on activity-based costing. Activity-based budgeting is a budgeting method where activities are thoroughly analysed
to predict costs. ABB does not take historical costs into account when creating a budget. Every cost incurred by a
business will be looked at closely to determine if efficiencies can be created and costs reduced. It can be in the form
of a reduction in activity levels or complete removal of unnecessary activities. Ultimately, ABB aims to analyse
business cost drivers and enable the business to become more profitable.
The following are the features of Activity Based Budgeting.
1. It uses the activity analysis to relate costs to activities.
2. It identifies cost improvement opportunities.
3. There is a clear link between strategic objectives and planning and the tactical planning of the ABC process.
There are three main steps in ABB viz. identifying cost drivers, projecting total units, and estimating the cost
per unit.
Identifying the cost drivers of various activities: For example, the cost drivers for a manufacturing facility can
be the total labour hours and wages paid to employees.

Projecting the number of units required within each cost driver: For example, the manufacturing facility may
always need three people on the production line, translating to 240 labour hours per week.
Estimating the cost per unit of activity relating to that cost driver: For example, wages for warehouse labour can
be ` 150/- per hour.
Activity Based Budgeting provides a strong link between the objectives of organization and objectives of a
particular activity. In other words, it involves identification of activities and dividing them into value adding and
non-value adding activities. The non-value adding activities are eliminated in due course of time.
Responsibility Accounting
Responsibility accounting involves separate reporting of revenues and expenses for each responsibility center
in a business. Doing so improves the management of operations. For example, the cost of rent can be assigned to
the person who negotiates and signs the lease, while the cost of an employee’s salary is the responsibility of that
person’s direct manager. This concept also applies to the cost of products, for each component part has a standard
cost (as listed in the item master and bill of materials), which is the responsibility of the purchasing manager to
obtain at the correct price. Similarly, scrap costs incurred at a machine are the responsibility of the shift manager.
Taking it forward, an activity-based responsibility accounting system assigns responsibility to processes and uses
both financial and nonfinancial measures of performance. It is the responsibility accounting system developed for
those firms operating in continuous improvement environments. Traditional responsibility accounting uses budgets
and variances to hold individuals responsible for those costs that they have the authority to incur causing them to
manage cost rather than the activities that cause the cost. Activity-based accounting redefines accountability from
costs to team-based activities.
The activity-based approach recognizes the need to manage interdependence. Explicit recognition of
interdependence shifts management’s focus from individual performance to the performance of the organization
as a holistic system, from cost control to analysing the activities that cause the costs, and from meeting engineered
standards to continuous improvement in the trended performance of the process in both operational and financial
terms. An Activity-based responsibility accounting system provides a database that identifies interrelated activities
and the resources required. This results in a matrix form of accounting that replaces the rigid structure of the
general ledger and supports decisions related to performance evaluation, product costing, and strategic planning.
The responsibility accounting model is defined by four essential elements:
i. Assigning responsibility
ii. Establishing performance measures or benchmarks
iii. Evaluating performance
iv. Assigning rewards
Activity-based responsibility accounting avoids the after-the-fact rationalizations, finger pointing,
gamesmanship, defensive actions, and myopic behaviour produced by traditional responsibility accounting. Using
the new forms of activity accounting and control offered by ABC, managers can learn about the interrelationships
and interdependences between activities, and change management’s role in the organization. Activity-based
responsibility accounting is one of the need-based sunrise avenues for every cost manager
Traditional vs. ABC System – Comparative Analysis

Activity-Based Costing (ABC) is a system that focuses on activities as the fundamental cost objects and uses the
cost of these activities for computing the costs of products. There are several reasons why managers are preferring
ABC to traditional system.

I. In the traditional system cost analysis is done by product. In ABC managers focus attention on activities
rather than products because activities in various departments may be combined and costs of similar activities
ascertained, e.g., quality control, handling of materials, repairs to machines etc. If detailed costs are kept by
activities, the total company costs for each activity can be obtained, analysed, planned and controlled.
II. Managers manage activities and not products. Changes in activities lead to changes in costs. Therefore, if the
activities are managed well, costs will fall and resulting products will be more competitive.
III. Allocating overhead cost to production based on a single cost driver (allocation base, such as unit basis,
percentage of material, percentage of prime cost, labour hour rate, machine hour rate etc.) can result in an
unrealistic product cost because the traditional system fails to capture cause-and-effect relationships. To
manage activities better and to make wiser economic decisions, managers need to identify the relationships
of causes (activities) and effects (costs) in a more detailed and accurate manner.
IV. ABC highlights problem areas that deserve management’s attention and more detailed analysis. Many
actions are possible, on pricing, on process technology, on product design, on operational movements and
on product mix.
Traditional costing can lead to under-costing or over-costing of products or services. Over or under costing of
products distorts cost information. A poor quality of cost information causes management to make poor decisions
for pricing, product emphasis, make or buy etc. ABC differs from the traditional system only in respect of allocations
of overheads or indirect costs. Direct costs are identified with, or assigned to, the cost object, in the same manner
as is done in case of traditional costing system. Overhead costs are linked to the cost objects based on activities.
Assimilation
Activity based costing has revolutionized product costing, planning, and forecasting in the last decade. It is based
on a philosophy of estimation that: “it is better to be approximately right, than precisely wrong.” In summary,
activity-based costing is a management decision-making tool. It provides financial support data structured in a
fashion fundamentally different from accounting data provided in the general ledger. By associating cost to the
activity, a clear relationship can be established between sources of activity demand and the related costs. This
association can benefit the distributor in determining where costs are being incurred, what is initiating the costs
and where to apply efforts to curb inflationary costs. This can be of particular value in tracking new products or
customers
Caselet 1: How Xu Ji achieved standardisation in working practices and processes (CIMA case study,
2011)
The Chinese electricity company Xu Ji used ABC to capture direct costs and variable overheads, which were
lacking in the state-owned enterprise’s (SOE) traditional costing systems. The ABC experience has successfully
induced standardisation in their working practices and processes. Standardisation was not a common notion in
Chinese culture or in place in many Chinese companies. ABC also acts as a catalyst to Xu Ji’s IT developments –
first accounting and office computerisation, then ERP implementation.
Prior to the ABC introduction in 2001, Xu Ji operated a traditional Chinese state-enterprise accounting system.
A large amount of manual bookkeeping work was involved. Accounting was driven predominantly by external
financial reporting purposes, and inaccuracy of product costs became inevitable. At this time, Xu Ji underwent a
series of flotations following China’s introduction of free market competition.
The inaccuracy of the traditional costing information seriously impeded Xu Ji’s ability to compete on pricing.
The two main tasks for the ABC system were to: trace direct labour costs directly to product and client contracts;
and allocate manufacturing overheads on the basis of up-to-date direct labour hours to contracts.

The learning was that the common ‘top-down’ management style and organisational culture among SOEs worked
well when instigating innovative ideas and inducing corporate-wide learning. Top management’s commitment to
trying out new management ideas and investing in new technology has been the unique feature.
Caselet 2: ABC in Automobile Industry:

Many automotive companies use activity-based costing to determine their costs and pricing. For example,
Ford decided the company needed this sort of determined, specific look into individual cost steps to see which
steps could be eliminated or improved. Chrysler has seen hundreds of millions of dollars saved using activity-
based costing to identify and eliminate useless, inefficient or redundant steps in its production, which has also
significantly streamlined product development. Since car and truck manufacturing is an established industry, where
the manufacturing process has many steps that combine to make the final product, activity-based costing is the
ideal analysis.
Caselet 3: Activity-Based Costing of Coca-Cola

Coca-Cola is another company that uses activity-based costing to determine its price points. Coca-Cola offers a
large portfolio of products and carries a huge amount of inventory, which can be a significant portion of production
cost that is often overlooked. Coca-Cola has used activity-based costing to evaluate the differences between its
bigger, world-wide products and its specialty, regionalized products that it may not offer on the global market. This
understanding of how production costs are different between established, familiar types and specialized types has
enabled them to set price points in each market that ensure them significant profit.
Illustration 1
A company manufactures 500 units of product AX. The following details are available:
Material cost to manufacture: ` 1,50,000
Labour cost: ` 2,65,000
Material Reordering Cost: ` 4,500
Material Handling Cost: ` 2,500
Material orders: 35
Material movements: 20
What is the Total Material cost under Activity based costing?
Answer
Total Material Cost under Activity Based Costing
Serial Particulars (`)

1 Material cost to manufacture 1, 50,000
2 Material Reordering Cost 4,500
3 Material Handling Cost 2,500
4 Total Material Cost- 1, 57,000
Explanatory Comment: Material Reordering Cost and Material Handling Cost are directly traced to the Total
Material Cost under the system of ABC.

Illustration 2
Production overheads of XYZ Manufacturers Pvt. Ltd. for 500 units of product X are
Machine oriented activity cost: ` 1,35,400
Material ordering overheads: ` 69,570
Machine hours are 1.50 hrs per unit and No. of material orders are 6 per unit.
Raw material cost ` 300 per unit and labour cost ` 150 per unit. What is the Total cost of X per Unit?
Answer
(i) Machine Oriented Cost per Unit
Machine oriented activity cost for 500 units = ` 1,35,400
Machine hours for 500 units = 1.5 × 500 = 750
Machine Oriented Cost per hour = (135400 ÷ 750) = ` 180.53
Machine Oriented Cost per Unit = (180.53 × 1.5) = ` 270.80
(ii) Material Ordering Cost per Unit
Material Ordering Cost = ` 69,570
Material Orders per unit = 6
Material Orders for 500 units = 6 × 500 = 3000
Material Ordering Cost per Order = (69570 ÷ 3000) = ` 23.19
Material Ordering Cost per Unit = (23.19 × 6) = ` 139.14
(iii) Total Cost of X per Unit
Serial Particulars (`)

1 Raw Material cost 300.00
2 Labour cost 150.00
3 Machine Oriented Cost 270.80
4 Material Ordering Cost 139.14
5 Total Cost 859.94
Explanatory Comment: Costs of activities, viz. Material Orientation and Material Ordering have been
computed per unit of Cost Driver.
Illustration 3
A company produces four products, viz. P, Q, R and S. The data relating to production activity are as under
Quantity of Material cost/ Direct labour Machine Direct Labour

Product
production `. per unit hours/unit hours/ unit cost/`. per unit
P 4,500 12 2 1.50 8
Q 13,640 15 2 0.75 9

Quantity of Material cost/ Direct labour Machine Direct Labour

Product
production `. per unit hours/unit hours/ unit cost/`. per unit
R 2,340 25 5 2.50 27
S 18,350 21 4 4.00 25
Production overheads are as under: `
(i) Overheads applicable to machine-oriented activity: 1,65,900

(ii) Overheads relating to ordering materials 8,760
(iii) Set up costs 21,400
(iv) Administration overheads for spare parts 44,690
(v) Material handling costs 25,545
The following further information have been compiled:
No. of materials No. of times

Product No. of set up No. of spare parts
orders materials handled
P 3 3 6 6
Q 18 12 30 15
R 5 3 9 3
S 24 12 36 12
Required:
(i) Select a suitable cost driver for each item of overhead expense and calculate the cost per unit of cost driver.
(ii) Using the concept of activity-based costing, compute the factory cost per unit of each product.
Answer
(i) Computation of Cost Driver Rates
(a) Overheads relating to Machinery oriented activity
Cost Driver: Machine Hour Rate
Machine Oriented Overheads = ` 1,65,900
Total Machine hours = {(4500 × 1.5) + (13640 × 0.75) + (2340 × 2.5) + (18350 × 4)}
= 6750 + 10230 + 5850 + 73400 = 96230
Cost Driver Rate = (1,65,900 ÷ 96,230) = ` 1.724 per hour
(b) Overheads relating to ordering materials
Material Ordering Overheads = ` 8,760
Cost driver: No. of Material orders
Cost Driver Rate = (8760÷30) = ` 292 per order
(c) Set up costs
Set Up Overheads = ` 21,400

Cost driver: No. of set ups

Cost Driver Rate = (21,400÷50) = ` 428 per set up
(d) Administrative Overheads for spare parts
Administrative Overheads = 44,690
Cost driver: No. of spare parts
Cost Driver Rate = (44690÷36) = ` 1241.39 per spare part
(e) Material Handling costs
Material Handling Overheads = 25,545
Cost driver: No. of times materials are handled
Cost Driver Rate = (25545÷81) = ` 315.37 per material handling
(ii) Computation of factory cost for each product
(a) Apportionment of Overheads on the basis of Cost Driver Rate
Activity P Q R S
Number of Units of Production 4,500 13,640 2,340 18,350
Machinery oriented activity
Number of Machine Hours 6750 10230 5850 73400
Total Cost @ ` 1.724 per hour 11,637 17,637 10,085 1,26,542
Cost per Unit ( ` ) 2.586 1.293 4.31 6.896
Material Ordering
Number of Material Orders 3 12 3 12
Total Cost @ ` 292/- per order 876 3,504 876 3,504
Cost per Unit ( ` ) 0.195 0.257 0.374 0.191
Set Up Cost
Number of Set Ups 3 18 5 24
Total Cost @ ` 428/- per set up 1,284 7,704 2,140 10,272
Cost per Unit ( ` ) 0.285 0.565 0.915 0.56
Admn. Costs for Spare Parts
No. of spare parts 6 15 3 12
Total Cost @ ` 1241.39 per spare part 7,449 18,621 3,724 14,897
Cost per Unit ( ` ) 1.655 1.365 1.591 0.812
Material Handling Costs
No. of times materials are handled 6 30 9 36
Total Cost @ ` 315.37 per handling 1,892 9,461 2,838 11,353
Cost per Unit ( ` ) 0.42 0.694 1.213 0.619
Total Overheads 23,138 56,927 19,663 1,66,568
Overhead Cost per Unit ( ` ) 5.142 4.174 8.403 9.077

(b) Cost per Unit ( ` )
Particulars P Q R S
Materials 12.00 15.00 25.00 21.00
Labour 8.00 9.00 27.00 25.00
Overheads
Machine oriented activity 2.586 1.293 4.310 6.896
Ordering of Materials 0.195 0.257 0.374 0.191
Set up costs 0.285 0.565 0.915 0.560
Administrative Spare Parts 1.655 1.365 1.591 0.812
Material handling 0.420 5.14 0.694 4.17 1.213 8.40 0.619 9.08
Factory Cost (Rs) 25.14 28.17 60.40 55.08
Illustration 4
The budgeted overheads and cost driver volumes of XYZ are as follows.
Budgeted Overheads
Cost Pool Cost Driver Budgeted Volume
( ` )
Material procurement 5,80,000 No. of orders 1,100
Material handling 2,50,000 No. of movements 680
Set-up 4,15,000 No. of set ups 520
Maintenance 9,70,000 Maintenance hours 8,400
Quality control 1,76,000 No. of inspections 900
Machinery 7,20,000 No. of machine hours 24,000
The company has produced a batch of 2,600 components of AX-15; its material cost was ` 1,30,000 and labour
cost ` 2,45,000. The usage activities of the said batch are as follows:
Material orders – 26, maintenance hours – 690, material movements – 18, inspections – 28, set ups – 25, machine
hours – 1,800
Calculate – cost driver rates that are used for tracing appropriate amount of overheads to the said batch and
ascertain the cost of batch of components using Activity Based Costing.
Answer
Step1: Computation of Cost Driver Rates
Budgeted Budgeted Cost Driver
Cost Pool Cost Driver Workings
( ` ) Volume Rate
Material 5,80,000 No. of orders 1,100 580000 ÷ 1100 527.27
procurement

Budgeted Budgeted Cost Driver

( ` ) Volume Rate
Material handling 2,50,000 No. of movements 680 250000 ÷ 680 367.65
Set-up 4,15,000 No. of set ups 520 415000 ÷ 520 798.07
Maintenance 9,70,000 Maintenance hours 8,400 970000 ÷ 8400 115.48
Quality control 1,76,000 No. of inspection 900 176000 ÷ 900 195.56
Machinery 7,20,000 No. of machine 24,000 720000 ÷ 24000 30.00
hours
Step 2: Apportionment of overheads to AX-15
Usage Cost Driver Overheads

Volume Rate ( ` )
Material No. of orders 26 527.27 26 × 527.27 13,709
procurement
Material No. of 18 367.65 18 × 367.65 6,618
handling movements
Set-up No. of set ups 25 798.07 25 × 798.07 19,952
Maintenance Maintenance 690 115.48 690 × 115.48 79,681
hours
Quality control No. of 28 195.56 28 × 195.56 5,476
inspections
Machinery No. of machine 1800 30.00 1800 × 30 54,000
hours
Total 1,79,436
Step 3: Computation of Batch Cost of 2600 units of AX-15
Sl Element (`) (`)

1 Material cost 1,30,000
2 Labour Cost 2,45,000
3 Prime Cost 3,75,000
4 Overheads
a. Material orders 13,709
b. Material handling 6,618
c. Set-up 19,952

Sl Element (`) (`)

d. Maintenance 79,681
e. Quality Control 5,476
f. Machinery 54,000
g. Sub Total 1,79,436
5 Total Cost 5,54,436
Illustration 5
AML Ltd is engaged in the production of three types of ice-cream products viz. Coco, Strawberry & Vanilla. The
Company presently sells 50,000 units of Coco @ ` 25 per unit, Strawberry 20,000 units @ ` 20 per unit and Vanilla
60,000 units @ ` 15 per unit. The demand is sensitive to selling price and it has been observed that every reduction
of ` 1 per unit in selling price increases the demand for each product by 10% to the previous level. The company
has the production capacity of 60,500 units of Coco, 24,200 units of Strawberry, and 72600 units of Vanilla. The
company marks up 25% of the cost of product.
The management decides to apply ABC analysis. For this purpose, it identifies four activities as store support
costs. The cost driver rates are as follows.
Activity Cost Driver Rate
Ordering ` 800 per purchase order
Delivery ` 700 per delivery
Shelf Stocking ` 199 per hour
Customer Support and Assistance ` 1.10 per unit sold
The other relevant information for the products is as follows
Coco Strawberry Vanilla

Direct Material p.u. (` ) 8 6 5
Direct Wages p.u. (` ) 5 4 3
No. of purchase orders 35 30 15
No. of Deliveries 112 66 48
Shelf stocking hours 130 150 160
Under the traditional costing system, store support costs are charged @ 30% of prime cost.
Required:
(i) Calculate the unit cost and total cost of each product at the maximum level using traditional costing.
(ii) Calculate the unit cost and total cost of each product at the maximum level using activity-based Costing.

Answer
(i) Computations under Traditional Costing
Element Coco Strawberry Vanilla

Unit Cost ( ` per Unit)
Direct Material 8 6 5
Direct Labour 5 4 3
Prime Cost 13 10 8
Store Support Costs @ 30% on PC 3.90 3.00 2.40
Total 16.90 13.00 10.40
Number of Units 60,500 24,200 72,600
Total Cost ( ` )
Direct Material 4,84,000 1,45,200 3,63,000
Direct Labour 3,02,500 96,800 2,17,800
Prime Cost 7,86,500 2,42,000 5,80,800
Store Support Costs 2,35,950 72,600 1,74,240
Total 10,22,450 3,14,600 7,55,040
(ii) Computations under Activity Based Costing
a. Computation of Store Support Costs per Unit
Activity Coco Strawberry Vanilla
Ordering Cost
Number of Purchase Orders 35 30 15
Cost @ ` 800 per order 28,000 24,000 12,000
Delivery Cost
Number of Deliveries 112 66 48
Cost @ ` 700 per delivery 78,400 46,200 33,600
Shelf Stocking Cost
Shelf stocking hours 130 150 160
Cost @ ` 199 per hour 25,870 29,850 31,840
Customer Support Cost
Number of Units Sold 60,500 24,200 72,600
Cost @ ` 1.10 per unit 66,550 26,620 79,860
Total Cost 1,98,820 1,26,670 1,57,300
Number of Units 60,500 24,200 72,600
Store Support Costs per Unit ( ` ) 3.286 5.234 2.167

b. Statement of Costs
Element Coco Strawberry Vanilla
Unit Cost ( ` per Unit)
Direct Material 8 6 5
Direct Labour 5 4 3
Prime Cost 13 10 8
Store Support Costs 3.286 5.234 2.167
Total 16.286 15.234 10.167
Number of Units 60,500 24,200 72,600
Total Cost ( ` )
Direct Material 4,84,000 1,45,200 3,63,000
Direct Labour 3,02,500 96,800 2,17,800
Prime Cost 7,86,500 2,42,000 5,80,800
Store Support Cost 1,98,803 1,26,663 1,57,324
Total 9,85,303 3,68,663 7,38,124
Explanatory Comments: The following statement draws comparison of unit costs and total costs under the
traditional and ABC systems
Statement of Comparison
Particulars Coco Strawberry Vanilla

Unit Costs
Under Traditional System 16.90 13.00 10.40
Under ABC System 16.286 15.234 10.167
Total Costs
Under Traditional System 10,22,450 3,14,600 7,55,040
Under ABC System 9,85,303 3,68,663 7,38,124
The differences between the cost computations under the two systems are obvious and self-explanatory. Prime
cost remaining the same, the differences arose on account of bettering the accuracy in the distribution of store
support costs under ABC.
Illustration 6
XYZ Limited makes three main products, using broadly the same production methods and equipment for each.
A conventional product costing system is used at present, although Activity Based Costing (ABC) system is being
considered. Details of the three products, for a typical period are:
Labour Hours Machine Hours Material

Product Volumes Units
per Unit per unit ( ` Per unit)
X 1½ 3½ 25 3,500

Labour Hours Machine Hours Material

Product Volumes Units
per Unit per unit ( ` Per unit)
Y ½ 2 15 2,250
Z 2 5 30 6,000
Direct labour costs are ` 8 per hour and production overheads are absorbed on machine hour rate basis. The
rate for the period is ` 18 per machine hour. Further analysis shows that the total of production overheads can be
divided as follows:
Activity %
Costs relating to set-ups 30
Costs relating to machinery 25
Costs relating to materials handling 22
Costs relating to inspection 23
Total production overhead 100
The following activity volumes are associated with the product line for the period as a whole.
Number of Number of movements Number of

Product
Set-ups of materials Inspections
X 65 15 150
Y 110 26 190
Z 485 79 570
Total 660 120 910
(a) Calculate the cost per unit for each product using conventional method
(b) Calculate the cost per unit for each product using ABC principles
Answer
(a) Computation of Cost per unit using Conventional Method
Element X Y Z
Materials 25 15 30
Labour @ ` 8 per hour 12 4 16
(8 ×1 ½) (8 × ½) (8 × 2)
Overheads @ ` 18 per 63 36 90
machine hour (18 ×3 ½) (18 ×2) (18 ×5)
Total 100 55 136

(b) Computation of Cost per unit using ABC principles

Step (i): Computation of Total Overheads
Machine Hours Overheads @ ` 18 per

Product Number of Units
per Unit machine hour
X 3,500 3½ 2,20,500
(3500 × 3 ½ × 18)
Y 81,000
2,250 2 (2250 × 2 × 18)
Z 5,40,000
6,000 5 (6000 × 5 × 18)
Total 8,41,500
Step (ii): Computation of Cost Driver Rates
Cost of Units of Cost Cost Driver

Activity % Cost Driver
Activity ( ` ) Driver Rate ( ` )
Set-ups 30 2,52,450 No. of setups 660 382.50
Machinery 25 2,10,375 Machine hours 46750 4.50
Materials 1,85,130 No. of Moment 120 1542.75
handling 22 of Materials
Inspection 23 1,93,545 No. of 910 212.69
Inspections
Total 100 8,41,500
Note : Total Machine Hours = (3500 × 3 ½) + (2250 × 2) + (6000 × 5) = 46,750
Step (iii): Computation of Overheads per Unit
Activity X Y Z Total
Units 3500 2250 6000
Set-up Cost
Number of Set-ups 65 110 485 660
Total Cost @ ` 382.50 per set-up 24862.50 42075.00 185512.50 252450
Cost per Unit ( ` ) 7.10 18.70 30.92
Machinery Cost
Number of Machine Hours 12250 4500 30000 46750
Total Cost @ ` 4.50 hour 55125 20250 135000 210375
Cost per Unit ( ` ) 15.75 9.00 22.50

Material Handling Cost

Number of Material Movements 15 26 79 120
T.C. @ ` 1542.75 per movement 23141.25 40111.50 121877.25 185130
Cost per Unit ( ` ) 6.61 17.83 20.31
Inspection Cost
Number of Inspections 150 190 570 910
Total Cost @ ` 212.69 per Inspn. 31903.50 40411.10 121233.30 193548
Cost per Unit ( ` ) 9.12 17.96 20.21
Step (iv): Computation of Cost per Unit
X Y Z
Element / Product
(`) (`) (`) (`) (`) (`)
Materials 25.00 15.00 30.00
Labour 12.00 4.00 16.00
Overheads
Setup Cost 7.10 18.70 30.92
Machine cost 15.75 9.00 22.50
Material Handling Cost 6.61 17.83 20.31
Inspection Cost 9.12 38.58 17.96 63.49 20.21 93.94
Total Cost 75.58 82.49 139.94
Explanatory Comments: The following statement draws comparison of unit costs under the traditional and
ABC systems
Statement of Comparison
X Y Z
Element / Product
(`) (`) (`) (`) (`) (`)
Materials 25.00 25.00 15.00 15.00 30.00 30.00
Labour 12.00 12.00 4.00 4.00 16.00 16.00
Prime Cost 37.00 37.00 19.00 19.00 46.00 46.00
Overheads 63.00 38.58 36.00 63.49 90.00 93.94
Total Cost 100.00 75.58 55.00 82.49 136.00 139.94
The differences between the two systems are obvious. Prime cost remaining the same, the differences arose on
account of the better methodology adopted under ABC principles for the distribution of Overheads.

Illustration 7
Vikas Associates, a firm of Chartered Accountants, offers three different types of services, namely, Accounting
and Auditing, Taxation and Management Consultancy. Each service is charged on the basis of number of billable
hours. The average charge per billable hours is ` 500. For the year ending 31.03.2022 the firm projects the following
estimate of direct and indirect costs:
Costs Particulars ( ` Lakhs) ( ` Lakhs)

Direct Costs: Accounting & Auditing 100.00
Taxation 100.00
Management Consultancy 50.00 250.00
Indirect Costs: Planning & Review 7.50
Computer Processing 7.20
Professional Salaries 5.60
Books, Seminars & Periodicals 1.80
Programming Costs 8.00
Building Costs 4.90
General Administration Costs 15.00 50.00
Total 300.00
Until 31.03.2021 the firm has been allocating the indirect costs on the basis of billable hours. For the year
ending 31.03.2022 it was decided to introduce a system of activity based costing to capture the indirect costs more
accurately. The following data were gathered accordingly:
Accounting Management
Particulars Taxation
& Auditing Consultancy
Billable Hours 55000 35000 10000
EDP Hours 5000 2500 500
Professionals (Nos.) 30 16 10
Books, Seminars & Periodicals (`) 57500 62500 60000
Programming Hours 1250 500 2250
Building (Sqft.) space occupied 8000 4000 2000
Administration (No. of clients) 150 250 100
Required:
(i) Prepare a profitability statement on the basis of conventional costing
(ii) Prepare a profitability statement on the basis of activity- based costing
(iii) Draw a comparative Statement of Indirect Costs & Profits
(iv) Any suggestion for improving the billable charge on the basis of ABC assuming the same rate of margin of
66.667% on total cost?

Answer
(i) Profitability Statement on the basis of Conventional Costing
Accounting Managemt. Total

Activity Taxation
& Auditing Consult. ( ` Lakhs)
Number of Billable Hours 55,000 35,000 10,000 1,00,000
Revenue in ` Lakhs @ ` 500/- per hour 275.00 175.00 50.00 500.00
Direct Costs 100.00 100.00 50.00 250.00
Indirect Costs in ` Lakhs @ ` 50/- per 27.50 17.50 5.00 50.00
hour
Total 127.50 117.50 55.00 300.00
Profit 147.50 57.50 (5.00) 200.00
(ii) Profitability Statement on the basis of Activity Based Costing

Step 1: Computation of Cost Driver Rates
Cost Driver Cost Driver

Cost Pool Cost Rate
Base Units ( ` per Unit)
( ` Lakhs)
Planning and Review Billable Hrs 1,00,000 7.50 7.50
Computer Processing EDP Hours 8,000 7.20 90.00
Professional Salaries Number of Professionals 56 5.60 10,000.00
Programming Costs Programming Hours 4,000 8.00 200.00
Building Costs Sq.ft. Occupied 14,000 4.90 35.00
Administration Costs Number of Clients 500 15.00 3000.00
Step 2: Apportionment of Indirect Costs on the basis of Cost Driver Rate
Accounting & Management

Activity Taxation
Auditing Consultancy
Planning and Review

Number of Billable Hours 55,000 35,000 10,000
Cost @ ` 7.50 per hour 4,12,500 2,62,500 75,000
Computer Processing
EDP Hours 5,000 2,500 500
Cost @ ` 90/- per hour 4,50,000 2,25,000 45,000


Activity Taxation
Professional Salaries
Number of Professionals 30 16 10
Cost @ ` 10,000/- per professional 3,00,000 1,60,000 1,00,000
Books, Seminars & Periodicals
Actuals 57,500 62,500 60,000
Programming Costs
Programming Hours 1,250 500 2,250
Cost @ ` 200/- per hour 2,50,000 1,00,000 4,50,000
Building Costs
Sq.ft. Occupied 8,000 4,000 2,000
Cost @ ` 35/- per sq.ft. 2,80,000 1,40,000 70,000
Administration Costs
Number of Clients 150 250 100
Cost @ ` 3,000/- per client 4.50.000 7,50,000 3,00,000
Total Indirect Costs 22,00,000 17,00,000 11,00,000
Step 3: Profitability Statement on the basis of ABC
Accounting Managmt. Total

Activity Taxation
& Auditing Consultancy ( ` Lakhs)
Number of Billable Hours 55,000 35,000 10,000 1,00,000
Revenue in ` Lakhs @ ` 500/- per hour 275.00 175.00 50.00 500.00
Direct Costs 100.00 100.00 50.00 250.00
Indirect Costs 22.00 17.00 11.00 50.00
Total 122.00 117.00 61.00 300.00
Profit 153.00 58.00 (11.00) 200.00
(iii) Comparative Statement

Activity Taxation
Indirect Costs ( ` Lakhs)
Conventional 27.50 17.50 5.00 50.00
ABC 22.00 17.00 11.00 50.00
Difference 5.50 0.50 (6.00)


Activity Taxation
Profits ( ` Lakhs)
Conventional 147.50 57.50 (5.00) 200.00
ABC 153.00 58.00 (11.00) 200.00
Difference (5.50) (0.50) 6.00
(iv) Suggestions
The comparative statement highlights the fact that the difference in profits between the Conventional and ABC
systems is on account of the difference in indirect costs. It is, therefore, desirable to change the billing rates in line
with ABC system.
Computation of Revised Billing Rates

Activity Taxation
Number of Billable Hours 55,000 35,000 10,000
Direct Costs
Total ( ` Lakhs) 100.00 100.00 50.00
Costs per Billable Hour ( ` ) 181.818 285.714 500.00
Indirect Costs
Total ( ` Lakhs) 22.00 17.00 11.00
Total Costs
Total ( ` Lakhs) 122.00 117.00 61.00
Target Profit @ 66.667% on Costs
Total ( ` Lakhs) 81.374 78.039 40.687
Profit per Billable Hour ( ` ) 147.953 222.968 406.870
Revised Billing
Total ( ` Lakhs) 203.374 195.039 101.687
` per Billable Hour 369.771 557.253 1016.87
Suggested Billing Rate (` per hour) by 370 560 1020
rounding off to the next multiple of five.
Explanatory Comments: The three different types of services, viz. (i) Accounting and Auditing, (ii) Taxation
and (iii) Management Consultancy, are the cost objects for which cost measurement is under taken. Planning &
Review; Computer Processing; Professional Salaries; Books, Seminars and Periodicals; Programming; Building;
and General Administration are the cost pools under which the indirect costs are accumulated.
Under the conventional system the indirect costs are apportioned by means of a single base, viz. billable hours.

Under the ABC system, a seperate base is adopted for each of the cost pools. The revised billing rate prevents the
under or over billing of any of the services.
Illustration 8
Precision Auto comp Ltd. Manufactures and sells two automobile components A and B. Both are identical with
slight variation in design. Although the market for both the products is the same, the market share of the company
for product A is very high and that of product B very low. The company’s accountant has prepared the following
profitability statement for the two products (Cost of production: same for both the products)
Direct Material ` 125

Direct Labour ` 24
Direct Expenses (sub-contract charges) ` 36
Overheads (400% of direct labour) ` 96
Total Cost ` 281
Particulars Product A Product B Total

Quantity sold No. 1,24,000 23,150 1,47,150
Unit sale price ` 300 290
Total sales realization ` 4,39,13,500
Cost of sales as above ` 4,13,49,150
Margin ` 25,64,350
The company’s marketing manager, after attending a workshop on activity-based costing challenges the
accountant’s figures. The nearest competitor’s prices for the two products are ` 330 and ` 275 per unit respectively
and, if the company can match the competitor’s prices, it can sell 75,000 nos. each of the two products. The
Production Manager confirms that he can produce this product mix with the existing facilities.
The management engages you as consultant, and the following facts have been identified by you:
a. Product A undergoes 5 operations and product B undergoes two operations by sub-contractors, although the
total subcontractcharges are the same for both the products, and
b. 75% of the overheads is accounted for under three major heads relating to sub-contracting operations, viz.,
ordering, inspection and movement of components, to and from the sub-contractor’s works.
Prepare a revised profitability statement to find out if the marketing manager’s proposal is viable.
Answer
Step (i): Segregation of Overheads
Total Overheads = (1,47,150 units × ` 96) = ` 1,41,26,400
Overheads relating to sub-contracting operations = 75% of the total overheads
= (14126400 × 75/100) = ` 1,05,94,800
Balance of 25% of the overheads, viz. Factory Overheads = (14126400 × 25/100)
= ` 35,31,600
Step (ii): Revision in apportionment of Overheads

Under the ABC refinement, Overheads relating to sub-contracting operations may be apportioned on the basis of
number of operations and Factory Overheads may be apportioned on per unit basis. Considering the revised product
mix of 75,000 units of A and 75,000 units of B, and the total overheads remaining unchanged, the apportionment
of overheads may be reworked as follows:
Sub-contacting overheads for A = (1,05,94,800 × 5/7) = ` 75,67,714
Or (75,67,714 ÷ 75,000) = ` 100.90 per unit
Sub-contacting overheads for B = (1,05,94,800 × 2/7) = ` 30,27,086
Or (30,27,086 ÷ 75,000) = ` 40.36 per unit
Factory Overheads = (35,31,600 ÷ 1,50,000) = ` 23.54/- per unit
Step (iii): computation of profit under Activity Based Costing
Particulars UOM A B
75000 75000 Total
No. of units No.
Total P.U. Total P.U.
Materials ` 93,75,000 125 93,75,000 125 1,87,50,000
Labour ` 18,00,000 24 18,00,000 24 36,00,000
Direct expenses ` 27,00,000 36 27,00,000 36 54,00,000
Prime Cost ` 1,38,75,000 185 1,38,75,000 185 2,77,50,000
Sub-con Overheads ` 75,67,714 100.90 30,27,086 40.36 1,05,94,800
Factory Overheads ` 17,65,800 23.54 17,65,800 23.54 35,31,600
Total Cost ` 2,32,08,514 309.44 1,86,67,886 248.90 4,18,76,400
Profit ` 15,41,486 20.56 19,57,114 26.10 34,98,600
Sales ` 2,47,50,000 330 2,06,25,000 275 4,53,75,000
Step (iv): Viability Comparison

Profit as per Accountant = ` 25,64,350
Profit as per ABC Computation = ` 34,98,600
The profit as per the revised computation is higher by ` 9,34,250/-.
Explanatory Comments: Revision of computations under the ABC has thrown up the fact of higher profit of
` 26.10 per unit of B in comparison to ` 20.56 per unit of A. As a strategic consequence, quantity of A has been
reduced from the level of 1,24,000 to 75,000 and quantity of B has been increased from 23,150 to 75,000 and
thus pushing up the total volume from 1,47,150 units to 1,50,000 units. The sales realization has gone up from
` 4,39,13,500/- to ` 4,53,75,000/-. The ultimate result is increase in profit by ` 9,34,250/-.

Illustration 9
State with brief reason whether you would recommend an Activity Based Costing system in each of the following
independent situations:
i. A consultancy firm consisting of Lawyers. Accountants and Computer Engineers provides management
consultancy services to clients.
ii. Company X produces one product. The overhead costs mainly consist of Depreciation.
iii. Company Z 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.
iv. Company Y produces 4 different products using different production facilities.
Answer
i. ABC system uses the cost of activities as the basis for assigning cost of services to jobs which provides more
accurate cost information for services. Hence ABC can be used for the consultancy firm.
ii. ABC is needed by organizations for product costing where there is a great diversity in product range. Since
company X produces only one product, ABC is not necessary. Moreover, overhead consists of mainly
depreciation. ABC is not required.
iii. Company Z is highly labour intensive and does not have a great diversity of products. All work is carried
out efficiently, hence ABC is not required. Moreover, Target costs are achieved, NVA activities have already
been identified and eliminated.
iv. There is diversity in product range which use different amounts of OH resources as different production
facilities are involved. ABC improves product costing by avoiding over or under costing of products. ABC
system is recommended.
4.2 JIT – Introduction, Benefits, Use of JIT in measuring the Performance
Introduction
Just-In-Time (JIT) has, probably, received more attention in a short time than any other new manufacturing
technique. The main reason is that JIT gets the credit for much of Japan’s manufacturing success.
Just-In-Time is a management technique in which goods are received from suppliers only as and when they are
needed. The main objective of this method is to reduce inventory holding costs and increase inventory turnover.
Just in time is a demand-pull system of production, wherein actual orders provide a signal for as to when a product
should be manufactured. Demand-pull enables a firm to produce only what is required, in the correct quantity
and at the correct time. This means that stock levels of raw materials, components, work in progress and finished
goods can be kept to a minimum. This requires a carefully planned scheduling and flow of resources through the
production process.
Modern manufacturing firms use sophisticated production scheduling software to plan production for each
period of time, which includes ordering the correct stock. Information is exchanged with suppliers and customers
through EDI (Electronic Data Interchange) to help ensure that every detail is correct. Supplies are delivered right
to the production line only when they are needed. For example, a car manufacturing plant might receive exactly the
right number and type of tyres for one day’s production, and the supplier would be expected to deliver them to the
correct loading bay on the production line within a very narrow time slot.
The JIT Strategy: By taking a JIT approach to inventory and product handling, companies can often cut
costs significantly. Inventory costs contribute heavily to the company expenses, especially in manufacturing

organizations. By minimizing the amount of inventory that you hold, you save space, free up cash resources, and
reduce the waste that comes from obsolescence.
In addition to the reduction of inventory and greater ROI, there are several improvements in manufacturing that
result from operating with low inventories. JIT removes the security blanket of high inventory and thus exposes
related operating problems. These are problems that need to be faced and solved with prudence. Converting to JIT
means a big change—in the culture of a company as well as in its manufacturing operations. Established routines
and rules become obsolete. Where backup inventories were once considered to be insurance against unexpected
shortages or delays, they are now viewed as evidence of lack-lustre planning or controls, even of laziness. Large
production batches can no longer be viewed as beneficial because they help amortize setup costs. JIT forces the
elimination of the waste inherent in long setups.
JIT Systems: To facilitate a JIT approach, you need a variety of systems in place. The most notable is a kanban.
This is a Japanese approach to ensuring a continuous supply of inventory or product. Kanbans were designed to
support the JIT philosophy. A kanban is a visual signal that indicates it is time to replenish stock and possibly
reorder. For instance, as the supply of bolts in a bin on the assembly line falls below a certain number, it may
uncover a yellow line painted around the inside of the storage bin. This yellow line indicates to the foreman that
he needs to prepare a requisition for more bolts. That requisition is given to the purchasing department, which
processes the order. This prevents the supply of bolts from dropping below a critical amount and allows production
continues to flow smoothly.
JIT also exists in concert with continuous improvement systems. Total Quality Management and Six Sigma are
overarching programs that help you take a detailed look at every point of the production process and identify ways
to make improvements. By applying JIT, you are continuously monitoring the production process. This gives you
opportunities for making the production process smoother and more efficient. Because JIT is intended to spread
throughout the organization, it can have an impact on many areas through improvements in processes. When the
emphasis is on lean production, systems tend to be made simpler and more predictable. From how a product moves
through the building to ways to increase worker involvement in system design, JIT improves efficiency.
Benefits of Just-In-Time System

Following are the advantages of adopting Just-In-Time Manufacturing System:
i. Just-in-time manufacturing keeps stock holding costs to a bare minimum. The release of storage space results
in better utilization of space and thereby bears a favorable impact on the rent paid and on any insurance
premiums that would otherwise need to be made.
ii. Just-in-time manufacturing eliminates waste, as out-of-date or expired product; do not enter into this equation
at all.
iii. As under this technique, only essential stocks are obtained, less working capital is required to finance
procurement. Here, a minimum re-order level is set, and only once that mark is reached fresh stocks are
ordered, making this a boon to inventory management too.
iv. Due to the afore-mentioned low level of stocks held, the organization’s return on investment (referred to as
ROI, in management parlance) would generally be high.
v. As just-in-time production works on a demand-pull basis, all goods made would be sold, and thus it
incorporates changes in demand with surprising ease. This makes it especially appealing today, where the
market demand is volatile and somewhat unpredictable.
vi. Just-in-time manufacturing encourages the right first time concept, so that inspection costs and cost of
rework is minimized.

vii. High quality products and greater efficiency can be derived from following a just-in-time production system.
viii. Close relationships are fostered along the production chain under a just-in-time manufacturing system.
ix. Constant communication with the customer results in high customer satisfaction.
x. Over production is eliminated, when just-in-time manufacturing is adopted.
Disadvantages: Following are the disadvantages of adopting Just-In-Time Manufacturing Systems:
i. Just-in-time manufacturing provides zero tolerance for mistakes, as it makes re-working very difficult in
practice, as inventory is kept to a bare minimum.
ii. There is a high reliance on suppliers, whose performance is generally outside the purview of the manufacturer.
iii. As there will be no buffers for delays, production downtime and line idling can occur, which would bear a
detrimental effect on finances and on the equilibrium of the production process.
iv. The organization would not be able to meet an unexpected increase in orders, due to the fact that there are no
excess finish goods.
v. Transaction costs would be relatively high, as frequent transactions would be made.
vi. Just-in-time manufacturing may have certain detrimental effects on the environment, due to the frequent
deliveries that would result in increased use of transportation which in turn would consume more fossil fuels.
Precautions: Following are the things to Remember When Implementing a Just-In-Time Manufacturing System:
(i) Management buy-in and support at all levels of the organization are required; if a just-in-time manufacturing
system is to be successfully adopted.
(ii) Adequate resources should be allocated, so as to obtain technologically advanced software, that is generally
required if a just-in-time system is to be a success.
(iii) Building a close, trusting relationship with reputed and time-tested suppliers will minimize unexpected
delays in the receipt of inventory.
(iv) Just-in-time manufacturing cannot be adopted overnight. It requires commitment in terms of time and
adjustments to corporate culture would be required, as it is starkly different to traditional production
processes.
(v) The design flow process needs to be redesigned and layouts need to be re-formatted, so as to incorporate
just-in-time manufacturing.
(vi) Lot sizes need to be minimized.
(vii) Work station capacity should be balanced whenever possible.
(viii) Preventive maintenance should be carried out, so as to minimize machine breakdowns.
(ix) Set up times should be reduced wherever possible.
(x) Quality enhancement programs should be adopted, so that total quality control practices can be adopted.
(xi) Reduction in lead times and frequent deliveries should be incorporated.
(xii) Motion waste should be minimized, so the incorporation of conveyor belts might prove to be a good idea
when implementing a just-in-time manufacturing system.
Just-in-time manufacturing is a philosophy that has been successfully implemented in many manufacturing
organizations. It is an optimal system that reduces inventory whilst being increasingly responsive to customer
needs, this is not to say that it is not without its pitfalls. However, the disadvantages can be overcome, with a little
forethought and a lot of commitment at all levels of the organization.

Use of JIT in measuring the Performance

Toyota first pioneered the concept of just-in-time (JIT) manufacturing in the 1970s. Since then, thousands of
companies have successfully taken a page from its playbook. From Dell to Burger King and Harley Davidson,
the JIT approach makes sense for a wide range of businesses. The main philosophy behind JIT is to eliminate
waste, whether stock, inventory or time. Manufacturers keep a lean supply of materials on hand and produce their
products when demanded in rapid-fire fashion. It takes a widespread, end-to-end supply chain approach, which can
be tricky, but worth it. Pulling off a winning JIT strategy requires the right building blocks
In a world where JIT is no longer a novelty, margins are thinner than ever, delivering faster than others is still a
competitive advantage. As a result, the pressure is on to differentiate with top-notch timing and service. Picking
the right key performance indicators (KPIs) to measure is critical to supporting JIT strategy. If a business isn’t on
top of indicators like the customer’s desired timing, delivery windows and communication, it can’t pull ahead of
the competition.
Timing: First and foremost, among the right KPIs is timing. “What’s your lead time?” is the vital KPI question.
The manufacturer will have to be on top of the number of hours or days between taking an order and putting a
finished product into the hands of customers.
What the Customer Wants: Important to timing is knowing exactly what the customer wants in this regard.
There is an instance of one manufacturer working with a client who was spending big money to meet same-day
production on any orders received by 4 p.m.; but the manufacturer didn’t check to see if its customers really wanted
that — they didn’t. So they were giving a service that wasn’t needed, at a high cost.
Missed Deliveries: Monitoring missed deliveries is also very important. The key observations are: “Examine by
how much you failed,”; “If you have a 2% failure rate, is that made up of deliveries that were 15 minutes late? Or
days late? There’s a significant cost differential in one versus the other.” On the other hand, “track your wins and
understand why those deliveries worked”.
Responding to Failures: Monitoring how well an organization responds when it doesn’t meet JIT and customer
expectations is a helpful KPI, as well. It is recommended to establish an EDI relationship with the partner company
in order to track all the data. Monitoring the data over time can get a good feel for what is happening It is suggested
baseline requirements be set for in-full and on-time deliveries.; which sets the benchmarks so that one can compare
them with those of the contracted levels.
JIT being an extended supply chain, forming the right partnerships is crucial when starting out with JIT. Point to
remember is that partnering with the wrong supplier can lead to downtime, slowdowns and materials sitting and
waiting. In the end, that can cost a manufacturer more than not implementing JIT.
JIT Success Stories

When pulled off, JIT can work for small and large manufacturers, as myriad examples reveal. Harley Davidson
is one such example, shrinking inventory levels by 75% while simultaneously raising productivity. Inventory turns
went from two a year to 17. While controversial from a union perspective, the main factory in York, Pennsylvania,
also cut the workforce from about 2,700 to 1,600 during its ‘80s push to lean out.
Dell is another JIT success story. It stands as unique from many others in that it requires its suppliers to carry
inventory. Dell demands they deliver components on short lead times, and Dell then quickly assembles the
computers and ships them off to the customer.
Even fast-food king McDonald’s famously improved its customer service by implementing a version of JIT.
High holding costs can lead to slow delivery and wastage in this business. McDonald’s changed its approach by

adding sophisticated burger-making technology and waiting to make burgers until they are ordered, delivering a
higher quality product and cutting down on waste.
The evident learning is that successful JIT implementation can lead to improved cash flow and as also happier
customers.
Illustration 10
B Ltd. has decided to adopt JIT policy for materials. The following effects of JIT policy are identified-
1. To implement JIT, the company has to modify its production and material receipt facilities at a capital cost
of ` 10,00,000. The new machine will require a cash operating cost ` 1,08,000 p.a. The capital cost will be
depreciated over 5 years.
2. Raw material stockholding will be reduced from ` 40,00,000 to ` 10,00,000.
3. The company can earn 15% on its long-term investments.
4. The company can avoid rental expenditure on storage facilities amounting to ` 33,000 per annum. Property.
Taxes and insurance amounting to ` 22,000 will be saved due to JIT programme.
5. Presently there are 7 workers in the store department at a salary of ` 5,000 each per month. After implementing
JIT scheme, only 5 workers will be required in this department. Balance 2 workers’ employment will be
terminated.
6. Due to receipt of smaller lots of Raw Materials, there will be some disruption of production. The costs of
stock- outs are estimated at ` 77,000 per annum.
Determine the financial impact of the JIT policy. Is it advisable for the company to implement JIT system?
Answer
Cost-Benefit Analysis of JIT policy
A. Costs
Serial Particulars Rupees

1 Interest on capital for modifying production facilities 1,50,000
( ` 10,00,000 × 15%)
2 Operating Costs of new production facilities 1,08,000
3 Stock-Outs Costs (given) 77,000
4 Total Costs 3,35,000
B. Benefits

1 Interest on investment on funds released due to reduction in raw 4,50,000
material stocking
( ` 40,00,000 - ` 10,00,000) ×15%
2 Saving in salary of 2 workers terminated 1,20,000
( ` 5,000×12 months×2)


3 Saving in rental Expenditure 33,000
4 Saving in Property Tax & Insurance 22,000
6 Total Benefits 6,25,000
C. Net Benefits = (6,25,000 – 3,35,000) = ` 2,90,000/-

Advise: The JIT policy may be implemented, as there is a Net Benefit of ` 2,90,000 per annum.
Note: Depreciation, being apportionment of capital cost, is ignored in decision-making, Tax Saving on
Depreciation is not considered in the above analysis.
Illustration 11
Altra Video Company sells package of blank Video tapes to its customers. It purchases video tapes from Yash
Tape Company at ` 150 per packet. Yash Tape Company pays all freight to Altra Video Company. No incoming
inspection is necessary because Yash Tape Company has a superb reputation for delivery of quality merchandise.
Annual demand of Altra Video Company is 15,600 packages. Altra Video Company requires 10% annual return on
its investment. The purchase order Lead time is 2 weeks. The purchase order is passed through internet and it costs
` 20 per order. The relevant insurance, material handling etc. is ` 10 per package per year.
Altra Video has to decide whether or not to shift to JIT purchasing. Yash Tape Company agrees to deliver 100
packages of Video tapes 156 times per year (6 times every 2 weeks) instead of existing delivery system of 1,200
packages 13 times a year, with additional amount of Re.0.05 per package. Altra Video Company incurs no stock out
under its current purchasing policy. It is estimated that Altra Video Company will incur stock out cost on 50 video
tape packages under a JIT purchasing policy. In the event of stock out, Altra video company has to rush order tape
packages, which costs ` 8 per package. Comment whether Altra Video Company should implement JIT purchasing
system.
Ram Co. also supplies video tapes. It agrees to supply at ` 145 per package under JIT delivery system. If video
tape is purchased from Ram Co. relevant carrying cost would be ` 9 per package against ` 10 in case of purchasing
from Yash Tape Company. However, Ram Co. does not enjoy a sterling reputation for quality. Altra Video Company
anticipates the following negative aspects of purchasing tapes from Ram Co.
1. Incurring additional inspection cost of ` 0.05 per package.
2. Average stock out of 360 tape packages per year would occur, largely resulting from late deliveries. Ram Co.
cannot rush order at short notice. Altra Video Company anticipates lost contribution margin per package of
` 10 from stock out.
3. Customers 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 would be incurred.
Comment on whether Altra Video Company can place an order with Ram Co.
Answer
(i) Computation of Carrying Costs
Current JIT with Yash JIT with Ram

SL Particulars
Policy Tape Co. Co.
1 Interest ( ` )


SL Particulars
Policy Tape Co. Co.
a. Cost per Package 150.00 150.05 145.00
b. Interest @ 10% on (a) 15.00 15.005 14.50
2 Insurance, Material Handling, etc. 10.00 10.00 9.00
3 Carrying Cost p.u. p.a. 25.00 25.005 23.50
4 Average Inventory
a. Quantity per Order 1200 100 100
b. Average Inventory @ 50% of the 600 50 50
order
5 Annual Carrying Costs ( ` ) = [3 × 4 (b)] 15,000 1250.25 1175
(ii) Comparative Statement of Total Relevant Costs

SL Particulars
Policy Tape Co. Co.
1 Cost of Tapes
a. Cost per Tape ( ` ) 150.00 150.05 145.00
b. Cost per 15,600 23,40,000 23,40,780 22,62,000
2 Ordering Costs
a. Ordering Cost per Order ( ` ) 20.00 20.00 20.00
b. Number order per annum 13 156 156
c. Ordering Costs per annum ( ` ) 260 3,120 3,120
3 Annual Carrying Costs ( ` ) 15,000 1250 1175
4 Stockout Costs
a. Number of Packages Nil 50 360
b. Loss per package - 8 10
c. Stockout Costs Nil 400 3600
(`) = (a × b)
5 Inspection Costs
a. Number of Packages Nil Nil 15600
b. Cost per package - - 0.05
c. Inspection Costs (`) = (a × b) Nil Nil 780
6 Customer Return Costs


SL Particulars
Policy Tape Co. Co.
a. Number of Packages Nil Nil 15600
b. Number of Returns - - 15600 x 2% =
312
c. Cost per Return ( ` ) Nil Nil 25
d. Customer Return Costs (`) = (b × c) 7,800
7 Total Costs ( ` ) 23,55,260 23,45,550 22,78,475
Observations & Comments

a. Cost Saving of implementing JIT purchasing system with Yash Tape Co = ( ` 23,55,260 - ` 23,45,550) =
` 9,710/-
Hence, implementation of JIT system is recommended.
b. Amongst the three alternatives JIT with Ram Co. results in the least total cost. Hence order may be placed
with Ram Co.
4.3 Throughput Accounting
Concept
Throughput Accounting (TA) is variable-cost-accounting presentation based on the definition of throughput
(sales minus material and component costs). Sometimes, it is referred to as super variable costing because only
material costs are treated as variable. It is a management accounting technique used as a performance measure in
the theory of constraints.
Throughput accounting is a process used in management accounting that focuses on a company’s production
efficiency. It looks at the rate at which a company converts its raw materials into finished goods and makes money
from them. The purpose of throughput accounting is to identify any bottlenecks in a production process. This
process allows companies to either eliminate those bottlenecks or use them as efficiently as possible.
“Throughput Accounting is a technique where the primary goal is to maximize throughput while simultaneously
maintaining or decreasing inventory and operating costs” CIMA Official
Throughput Accounting is an alternative accounting methodology that attempts to eliminate harmful distortions
introduced from traditional accounting practices – distortions that promote behaviours contrary to the goal of
increasing profit in the long term.
In traditional accounting, inventory is an asset (in theory, it can be converted to cash by selling it). This often
drives undesirable behaviour at companies – manufacturing items that are not truly needed. Accumulating inventory
inflates assets and generates a “paper profit” based on inventory that may or may not ever be sold (e.g., due to
obsolescence) and that incurs cost as it sits in storage. The Theory of Constraints, on the other hand, considers
inventory to be a liability – inventory ties up cash that could be used more productively elsewhere.
In traditional accounting, there is also a very strong emphasis on cutting expenses. The Theory of Constraints,
on the other hand, considers cutting expenses to be of much less importance than increasing throughput. Cutting
expenses is limited by reaching zero expenses, whereas increasing throughput has no such limitations.

Throughput accounting aims to maximize a company’s profitability while also reducing its operating costs
and inventory. It does so by evaluating which factors contribute to a stoppage or act as a bottleneck in the production
process. Through this, throughput accounting identifies any factors that prevent a company’s throughput from
being higher.
Throughput accounting is a method commonly used in Just-In-Time (JIT) systems. In these systems, any stoppage
or bottlenecks can significantly increase costs or cause losses. For companies, it may not be possible to eliminate
those bottlenecks every time. Therefore, throughput accounting focuses on the efficient use of limited resources to
maximize throughput.
Throughput accounting works by identifying any bottlenecks that may exist in a system. By doing so, it allows a
company to understand its restraints and how they limit production. After identifying these, companies can decide
on how to exploit those limited resources. This process requires companies to consider which products or processes
can maximize profits.
Once companies identify the best use of their resources to maximize profitability, they can structure the process
around the decision. In this process, companies can allocate the maximum use of any limited resources to the
process with the highest profit contribution. Similarly, it requires them to provide the bare minimum resources for
other processes to function.
However, throughput accounting may not end there. This process is continuous for most companies. By efficiently
allocating one resource, companies may come across other bottlenecks. Similarly, two or more resources may
contribute to stoppages to a process at the same time. Companies need to identify these and repeat the same steps
as above continuously.
Core Measures and Terms

These and other conflicts result in the Theory of Constraints emphasizing Throughput Accounting, which uses as
its core measures: Throughput, Investment, and Operating Expense which are defined as below:
Core Measures Definition

Throughput The rate at which customer sales are generated less truly variable costs (typically raw
materials, sales commissions, and freight). Labour is not considered a truly variable cost
unless pay is 100% tied to pieces produced.
Investment Money that is tied up in physical things: product inventory, machinery and equipment,
real estate, etc. Formerly referred to in TOC as Inventory.
Operating Money spent to create throughput, other than truly variable costs (e.g., payroll, utilities,
Expense taxes, etc.). The cost of maintaining a given level of capacity.
In addition, Throughput Accounting has four key derived measures, viz. Net Profit, Return on Investment,
Productivity, and Investment Turns.
Net Profit = (Throughput − Operating Expenses)
Return on Investment = (Net Profit ÷ Investment)
Productivity = (Throughput ÷ Operating Expenses)
Investment Turns = (Throughput ÷ Investment)

The other terms used in TA are as follows:

Totally Variable Cost: Totally Variable Cost is considered as the cost which is incurred only if a product is
produced. In many cases only direct materials are considered as totally variable cost. Direct labour is not totally
variable, unless piece rate wages are paid.
Capacity Constraint: Capacity Constraint refers to any resource within a company, that limits its total output.
For example, it can be a machine that can produce only a specified amount of a key component in a given time
period, thereby keeping overall sales from expanding beyond the maximum capacity of that machine. There may
be more than one capacity constraint in a company, but rarely more than one for a specified product or product line.
Throughput (or Cycle) Time: Throughput (or cycle) time is the average time required to convert raw materials
into finished goods ready to be shipped to customer. It includes the time required for activities such as material
handling, production processing, inspecting and packaging.
Throughput Efficiency: Throughput efficiency is the relation of throughput achieved to resources used.
Expressed as a formula:
Throughput efficiency = Throughput Cost ÷Actual Factory Cost

Throughput Time Ratio: Throughput Time Ratio is the ratio of time spent adding customer value to products
and services divided by total cycle time. It is also known as the ‘ratio of work content to lead time’.
Total Factory Cost: With the exception of material costs, in the short run, most factory costs (including direct
labour) are fixed. These fixed costs can be grouped together and called total factory costs (TFC).
Manufacturing Response Time: With JIT, products should not be made, unless there is a customer waiting
for them, because the ideal inventory level is zero. The effect of this will be that there will be idle capacity in
some operations except the operation, which is bottleneck of the moment. Working on output just to increase WIP
or Finished Goods stocks creates no profit and so would not be encouraged. This means that profit is inversely
proportional to the level of inventory in the system.
The throughput formula for a specific product is as follows.
Throughput = Sale revenue from the product – Direct material costs

The throughput accounting ratio is a metric often used in throughput accounting. This ratio looks at the return
a company generates for each hour of work compared to its costs for the same time. Through the throughput
accounting ratio, companies can determine the rate at which they are making income from selling their products.
The formula given below is used to calculate the throughput accounting ratio.
Throughput Accounting Ratio (TPAR) = Return per factory hour ÷ Cost per factory hour
The throughput accounting ratio requires calculating two figures. As mentioned, these are the return per factory
hour and the cost per factory hour. The formulae to calculate the return per factory hour and the cost per factory
hour are as follows.
Return per Factory Hour = (Throughput per Unit ÷ Product’s time taken for the Limited Resource)
Cost per Factory Hour = (Total Factory Cost ÷ Total Limited Resource Time Available)
When a company’s throughput accounting ratio is 1, it means that the company generates the same return as it
incurs costs. However, companies prefer for the ratio to be greater than 1. The higher the ratio is for a company, the
better. It signifies that the company is generating more income than its costs for a unit of factor hour.

When a company’s throughput accounting ratio is greater than 1, meaning that its throughput is profitable. In
that case, it is beneficial for the company to continue with the process as it will help cover the fixed costs while
also making profits. A TPAR ratio of below 1, on the other hand, means that the company cannot recover its fixed
costs from the throughput.
Example 1
A company, ABC Co.., produces a product that has a selling price of ` 50. The direct material cost for each
product manufactured is ` 20. Each unit of product manufactured takes two factory hours to produce. ABC Co. has
a limited amount of factory hours for production, which is only 10,000 hou ` ABC Co.’s operating expenses for
each month is ` 100,000. Relevant throughput workings would be as follows:
Throughput = Sale revenue from the product – Direct material costs
= ` 50 – ` 20 = ` 30
Return per factory hour
= Throughput per unit ÷Product’s time taken for the limited resource
= ` 30 ÷2 = ` 15/hour
Cost per factory hour = Total factory cost ÷ Total limited resource time available
= ` 100,000 ÷ 10,000 hours = ` 10/hour
Throughput Accounting Ratio (TPAR)
= Return per factory hour ÷ Cost per factory hour
= ` 15 per hour ÷ ` 10 hour = 1.5
Therefore, producing the product will be overall profitable.
Throughput accounting is a process companies use to maximize profitability and reduce costs when there are
bottlenecks involved. The throughput accounting ratio looks at the returns from a product in comparison to its
costs. Companies prefer products that have a throughput accounting of above 1.
Theory of Constraints
The Theory of Constraints is a methodology for
Identity
identifying the most important limiting factor (i.e.,
constraint) that stands in the way of achieving a goal and
then systematically improving that constraint until it is no
longer the limiting factor. In manufacturing, the constraint
is often referred to as a bottleneck. Repeat Exploit
The core concept of the Theory of Constraints is that The Five
every process has a single constraint and that total process Focusing
throughput can only be improved when the constraint Steps
is improved. A very important corollary to this is that
spending time optimizing non-constraints will not provide
significant benefits; only improvements to the constraint
will further the goal (achieving more profit). Subordinate
Elevate
Thus, TOC seeks to provide precise and sustained focus
on improving the current constraint until it no longer

limits throughput, at which point the focus moves to the next constraint. The underlying power of TOC flows from
its ability to generate a tremendously strong focus towards a single goal (profit) and to removing the principal
impediment (the constraint) to achieving more of that goal. In fact, Goldratt considers focus to be the essence of TOC.
The Theory of Constraints provides a specific methodology for identifying and eliminating constraints, referred
to as the Five Focusing Steps.
The Five Focusing Steps
STEP OBJECTIVE
Identify Identify the current constraint (the single part of the process that limits the rate at which
the goal is achieved).
Exploit Make quick improvements to the throughput of the constraint using existing resources
(i.e., make the most of what you have).
Subordinate Review all other activities in the process to ensure that they are aligned with and truly
support the needs of the constraint.
Elevate If the constraint still exists (i.e., it has not moved), consider what further actions can be
taken to eliminate it from being the constraint. Normally, actions are continued at this
step until the constraint has been “broken” (until it has moved somewhere else). In some
cases, capital investment may be required.
Repeat The Five Focusing Steps are a continuous improvement cycle. Therefore, once a constraint
is resolved the next constraint should immediately be addressed. This step is a reminder
to never become complacent – aggressively improve the current constraint…and then
immediately move on to the next constraint.
Basic logic of throughput costing and comparison with absorption costing

Throughput costing assigns only unit level spending for direct costs as the cost of products or services. Advocates
of throughput costing argue that adding any other indirect cost, past or committed cost, to product cost creates
improper incentives to drive down the average cost per unit by making more products than can be used or sold. Since
these are committed costs, making more units with the same level of spending arithmetically reduces the average
cost per unit and makes the production process appear to be more efficient. Throughput accounting (costing) avoids
this incentive because the cost per unit depends only on the unit level spending (i.e., cost of materials) and not on
how many units are made.
Using throughput accounting (costing) means that cost management analyst must distinguish between:
a. Spending for resources caused by the decision to produce different levels of products and services, and
b. The use of resources that organisation has committed to supply regardless of level of products and services
provided.
Problems with throughput accounting

1. When throughput accounting is the driving force behind all production scheduling, a customer that has
already placed an order for a product, which will result in a sub-optimal profit level for the manufacturing,
may find that his order is never filled.
2. The company’s ability to create the highest level of profitability is now dependent on the production
scheduling staff, who decide, what products are to be manufactured and in what order.

3. Another issue is that all costs are totally variable in the long-run, since the management has the time to adjust
them to long-range production volumes.
Reporting under throughput accounting

When the throughput model is used for financial reporting purposes, the format appears slightly different. The
income statement includes only direct materials in the cost of goods sold, which results in a ‘throughput contribution’
instead of gross margin. All other costs are bounded into an ‘Operating Expenses’ category below the throughput
contribution margin, yielding a net income figure at the bottom. All other financial reports stay the same. Though this
single change appears relatively minor, it has significant impact. The primary change is that throughput accounting
does not charge any operating expenses to inventory so that they can be expressed in future period. Instead, all
operating expenses are realized during the current period. As a result, any incentive for managers to over produce is
completely eliminated because they cannot use the excess amount to shift expenses out of current period, thereby
making their financial results look better than they would otherwise. Though this is a desirable result, such a report
can be used only for internal reporting because of the requirement of generally accepted accounting principles that
some overheads should be charged to excess production.
Systematic changes required for acceptance of the Throughput Accounting

Throughput accounting does not have a logical linkage with the more traditional form of cost accounting. This
makes it difficult for it to gain acceptance. The main problem is that this method does not use cost as the basis for the
most optimal production decisions. This is entirely contrary to the teachings of any other type of accounting, which
holds that the highest margin products should always be produced first. Now question is whether the enterprise
should either use throughput or traditional costing exclusively or is there any way to merge the two. Following
discussion relates to this issue:
1. Inventory Valuation: Generally accepted accounting principles clearly state that cost of overhead must
be apportioned to inventory. Throughput accounting states that none of the overhead costs should be so
assigned. In this case, since the rules are so clear, it is apparent that throughput accounting loses. The existing
system must continue to assign costs irrespective of how throughput principles are used for other decision
making (short-range) activities.
2. Inventory Investment Analysis: There are fundamental differences between the two methodologies. Both
hold that the objective is always to keep one’s investment at a minimum. In the case of traditional cost
accounting, this is because the return on investment is higher when the total amount of investment is forced
to the lowest possible level. Throughput accounting, however, wants to shrink the amount of investment
because it includes work-in-progress inventory in this category. It tries to keep WIP levels down so that waste
is reduced in the production system. In short, first system advocates a small investment for financial reasons,
while the alternative system favours it because it makes more operational sense. Despite the differences in
reasoning, the same conclusion is reached by both methodologies. However, throughput approach is still
better, for it forces one to analyse all inventory reduction projects in the light of how they together will
impact the capacity constraint rather than individually.
3. Capital Investment Analysis: Traditional cost accounting only analyses each investment proposal on its
own rather than considering its impact on the production processes as a whole. It tends to recommend
investments that will result in an incremental investment but no overall change in the level of corporate
capacity, which is driven by capacity constraint. Throughput accounting, however, has a tight focus on
investment only in areas that impact capacity constraint – to other investment proposals are rejected. In this
instance, it is best to reject the traditional system and conduct analysis based on throughput principles.
4. Product Costing: Under throughput accounting, a product has only a totally variable cost, which may be far
lower than the fully absorbed cost, that would be assigned to it under more traditional costing system. This

totally variable cost is almost always direct materials, which is an easily calculated figure. Full absorption
costing, however, requires a large amount of calculation effort, before a detailed cost can be compiled
for a product. For companies selling to Government under cost-plus contracts, there are lengthy detailed
requirements as to what variable and overhead costs should be assigned to each product manufactured.
These rules virtually require the use of absorption costing – throughput costing is not a viable solution. For
companies, that do not require detailed costing justifications while selling their products, it may be possible
to use the much simpler throughput accounting approach.
5. Production Scheduling: Traditional systems do not include any kind of throughput accounting, that tells
production planners which orders should be produced first. These days with throughput accounting, it is
possible to customize existing systems or to upgrade packaged software so that this option is available to
planners. This would allow them to produce the items that result in the highest throughput per minute of
the capacity constraint. Here it is difficult to fully support the throughput approach. Any company that has
already received an order from customer has an obligation to fill it, even if the resulting sale will reduce
its overall level of profit from the theoretical maximum that can be calculated with throughput accounting.
Maximising short-term profit by ignoring orders tantamounts to long-term suicide since customers will leave
in droves. Consequently, production planners should be left alone to schedule production in the traditional
manner rather than basing their decisions on short-term profit maximisation.
6. Long-term planning: This is the main application area of throughput accounting. The enterprise should
estimate the approximate sales levels for each product for a long-time frame, enter into a throughput model
and determine what mix of prospective sales will result in the highest level of profitability. This method is
much superior to using throughput costing for short-term production decisions, since long-term planning
sidesteps problems by avoiding existing customer orders that will result in low profits. Long-term planning
does not involve existing customer orders so that decisions to produce various types of products at different
price points can be made before the sales force goes out to obtain orders.
7. Price Setting: Throughput accounting is favoured by the sales and marketing staff because the margin on
products is simple to obtain-just subtract totally variable costs from the price. This beats the incomprehensible
image of allocations accompanying activity-based costing. Price setting in throughput environment focuses
more on what products can be inserted into the existing production mix at a price that will incrementally
increase overall profitability, rather than the painful accumulation and allocation of costs to specific products.
Throughput accounting is the clear choice here based on case of understandability and the speed with which
information can be accumulated.
Illustrative 12
A factory has a key resource (bottleneck) of Facility A which is available for 62,600 minutes per week. The
time taken per unit of Product X and Y in Facility A are 5 minutes and 10 minutes respectively. Last week’s actual
output was 9500 units of product X and 1300 units of Product Y. Actual factory cost was ` 1,56,500/-. What is the
throughput cost for the week?
Answer
Cost per Factory Minute = Total Factory Cost / Minutes Available
= ` 1,56,500 ÷ 62,600 = ` 2.50
Standard Minutes of throughput for the week = (9500 units of X × 5 hours) + (1300 units of Y × 10 hours)
= (47500 + 13000) = 60,500 minutes
Therefore, throughput Cost for the week = 60,500 × ` 2.50 = ` 1,51,250/-

Illustration 13
Modern Co produces 3 products, A, B and C, details of which are shown below:
Particulars A B C
Selling price per unit ( ` ) 120 110 130
Direct material cost per unit ( ` ) 60 70 85
Variable overhead ( ` ) 30 20 15
Maximum demand (units) 30,000 25,000 40,000
Time required on the bottleneck resource (hours per unit) 5 4 3
There are 3,20,000 bottleneck hours available each month.
Required:
Calculate the optimum product mix based on the throughput concept.
Answer
Step1: Computation of Rate per Factory Hour
Serial Particulars A B C
1 Selling price per unit ( ` ) 120 110 130
2 Direct material cost per unit ( ` ) 60 70 85
3 Throughput per unit ( ` ) 60 40 45
4 Time required on the bottleneck resource (hours per unit) 5 4 3
5 Return per Factory Hour ( ` ) 12 10 15
6 Ranking II III I
Step 2: Allocation of Hours according to Ranking

Hours
Description Balance
Allocated
Total of Bottleneck Hours Available 3,20,000
Hours allocated for C (40,000 units × 3 hours per unit) 1.20,000 2,00,000
Hours allocated for A (30,000 units × 5 hours per unit) 1,50,000 50,000
Hours allocated for B (Being the balance) 50,000 -
Step 3: Optimum Product MIX

No. of units of B that can be made in balance hours = (50,000 hours ÷ 4 hours per unit) = 12,500 units
Therefore, Optimum Product MIX:
A = 30,000 units

B = 12,500 units
C= 40,000 units
Illustration 14
Cat Co makes a product using three machines – X, Y and Z. The product has to pass through all the three
machines.
The capacity of each machine is as follows:
X Y Z
Machine capacity per week (in units) 800 600 500
The demand for the product is 1,000 units per week. For every additional unit sold per week, profit increases by
` 50,000. Cat Co is considering the following possible purchases (they are not mutually exclusive):
Proposal 1: Replace machine X with a newer model. This will increase capacity to 1,100 units per week and
costs ` 60 Lakhs.
Proposal 2: Invest in a second machine Y, increasing capacity by 550 units per week. The cost of this machine
would be ` 68 Lakhs.
Proposal 3: Upgrade machine Z at a cost of ` 75 Lakhs, thereby increasing capacity to 1,050 units.
Required: Which is Cat Co’s best course of action under throughput accounting?
Answer
Since the product has to pass through all the machines, machine capacity is the bottleneck.
Bottleneck resource in order of preference is firstly machine ‘Z’, secondly machine ‘Y’ and lastly machine ‘X’
because the no. of units is in that order in the existing capacity.
Particulars X Y Z Demand
Current capacity per week 800 600 500* 1,000
Buy Z 800 600* 1,050 1,000
Buy Z & Y 800* 1,150 1,050 1,000
Buy Z, Y & X 1,100 1,150 1,050 1,000*
* = bottleneck resource
All the three machines are to be purchased in the above order to meet the existing demand.
Illustration 15
A factory has a key resource (bottleneck) of Facility A which is available for 31,300 minutes per week. Budgeted
factory costs and data on two products, X and Y, are shown below:
Product Selling Price/Unit Material Cost/Unit Time in Facility A

X ` 35 ` 20 5 minutes
Y ` 35 ` 17.50 10 minutes

Budgeted factory costs per week:
`
Direct labour 25,000

Indirect labour 12,500
Power 1,750
Depreciation 22,500
Space cost 8,000
Engineering 3,500
Administration 5,000
Actual production during the last week is 4,750 units of product X and 650 units of product Y. Actual factory
cost was ` 78,250.
Calculate:
(i) Total factory costs (TFC)
(ii) Cost per factory minute
(iii) Return per Factory Minute for both products
(iv) TA ratios for both products
(v) Throughput cost per week
(vi) Efficiency ratio
Answer
(i) Total Factory Costs = (Total of all costs except materials
= ( ` 25,000 + ` 12,500 + ` 1,750 + ` 22,500 + ` 8,000 + ` 3,500 + ` 5,000) = ` 78,250
(ii) Cost per factory minute = Total factory cost ÷ Minutes available
= ` 78,250 ÷ 31,300 = ` 2.50
(iii)
(Selling Price-Material Cost)
(a) Return per bottleneck minute for Product X =
(Minutes in bottleneck)
35 – 20
= = ` 3
5
(Selling Price-Material Cost)
(b) Return per bottleneck minute for Product Y =
(Minutes in bottleneck)
35 – 17.5
= = ` 1.75
10

Return per minute

(iv) Throughput Accounting (TA) Ratio for Product X =
Cost per Minute
35 – 17.5
= = 1.20
10
Return per minute

Throughput Accounting (TA) Ratio for Product Y =
Cost per Minute
35 – 17.5
= = 0.70
10
Explanatory Observations:
a. TA ratio of Product X is greater than 1 (1.20) and hence increasing the production of X will be more
profitable
b. TA ratio of Product Y is less than 1 (0.75) and hence decreasing the production of Y will reduce the
losses and be more profitable)
(v) Standard minutes of throughput for the week:

= [4,750 × 5] + [650 × 10] = 23,750 + 6,500 = 30,250 minutes
Throughput cost per week = 30,250 × ` 2.5 per minute = ` 75,625
(vi) Efficiency % = (Throughput cost ÷ Actual TFC) %

= ( ` 75,625 ÷ ` 78,250) × 100 = 96.6%
Explanatory Observations:
The bottleneck resource of Facility A is available for 31,300 minutes per week but produced only 30,250
standard minutes. This could be due to:
a. The process of a ‘wandering’ bottleneck causing facility A to be underutilized.
b. Inefficiency in facility A)
Illustration 15
Given below is the basic data relating to New India Company for three years
Year 1 Year 2 Year 3

Production and Inventory data
Planned production (in units) 2,500 2,500 2,500
Finished goods inventory (in units), Jan 1 0 0 750
Actual production (in units) 2,500 2,500 2,500
Sales (in units) 2,500 1,750 3,250
Finished goods inventory (in units), Dec. 31 0 750 0

Revenue and Cost data, all three years
`
Sales price per unit 48

Manufacturing costs per unit
Direct material 12
Direct labour 8
Variable manufacturing overheads 4
Total variable cost per unit 24
Used only under absorption costing:
Fixed manufacturing overhead = Annual fixed OH / Annual Production 12
= ` 30,000 / 2,500
Total absorption cost per unit 36
Variable selling and administration cost per unit 4
Fixed selling and administrative cost per year 5,000
You are required to Prepare:
(a) Absorption Costing Income Statement
(b) Marginal Costing Income Statement
(c) Reconciliation of Income under Absorption and Marginal Costing.
(d) Throughput Costing Income Statement.
(e) Draw your observations.
Answer
Actual production is 2500 units in each year.
(a) Absorption Costing Income Statement
New India Company: Income Statement as per Absorption Costing
Particulars Year 1 ( ` ) Year 2 ( ` ) Year 3 ( ` )

Number of Units Sold 2500 1750 3250
Sales Revenue (at ` 48 per unit) 1,20,000 84,000 1,56,000
Less: Cost of goods sold (at absorption cost of 90,000 63,000 1,17,000
` 36 per unit)
Gross margin 30,000 21,000 39,000

Less: Selling and administration expenses:
Variable (at ` 4 per unit) 10,000 7,000 13,000


Fixed 5,000 5,000 5,000
Operating Income 15,000 9,000 21,000
(b) Marginal Costing Income Statement

New India Company: Income Statement as per Variable Costing
Less: Variable Expenses
Variable manufacturing costs (at ` 24 per unit) 60,000 42,000 78,000
Variable selling & admin. costs (at ` 4 per unit) 10,000 7,000 13,000
Contribution margin 50,000 35,000 65,000
Less: Fixed Expenses:
Fixed manufacturing overhead 30,000 30,000 30,000
Fixed selling & admin. Expenses 5,000 5,000 5,000
Operating Income 15,000 0 30,000
(c) Reconciliation of Income under Absorption and Marginal Costing.

New India Company: Reconciliation of Income
Serial Particulars Year 1 ( ` ) Year 2 ( ` ) Year 3 ( ` )
A Operating Income under absorption costing 15,000 9,000 21,000
B Operating Income under marginal costing 15,000 0 30,000
C Difference (A-B) 0 9,000 (9,000)
Analysis of Difference
Year 1: There is no difference
Year 2: Operating Income under absorption costing is higher by ` 9,000/-.
Production in Year 2= 2500 units
Sales in Year 2= 1750 units
Change in FG Inventory = (2500-1750) =750 units i.e., increase
The absorption of overheads being on the basis of units sold, under-absorbed Fixed Overheads on 750 units
@ ` 12/- per unit aggregating to ` 9,000/- have resulted in the higher Operating Income under absorption
costing.

Year 3: Operating Income under absorption costing is lower by ` 9,000/-.

Production in Year 3= 2500 units
Sales in Year 3= 3250 units
Change in FG Inventory = (2500- 3250) = (750) units i.e., decrease
The absorption of overheads being on the basis of units sold, over-absorbed Fixed Overheads on 750 units @
` 12/- per unit aggregating to ` 9,000/- have resulted in the lower Operating Income under absorption costing.
(d) Throughput Costing Income Statement
New India Company: Income Statement as per Throughput Costing
Number of Units Produced 2500 2500 2500
Less: Cost of goods sold (at throughput cost: 30,000 21,000 39,000
Direct material cost of ` 12/- per unit)1
Throughput 90,000 63,000 1,17,000
Less: Operating costs:
Direct labour @ ` 8/- Per unit on units produced 20,000 20,000 20,000
Variable manufacturing overhead @ ` 4/- Per 10,000 10,000 10,000
unit on units produced
Fixed manufacturing overhead 30,000 30,000 30,000
Variable selling & admin. Expenses @ ` 4/- per 10,000 7,000 13,000
unit on units sold
Fixed selling & admin. Expenses 5,000 5,000 5,000
Total Operating Costs 75,000 72,000 78,000
Operating Income 15,000 (9,000) 39,000
(e) Observations
Comparative Statement of Operating Income (Rupees)
Production Sales Operating Income (Rupees)
Year
Units Units Absorption Costing Marginal Costing Throughput Costing
1 2,500 2,500 15,000 15,000 15,000
2 2,500 1,750 9,000 0 (9,000)
3 2,500 3,250 21,000 30,000 39,000
Total 7,500 7,500 45,000 45,000 45,000

Observations:
i. In year 1 number of units produced (2,500) are equal to units (2,500) sold; Operating Income remains the
same (i.e., ` 15,000/-) under all the three systems.
ii. In year 2 number of units produced (2,500) are greater than units sold (1750); Operating Income is the
highest (i.e., ` 9,000/-) under Absorption Costing, and the lowest (i.e., ` 9,000/-) under Throughput System.
iii. In year 3 number of units (2,500) produced are less than units sold (3,250); Operating Income is the highest
(i.e., ` 39,000/-) under Throughput System followed by Marginal Costing (i.e., ` 30,000/-); Operating Income
is the lowest (i.e., ` 21,000/-) under Absorption Costing.
iv. When all the three years are totalled, number of units produced (7,500) are equal to units (7,500) sold; and
Operating Income remains the same (i.e., ` 45,000/-) under all the three systems.
v. Operating Income being sales driven, Throughput and marginal systems facilitate better control.
Illustration 16
T Ltd, produces a product which passes through two processes - cutting and finishing.
The following information is provided:
Cutting Finishing
Hours available per annum 50,000 60,000
Hours needed per unit of product 5 12
Fixed operating costs per annum excluding direct material 10,00,000 10,00,000
The selling price of the product is ` 1,000 per unit and the only variable cost per unit is direct material, which
costs ` 400 per unit. There is demand for all units produced.
Evaluate each of the following proposals independent of each other:
(i) An outside agency is willing to do the finishing operation of any number of units between 5,000 and 7,000
at ` 400 per unit.
(ii) Another outside agency is willing to do the cutting operation of 2,000 units at ` 200 per unit
(iii) Additional equipment for cutting can be bought for ` 10,00,000 to increase the cutting facility by 50,000
hours, with annual fixed costs increased by ` 2 lakhs.
Answer
Cutting process capacity = 50,000hours ÷ 5 = 10,000 units
Finishing process capacity = 60,000hours ÷ 12 = 5,000 units
Throughput contribution per unit = (Selling Price – Material Cost)
= ( ` 1,000 – ` 400) = ` 600 per unit
Observation: Finishing capacity (5,000 units) is less than the cutting capacity (10,000 units). Therefore,
Finishing Capacity is the bottleneck resource.
Alternative-I: If an outside agency is willing to do the finishing operation of any number of units between 5,000
and 7,000

Increase in throughput contribution per unit = (Throughput contribution - Subcontracting charges)

= ( ` 600 – ` 400) = ` 200/-
Throughput Contribution for 5,000 units = (5000 × 200) = ` 10,00,000/-
Throughput Contribution for 7,000 units = (7000 × 200) = ` 14,00,000/-
Observation: Increase in throughput contribution is higher than the fixed operating costs of ` 10,00,000- per
annum beyond 5,000 level of subcontracting. Therefore, subcontracting above the 5,000 level is beneficial.
Alternative-II: If an outside agency is willing to do the cutting operation
The capacity of cutting process is 10,000 unis as against the finishing capacity of 5,000 units. Cutting is not the
bottleneck and hence outsourcing is not beneficial.
Alternative-III: Installation of additional equipment for cutting process.
The cutting process has surplus capacity. It is, therefore, suggested not to increase non-bottleneck capacity.
Illustration 17
H Ltd. manufactures three products. The material cost, selling price and bottleneck resource details per unit are
as follows:
Particulars Product X Product Y Product Z

Selling Price ( ` ) 66 75 90
Material and other variable cost ( ` ) 24 30 40

Bottleneck resource timeline (minutes) 15 15 20
Budgeted factory costs for the period are ` 2,21,600. The bottleneck resources time available is 75,120 minutes
per period.
Required:
(i) Company adopted throughput accounting and products are ranked according to ‘product return per minute’.
Select the highest rank product.
(ii) Calculate throughput accounting ratio and comment on it.
Answer
(i) Calculation of Rank according to product return per minute
Particulars X Y Z
Selling Price 66 75 90
Less: Variable cost 24 30 40
Throughput contribution (a) 42 45 50
Minutes per unit (b) 15 15 20
Contribution per minute [(a) ÷ (b)] 2.8 3 2.5
Ranking II I III

Comment: Product Y with a contribution of ` 3/- per minute ranks the highest.
(ii) Calculation of throughput accounting ratio
Particulars X Y Z
Factory cost per minute ( ` ) 2.95 2.95 2.95
( ` 2,21,600 ÷ 75,120 minutes)
TA ratio 0.95 1.02 0.85
(Contribution per minute ÷ Cost per minute)
Ranking based on TA ratio II I III
Comments: TA Ratio of Product Y is greater than 1 whereas TA Ratios of Product X and Product Z are less
than 1. It is beneficial to maximise the production of Y and minimise the production of Z and X.
4.4 Back-flush Accounting
Concept
Backflush Costing or Backflush Accounting is a product cost accounting approach that, as the name suggests,
flushes back the cost from the end of the production process. It is different from the traditional costing system
in that this system records costs after the production process ends. As such, the costing process is deferred until
the final production of goods and services. This system does away with the requirement of keeping work-in-
process accounts and the manual assignment of costs at separate production stages. Companies that use just-in-time
(JIT) inventory systems generally use backflush approach.
Backflush costing system does not create any journal entry to record the transactions of raw materials and work
in process unless and until the production is completed. Only after the production process ends, backflush costing
uses one main journal entry to record the entire inventory, which was used in the production process.
For example, a producer estimates the standard cost of ` 10 per unit. Assuming that the total number of units that
the producer produces is 500 units; after the end of the production cycle, a single journal entry of ` 5,000 will be
made. The journal entry would be – Dr. Parts Expense ` 5,000 and Cr. Cash ` 5,000. In any other costing system,
several journal entries would have to be made, such as – Dr. Part A Expense and Cr. Cash; Dr. Part B Expense and
Cr. Cash; Dr. Part C Expense and Cr. Cash; and so more. As no journal entries are made initially or intermittently,
the manager uses standard or normal costing later and works backward to assign a cost to the goods or services. In
this way, the costs are “flushed back” to the already completed production cycle.
Backflushing is usually employed in parallel with JIT, where there is no work-in-progress to consider nor, does
work –in-progress materially fluctuates. What is essential, however, is an accurate bill of materials, good measures
of yield, generally effective production control and accurate engineering change notice when yields do change.
The principle of a just-in-time system is that production is pulled by customer demand and this in turn pulls the
purchasing procedures. Thus, theoretically there are zero stocks of raw materials, work-in-progress and finished
goods. For such a situation to exist there needs to be an excellent system of production planning and communication
with materials suppliers.
The backflushing formula used to assign the cost is:
Number of Raw Material units used = Total Production × Listed Unit Count in the Bill of Materials for
from Inventory Each Component

The Process
~~ Once a company gets an order, it records only the essential information into the system, such as quantity,
delivery date, and the item code. Based on this, the list of materials needed to complete the order is made.
~~ When the production is about to start, the company takes the delivery of the raw material and shifts it to the
production floor.
~~ Now software does the routing of all the components for that production order. The cost manager still has a
say on what parts and how much quantity to push in.
~~ After the end of the production process, the operator enters all information about the product into the
computer. The software then prepares the production report.
~~ Based on that report, the operator in a single transaction assign materials cost to the production order.
Benefits
Backflush costing method is more useful for companies with complex products or where the production process
involves several stages. With such companies, each stage of production would require several journal entries
to track the cost accurately. It could result in hundreds of entries for one product, making accountants’ job very
cumbersome. If such a company uses backflush costing, the accounts department will not have to post journal
entries throughout the production process. The system, thus, simplifies the costing operation and accounting tasks
without compromising too much on the information.
Other benefits of this system are:
~~ It makes it relatively easier to verify the materials used for production.
~~ Makes post-production issuance simpler.
~~ It makes it easier to track the inventory.
~~ When handling bulk materials, it keeps a check on the reverse issuance of materials.
Backflush system works best for products with short production times and the ones that use JIT (just-in-time)
inventory systems. Usually, the companies that use this costing are those:
●● That wants a simple accounting system.
●● That is okay with assigning standard costs to every product.
●● The inventory of the raw materials is either low or constant.
Limitations
Though the backflush costing system seems simple to implement, it is not suitable for all products and production
processes. For instance, one should not use this system that has a long manufacturing process, or the products that
take too much time to produce. It is because, the more time it takes, the more difficult it becomes to assign costs
correctly. Suppose a product takes a day to produce. One can easily assign costs to it. But what if it takes about a
year to manufacture a product. It would get complicated to map and keep track of the cost correctly.
Since this costing system works backward to assign costs after the end of the production, it often assigns standard
costs to the product. It could result in variance with the actual costs. Thus, in the real world, companies need to
recognize these variances. For example, one can identify the variation by comparing the labour cost assigned to the
production with the actual cash outflow for the labour expenses.
Similarly, such a costing method is not suitable for custom orders. It is because such orders would require

separate invoices for each material that is used in the production of custom orders. Also, backflush costing system
is not suitable for companies with slow inventory turnover.
One big drawback of this costing system is that it is not in-line with the GAAP (generally accepted accounting
principles), and thus, makes it difficult to audit.
Other drawbacks of backflush costing system are:
~~ It is relatively difficult to implement.
~~ For the results to be accurate, this system needs an accurate production count. In the formula above, the
finished goods count is one of the two inputs. So, if this number is wrong, then the resultant figure will not
be accurate as well.
~~ Its success also depends on the accuracy of the bill of materials. A bill of material contains the list of all
components and raw materials that a product will require. Thus, if there is a discrepancy in the bill of
materials, the backflush costing will assign an incorrect amount of raw materials and components.
~~ Scrap reporting also needs to be accurate. Usually, in a production process, there is a large amount of scrap.
The bill of material does not account for this scrap. It is essential to remove these scraps from the inventory
to get the right picture.
~~ Since this system does not record the work-in-process inventory, it needs a fast production cycle time. This
costing system does not record inventory until the end of the production. So, during this timeframe, the
records will remain incomplete. The only way to ensure records get updated quickly is to shorten or quicken
the production cycle.
The Variants of Backflush Accounting

There are a number of variants of the Backflush system, each differing as to the ‘trigger points’ at which costs are
recognized within the cost accounts and thus associated with products. All variants, however, have the following
common features:
~~ The focus is on output – costs are first associated with output (measured as either sales or completed
production) and then allocated between stocks and costs of goods sold by working back.
~~ Conversion costs (labour and overheads) are never attached to products until they are complete (or even
sold) – thus the traditional WIP account doesn’t exist. Materials are recognized at different points according
to the variant used, but only to the extent of being either stock of raw materials or part of the cost of stock of
finished goods. Again, materials are not attached to WIP.
Two variants of the Backflush system are summarized below. Note that in each as conversion costs (labour and
overheads) are incurred they will be recorded in a conversion cost (CC) account.
Variant 1
This has two Trigger Points (TP), viz.
~~ TP 1: Purchase of raw materials / components. A ‘Raw Material in Process (RIP)’ account will be debited
with the actual cost of materials purchased, and creditors credited.
~~ TP 2: Completion of good units. The finished goods (FG) account will be debited with the standard cost of
units produced and the RIP and CC account will be credited with the standard cost.
Under this variant, then, there will be two stock accounts i.e., (i) raw materials (which may, in fact, be incorporated
into WIP) and (ii) finished goods

Variant 2
This has only one trigger point – the completion of good units. The FG account is debited with the standard cost
of units produced, with corresponding credits to the CC account and the creditors account. Thus, the cost records
exclude:
●● Raw materials purchased but not yet used for complete production
●● The creditors for these materials (and any price variance)
And there is only stock account, carrying the standard cost of finished goods stock.
Other variants include those using the sale of completed good units as a trigger point for the attachment of
conversion cost to unit -- thus there is no finished goods account, just a raw materials stock account, carrying the
materials cost of raw materials, WIP and finished goods. It should be seen that as stock of raw materials, WIP and
finished goods are decreased to minimal levels, as in a ‘pure’ JIT system, these variants will give the same basic
results.
Assimilation
Backflush costing is an easy solution to the difficulties in assigning costs to the products, but its implementation
is not that simple. Many companies, however, still use it because of its ease and other benefits.
Illustration 18
The manufacturing cost information for March for a division of XYZ plc is as follows:
Cost incurred in March ` ‘000
Purchase of Raw Materials 4,250

Labour 2,800
Overheads 1,640
Activity in March Units (‘000)
Finished goods manufactured during the period 180
Sales 145
Standard cost per unit `
Materials 20
Labour 15
Overheads 9
44
There were no opening stocks of raw materials, WIP or finished goods. It should be assumed that there are no
direct materials variance for the period. Show the relevant Journal entries and ledger accounts in Variant 1 and
Variant 2 of backflush system.
Answer
Variant 1 (Entries when there are two trigger points):

The double entry would be as follows
Serial Particulars Dr. ` ‘000 Cr. ` ‘000

1 RIP account 4,250
Creditor 4,250
2 Conversion Cost account 4,440
Cash 2,800
Cash/creditor 1,640
3 FG account (180 × 44) 7,920
RIP account (180 × 20) 3,600
Conversion Cost account (180 × 24) 4,320
4 COGS (145 × 44) 6,380
FG account 6,380
The ledger would appear as follows
Raw and in process materials

Particulars ` ‘000 Particulars ` ‘000
To Creditor 4,250 By FG 3,600

By Bal c/d 650
4,250 4,250
Bal c/d 650
Conversion costs
To Cash/Creditor 4,440 By FG 4,320

Bal c/d 120
4,440 4,440
To Bal c/d 120
Finished goods
To RIP 3,600 By COGS 6,380

To Conversion Cost 4,320 By Bal c/d 1,540
7,920 7,920
To Bal c/d 1,540

Cost of goods sold

Particulars ` ‘000 ` ‘000
To FG 6,380 By Sales 6,380

6,380 6,380
The stock balances at the end of March would be
` ‘000
Raw and in process material 650

Finished goods 1,540
2,190
The balance on the Conversion Cost (CC) Account will be carried forward and written off at the end of the year.
Variant 2: Accounting entries where there is only one trigger point (i.e.,on completion of units):
Dr. ` ‘000 Cr. ` ‘000

1 Conversion Cost account 4,440
Cash 2,800
Cash/creditor 1,640
2 FG account (180 × 44) 7,920
RIP account (180 × 20) 3,600
Conversion Cost account (180 × 24) 4,320
3 COGS 6,380
FG account 6,380
Variant 2 is, thus, suitable for JIT system with minimal raw materials stocks.
Illustration 19
Dandia Ltd. follows JIT system. It had following transactions in May, 221:
i. Raw materials were purchased for ` 2,00,000.
ii. Direct labour cost incurred ` 36,000
iii. Actual overhead costs ` 3,00,000
iv. Conversion costs applied ` 3,16,000
All materials, that were purchased, were placed into production and the production was also completed and sold
during the month. The difference between actual and applied costs is computed.
You are required to pass both Traditional journal entries and back flush journal entries.

Answer
In the books of Dandia Ltd.
Journal Entries (Traditional)
Particulars Debit ( ` ) Credit ( ` )
Material A/c…………………...Dr. 2,00,000
To Accounts Payable 2,00,000
(Being purchase of raw materials)
WIP A/c……………………… Dr. 2,00,000
To Materials A/c 2,00,000
(Being materials issued to production)
WIP A/c……………………….Dr. 36,000
To Direct wages A/c 36,000
(Being direct labour cost incurred)
Overhead Control A/c…………Dr. 3,00,000
(Being overhead cost incurred)
WIP A/c………………………..Dr. 2,80,000
To Overhead Control A/c 2,80,000
(Being application of overhead)
Finished Goods A/c…………….Dr. 5,16,000
To WIP A/c 5,16,000
(Being completion of goods)
Cost of Goods Sold A/c………..Dr. 5,16,000
To Finished Goods 5,16,000
(Being cost of finished goods sold transferred)
Cost of Goods Sold A/c………..Dr. 20,000
To Overhead Control A/c 20,000
(Being variance recognized)
In the books of Dandia Ltd.

Journal Entries (Backflush)
Raw Material in Process A/c………Dr. 2,00,000


(Being purchase of raw materials)
Conversion Cost Control A/c……….Dr. 3,36,000
To Direct wages A/c 36,000
(Being overhead cost incurred)
Finished Goods A/c…………………….Dr. 5,16,000
To Raw Material in Process A/c 2,00,000
To WIP A/c 3,16,000
(Being completion of goods)
Cost of Goods Sold A/c…………………Dr. 5,16,000
To Finished Goods 5,16,000
(Being cost of finished goods sold transferred)
Cost of Goods Sold A/c………………….Dr. 20,000
To Overhead Control A/c 20,000
(Being variance recognized)
4.5 Benchmarking
Concept
It is believed that the term benchmark, originates from the history of guns and ammunition, and with the same
aim as for the business term; comparison and improved performance. Benchmarking is the continuous process of
measuring products, services or activities against the best levels of performance that may be found either inside or
outside the organization. It is a process of comparing a firm’s activities with best practices. The process involves
establishment of benchmarks (targets or comparators), through the use of which the levels of performance of the
organization is sought to be improved.
The idea behind benchmarking is to measure internal processes against a chosen standard. Benchmarking is used
to measure the internal performance using a specific indicator encompassing cost, time or quality resulting in a
metric of performance that can be compared to others. The examples of indicators include cost per unit of measure,
productivity per unit of measure, cycle time of x per unit of measure or defects per unit of measure, and so on.
Benchmarking can focus on roles, processes, or strategic issues. It can be used to establish a function or mission
of an organization. It can also be used to examine existing practices while looking at the organization as a whole to
identify practices that support major processes or critical objectives. Benchmarking is, also, a potentially powerful
tool to promote continuous improvement in an enterprise.
Benchmarking is a powerful management tool because it overcomes “paradigm blindness” and overcomes the
thinking, “the way we do it is the best because this is the way we’ve always done it”. Bench Marking opens

organizations to new methods, ideas and tools to improve their effectiveness. It helps crack through resistance to
change by demonstrating other methods of solving problems than the one currently employed and demonstrating
that they work, because they are being used by others. The benefits of benchmarking include several avenues
of cost reduction and cost control such as reducing labour cost, streamlining the work flow, and optimising
productivity, etc.
Types of Benchmarking
Noteworthy types of Benchmarking are:
1. Product Benchmarking (Reverse Engineering)
2. Competitive Benchmarking
3. Process Benchmarking
4. Internal Benchmarking
5. Strategic Benchmarking
6. Global Benchmarking
Product Benchmarking (Reverse Engineering): Product Benchmarking is an age-old practice of product
oriented reverse engineering. Every organization buys its rival’s products and tears down to find out how the
features and performances etc., compare with its products. This could be the starting point for improvement.
Competitive Benchmarking: Competitive Benchmarking looks at a company’s direct competitors and
evaluates how the company is doing in comparison. Competitive Benchmarking moves beyond product-oriented
comparisons to include comparisons of process with those of competitors. In this type, the process studied may
include marketing, finance, HR, R&D etc. Knowing the strengths and weaknesses of the competition is not only
important in plotting a successful strategy, but it can also help prioritize areas of improvement as specific customer
expectations are identified.
Process Benchmarking: Process benchmarking consists of a mechanism for identifying specific work procedures
that could be improved by imitating external examples of excellence that can be set as the best standard in the
industry. In that sense, Process Benchmarking involves the comparison of one’s own utility with other similar
utilities, with the purpose of self-improvement through adopting structures or methods that happen to be successful
elsewhere. It allows a firm to find out how others do business, whether they are more efficient or not and, if so,
whether the firm can understand and use those methods to its own advantage. The goal of process benchmarking is
to improve different stages of the production process and to increase efficiency by “learning from others”. Sharing
experiences is crucial for the success of the technique. For example, by comparing specific core indicators (and the
procedures currently used that affect those indicators) for a set of utilities, best practice can be hopefully identified
and transferred to weak performers, who should adopt in order to increase efficiency.
Internal Benchmarking: Internal Benchmarking is an application of process benchmarking, within an organization
by comparing the performance of similar business units or business process. Internal Benchmarking is the analysis
of existing practice within various departments or divisions of the organization, looking for best performance as
well as identifying baseline activities and drivers. Organizations collect data on their own performance at different
points in time and under different circumstances and identify gaps or areas for strengthening.
Strategic Benchmarking: Strategic Benchmarking is used to describe the situation when a firm is interested in
comparing its performance versus the best-in-class or what is deemed as world-class performance. This process
often involves looking beyond the firm’s core industry to firms that are known for their success with a particular
function or process. The best-in-class form of benchmarking examines multiple industries in search of new,
innovative practices. It not only provides a broad scope, but also the best opportunities over that range. Looking

beyond your own industry for best-in-class performance for particular processes or functions is an excellent way
to challenge your firm to rethink long-standing assumptions and practices. A unique example is that of Southwest
Airlines which had analysed the processes, approaches, and speed of automobile racing pit crews to gain ideas
for improving their airplane turn-around time at the gate. The outcome of this benchmarking study is reported to
have helped Southwest reconfigure their gate maintenance, cleaning, and customer loading operations, and to have
saved the firm millions of dollars per year.
Global Benchmarking: Global Benchmarking is an extension of Strategic Benchmarking to include
benchmarking partners on a global scale. E.g. Ford Co. of USA benchmarked its A/c payable functions with that of
Mazada in Japan and found to its astonishment that the entire function was managed by 5 persons as against 500
in Ford.
Process of Benchmarking
The benchmarking process is relatively uncomplicated. Some knowledge and a
practical dent are all that is needed to make such a process a success. The key stages in Planning
the benchmarking process may be summarized as:
(i) Planning Collection Of Data
(ii) Collection of Data
(iii) Analysis of Data
Analysis
(iv) Implementation
(v) Monitoring
Planning (Stage 1): Planning starts with determination of benchmarking goal Implementation
statement. It is imperative that the organization identifies the activities that need to be
benchmarked prior to engaging in benchmarking. Since benchmarking can be applied
to any business process or function, a range of research techniques may be required. Monitoring
These include informal conversations with customers, employees or suppliers. These
also include exploratory research techniques, re-engineering analysis, process mapping, quality control variance
reports, financial ratio analysis, or simply reviewing cycle times or other performance indicators.
Second step in planning is Identification of best performance, i.e., seeking the “best”. To arrive at the best is both
expensive and time consuming, so it is better to identify a Company which has recorded performance success in a
similar area. Before embarking on comparison with other organizations it is essential to know the organization’s
functions and processes. Base lining performance provides a point against which improvement effort can be
measured. The benchmark organization can be a single entity or a collective group of organizations, which operate
at optimal efficiency. If such these organizations operate in a similar environment or if they adopt a comparable
strategic approach to reach their goals, its relevance would be greater.
The third step is eestablishment of the benchmarking or process improvement team. This should include
persons who are most knowledgeable about the internal operations and will be directly affected by changes due to
benchmarking.
The last step in planning is defining the relevant benchmarking measures. Relevant measures will not be restricted
to include the measures used by the firm today, but they will be refined into measures that comprehend the true
performance differences. Developing good measurement is key and critical to successful benchmarking.
Collection of Data and Information (Stage 2): This stage involves the following steps: –
a. Compiling information and data on performance. They may include mapping processes.

b. Selecting and contacting partners.

c. Developing a mutual understanding about the procedures to be followed and, if necessary, to prepare a
Benchmarking Protocol with partners.
d. Preparing questions and conceiving terminology and performance measures to be used.
e. Distributing a schedule of questions to each partner.
f. Undertaking information and data collection by chosen method for example, interviews, site-visits, telephone
tax and e-mail.
g. Collecting the findings to enable analysis.
Data can be in the form of primary data and secondary data. Primary data refers to collection of data directly
from the benchmarked organization/organizations itself, while secondary data refers to information generated
from the media, publications or internet. Exploratory research, market research, quantitative research, informal
conversations, interviews and questionnaires are some of the most popular methods of collecting information.
When engaging in primary research, the organization needs to redefine its data collection methodology. Drafting
a questionnaire or a standardized interview format, carrying out primary research via the telephone, e-mail or in
face-to-face interviews, making on-site observations; and documenting such data in a systematic manner is vital, if
the benchmarking process is to be a success.
Analysis of Data (Stage 3): Once sufficient data is collected, the proper analysis of such information is of
foremost importance. The process may consist of the following steps.
(a) Reviewing the findings and producing tables, charts and graphs to support the analysis
(b) Identifying gaps in performance between our firm and better performers.
(c) Seeking explanations for the gaps in performance. The performance gaps can be positive, negative or zero.
(d) Ensuring that comparisons are meaningful and credible
(e) Communicating the findings to those who are affected.
(f) Identifying realistic opportunities for improvements. The negative performance gap indicates an undesirable
competitive position and provides 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.
Recommendation & Implementation (Stage 4): This is the stage in the benchmarking process, where it
becomes mandatory to walk the talk for success. This usually means that far reaching changes need to be made so
that the performance gap between the target and the actual is narrowed and eliminated. It starts with deciding the
feasibility of making the improvements in the light of conditions that apply within own firm A formal action plan,
that promotes change, is to be formulated keeping the culture of the organization in mind so that the resistance
that normally accompanies change is minimized. The commitment of management and staff is to be fully ensured
for the process and sufficient resources are to be there to meet the cost of facilitating the necessary improvements.
Monitoring & Review (Stage 5): Benchmarking process need to be properly monitored in order to reap the
maximum benefit out of the benchmarking process. This could involve:
a. Evaluating the benchmarking process undertaken and the results of the improvements against objectives and
success criteria plus overall efficiency and effectiveness.
b. Documenting the lessons learnt and make them available to others.
c. Periodically re-considering the benchmarks for continuous improvement.

A systematic evaluation is required to be carried out on a regular basis. Assimilating the needed information,
evaluating the progress made, reiterating the impact of the changes and making any necessary adjustments, are all
part of the monitoring process.
Pre-requisites of Benchmarking
1. Commitment: Senior Managers should support benchmarking fully and must be committed to continuous
improvements.
2. Clarity of Objectives: The objectives should be clearly defined at the preliminary stage. Benchmarking
teams must have a clear picture of their firm’s performance before approaching others for comparisons.
3. Appropriate Scope: The scope of the work should be appropriate in the light of the objectives, resources,
time available and the experience level of those involved.
4. Resources: Sufficient resources must be made available to complete projects within the required time scale.
5. Skills: Benchmarking teams should have appropriate skills and competencies.
6. Communication: Stakeholders, and also staff and their representatives, are to be kept informed of the
reasons for benchmarking.
Difficulties in implementation of Bench Marking

1. Time consuming: Benchmarking is time consuming and at times difficult. It has significant requirement of
staff time and Company resources. Companies may waste time in benchmarking non-critical functions.
2. Lack of management Support: Benchmarking implementation requires the direct involvement of all
managers. The drive to be best in the industry or world cannot be delegated.
3. Resistance from employees: It is likely that their maybe resistance from employees.
4. Paper Goals: Companies can become pre-occupied with the measures. The goal becomes not to improve
process, but to match the best practices at any cost.
5. Copy-paste attitude: 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 leading to a failure of bench marking goals.
Case Study: Drive thru Practice

A quick service (fast food) restaurant chain dependent upon speedy, accurate service in the drive-thru to
maximize efficiency, cut costs and increase profits may study the drive-thru practices of key competitors. Every
second gained without sacrificing customer quality allows the firm to increase profits. Over the years, competitors
have consistently innovated in their drive-thru operations with configuration, number of windows, menu and
speaker boards and ordering approaches in an attempt to improve in this area. They are constantly watching and
benchmarking against each other.
Pal’s Sudden Service, a small hamburger and hot dog chain and a Baldrige Quality Award winner, is so successful
at achieving best-in-class performance for drive-thru and overall restaurant operations. Pal’s does not offer sit-
down service inside its restaurants. Instead, customers pull up to a window, place their orders face-to-face with
an employee (no scratchy loudspeakers), pull around to the other side of the facility, take their bag, and drive on.
All this happens at a lightning pace – an average of eighteen seconds at the handout window to place an order, an
average of twelve seconds at the drive-up window to receive the order. That’s four times faster than the second-
fastest quick serve restaurant, which requires more than a minute on average to take an order.
Many companies in the fast-food market use Pal’s as a best-in-class benchmark for their own firms. It is no
wonder that Pal’s opened an educational institute to train other organizations.

Terms to Master
Activity Based Costing System: Activity Based Costing may be defined as ‘cost attribution to cost units on the
basis of benefit received from indirect activities e.g. ordering, setting up, and assuring quality.’ The system assumes
that products consume activities and activities consume costs. It leads to more precise allocation of manufacturing
overheads amongst the products. Activity-based costing provides a means to collect indirect costs in multiple
categories and then applies the results individually to the products and services.
Activity: An activity means an aggregate of closely related tasks having some specific functions which are used
for completion of a goal or objective.
Resource: Resources are elements that are used for performing the activities or factors helping in the activities.
Cost: Cost is the amount paid for the resources consumed by an activity.
Cost Object: Cost Object refers to an item for which cost measurement is required. e.g., a product, a service, or
a customer.
Cost Pool: A cost pool is a term used to indicate grouping of costs incurred on a particular activity which drives
them.
Cost Driver: Any element that would cause a change in the cost of activity is cost driver. Cost drivers are the
basis of charging cost of activity to cost object.
Activity Based Management: Activity Based Management is a set of actions that management can take, based
on information from an Activity Based Costing system, to improve profitability.
Activity Based Budgeting: Activity-based budgeting is a budgeting method where activities are thoroughly
analysed to predict costs.
Activity Based Responsibility Accounting: Activity Based Responsibility Accounting is an accounting
system that assigns responsibility to processes and uses both financial and nonfinancial measures of performance.
Activity-based accounting redefines accountability from costs to team-based activities.
Just-In-Time: Just-In-Time is a management technique in which goods are received from suppliers only as
and when they are needed. The main objective of this method is to reduce inventory holding costs and increase
inventory turnover.
Throughput Accounting: Throughput Accounting (TA) is variable-cost-accounting presentation based on the
definition of throughput (sales minus material and component costs). Sometimes, it is referred to as super variable
costing because only material costs are treated as variable. It is a management accounting technique used as a
performance measure in the theory of constraints.
Theory of Constraints: The Theory of Constraints is a methodology for identifying the most important limiting
factor (i.e., constraint) that stands in the way of achieving a goal and then systematically improving that constraint
until it is no longer the limiting factor. In manufacturing, the constraint is often referred to as a bottleneck.
Backflush Costing: Backflush Costing or Backflush Accounting is a product cost accounting approach that, as
the name suggests, flushes back the cost from the end of the production process.
Bench-marking: Benchmarking is the continuous process of measuring products, services or activities against
the best levels of performance that may be found either inside or outside the organization.

QQ1. Elaborate the concept and purpose of Activity Cost Management.

QQ2. What are the vital stages of implementation of Activity Based Costing?
QQ3. Write a note on Activity Based Budgeting.
QQ4. Differentiate between Traditional Cost systems and ABC systems.
QQ5. What are the benefits of just-in-time manufacturing systems?
QQ6. What are the precautions that should be taken while implementing a just-in-time manufacturing system?
QQ7. What is the need for throughput accounting?
QQ8. What are the core measures and terms which are used in throughput accounting?
QQ9. Write a note on theory of constraints.
QQ10. Discuss the process of back-flush costing.
QQ11. What are the limitations of back-flush costing?
QQ12. What are the noteworthy types of benchmarking?
QQ1 P operates an activity-based costing (ABC) system to attribute its overhead costs to cost objects. In its
budget for the year ending 31st March 2022, the company expected to place a total of 2,895 purchase orders
at a total cost of ` 1,10,010. This activity and its related costs were budgeted to occur at a constant rate
throughout the budget year, which is divided into 13 four-week periods. During the four-week period ended
30 June 2021, a total of 210 purchase orders were placed at a cost of ` 7,650. The over-recovery of these
costs for the four-week period was:
A. ` 330
B. ` 350
C. ` 370
D. ` 390 Answer: A
Workings
Cost driver rate = Budgeted cost of orders ÷ Budgeted number of orders
= 1,10,010 ÷2895 = 38 for each order
Cost recovered for 210 orders = 210 × 38 = 7,980
Actual costs incurred = 7,650
Over-recovery of costs for four-week period = 7980 - 7650 = ` 330/-

QQ2 A company manufactures and sells packaging machines. It recently introduced activity-based costing to
refine its existing system. Each packaging machine requires direct materials costs of ` 50,000; 50 equipment
parts; 12 machine hours; 15 assembly line hours and 4 inspection hou ` The details about the cost pools,
allocation bases and allocation rates are given below:
Indirect cost pool Cost allocation base Budgeted allocation rate

Material handling No. of component parts ` 8 per part
Machining Machine hours ` 68 per machine hour
Assembly Assembly line hours ` 75 per assembly hour
Inspection Inspection hours ` 104 per inspection hour
The company has received an order for 40 can-packaging machines from a customer. Using activity-based
costing, indirect costs allocated to the order of the customer would be:
A. ` 1,30,850
B. ` 1,25,280
C. ` 1,15,050
D. ` 1,10,280 Answer: D
Workings
Indirect Costs per Packaging Machine
Indirect cost pool Cost allocation base Allocation rate Workings

Material handling 50 comp. parts ` 8 per part 50 × 8 = 400
Machining 12 Machine hours ` 68 per mach.hr. 12 × 68 = 816
Assembly 15 Asly. line hours ` 75 per asly. hr. 15 × 75 = 1125
Inspection 4 Inspection hours ` 104 per ins.hr. 4 × 104 = 416
Total ` 2,757/-
Therefore, for 40 machines the indirect cost = 40 × 2757= ` 1,10,280/-
QQ3 Process of Cost allocation under Activity Based Costing is

A. Cost of Activities—Activities—Cost Driver – Cost allocated to cost objects
B. Cost Driver — Cost of Activities— Cost allocated to cost objects -- Activities
C. Activities— Cost of Activities—Cost Driver – Cost allocated to cost objects
D. Activities—Cost Driver – Cost allocated to cost objects — Cost of Activities Answer: C
QQ4 At KL Company, cost of personnel department has always been charged to production department based
upon number of employees. Recently, opinion gathered from the department managers indicate that number
of new hires might be better predictor of personnel cost,
Total personnel department cost are ` 2,00,000.
Department A B C
Number of employees 30 270 100
The number of new hires 8 12 5

If number of new hires is considered the cost driver, what amount of cost will be allocated to Department A?
A. ` 15,000
B. ` 64,000
C. ` 72,000
D. ` 40,000 Answer: B
Workings
Total Cost of Personnel Department = ` 2,00,000
Total No. of New Hires – 8 + 12+ 5 = 25
Personnel Cost per New Hire = 2,00,000 ÷ 25 = ` 8000
Total Cost allocated to Department A = ` 8000 × 8 = ` 64,000
QQ5 Cost Driver is

A. Grouping of costs on a particular activity which drives them
B. Item for which cost measurement is required.
C. Elements that would cause a change in the cost activity.
D. All of the above Answer: C
QQ6 ABC Management

A. Accurately identifies sources of profit and loss
B. Assigns costs using measure of service consumed
C. Recognizes the casual relationship of cost drivers to activities
D. All of the above Answer: D
QQ7 Which of the following is not suitable for a JIT production system?
A. Batch production
B. Jobbing production
C. Process production
D. Service production Answer: A
Batch production uses stocks to supply customers whilst other products are being produced. Stocks are
avoided in a JIT system. Jobbing production makes products to customer order and is ideal for JIT.
QQ8 Kanban Japanese System under JIT approach ensures that

A. Continuous supply of inventory or product
B. Minimum & maximum level of stock to be maintained
C. Inventory valuation
D. All of the above Answer: A
QQ9 JIT relates to

A. Time Management
B. Inventory and product handling
C. Delivery systems
D. None of the above Answer: B
QQ10 Glasso, a manufacturer of large windows, is experiencing a bottleneck in its plant. Setup time at one of its
workstations has been identified as the culprit. A manager has proposed a plan to reduce setup time at a cost
of ` 7,20,000. The change will result in 800 additional windows. The selling price per window is ` 18,000,
direct labour costs are ` 3000 per window, and the cost of direct materials is ` 7,000 per window. Assume
all units produced can be sold. The change will result in an increase in the throughput contribution of
………………
A. ` 64,00,000
B. ` 88,00,000
C. ` 56,80,000
D. ` 1,44,00,000 Answer: B
Workings
Selling Price per Window = ` 18000
Material Cost per window = ` 7000
Throughput contribution per window = ` 11000
Total through put Contribution = ` 11000 × 800 = ` 88,00,000
QQ11 Cost per unit under throughput accounting and marginal costing are mainly different because
A. Labour is not considered in throughput accounting
B. Direct labour is considered fixed in throughput accounting
C. Total cost is considered in throughput accounting
D. Variable cost is considered in marginal costing Answer: B
QQ12 Ankit Ltd., operates throughput accounting system. The details of product A per unit are as under:
Selling Price: ` 75
Material Cost: ` 30
Conversion Cost: ` 20
Time to bottleneck resources: 10 minutes
What is the throughput contribution per bottleneck resource per hour?
A. ` 270
B. ` 150
C. ` 120
D. ` 90 Answer: A
Workings
Throughput Contribution
= (Selling Price – Material Cost) ÷ Time on bottleneck resources.
= [( ` 75 – ` 30) ÷10 minutes] × 60 = ` 270
QQ13 Producing more non-bottleneck output

A. Creates more inventory, but does not increase throughput contribution

B. Creates more inventory and increases throughput contribution

C. Creates less pressure for the bottleneck workstations
D. Allows for the maximization of overall contribution Answer: A
QQ14 Twin Ltd. uses JIT and back flush accounting. It does not use a raw material stock control account. During
September 2021, 10000 units were produced and sold. The standard cost per unit is ` 150 which includes
materials of ` 60. During September 2021, ` 9,90,000 of conversion costs were incurred. The debit balance
in cost of goods sold account for September 2021 is:
A. ` 14,00,000
B. ` 14,80,000
C. ` 15,90,000
D. ` 16,20,000 Answer: C
Workings
Standard Material Cost = (10,000 × 60) = 6,00,000
Actual Conversion Cost = 9,90,000
Debit Balance = (Material Cost + Conversion Cost) = 6,00,000 + 9,90,000
= 15,90,000
QQ15 The companies that would benefit from back-flush costing include companies
A. Which have fast manufacturing lead time
B. Whose inventory vary from period to period
C. Companies that require audit trails
D. None of these Answer: A
QQ16 Bench marking is

A. A continuous process
B. The practice of setting targets using external information
C. Method to provide performance assessment


Evaluating Performance
Evaluating Performance 5

5.1 Variance Analyses
5.2 Uniform Costing and Inter-firm Comparison

Evaluating Performance 5
5.1 Variance Analyses
5.1.1 Introduction (Recapitulation)
Variance
Variance, by definition, denotes the deviation between the standard proposition and the actual incidence. The
proposition could be a preset benchmark, budget or estimate and so on. The concept of variance is intrinsically
connected with planned and actual results and effects of
the difference between these two on the performance of
the entity. (Standard
Variance analysis involves breaking down and analyzing Proposition)
Variance
the total variance to explain: -
(Actual Incidence)
a. Quantity: How much of the variance is caused
by using the resources that are different from the
standards, i.e., the quantity variance; and
b. Rate: How much of the variance is caused by the cost of the resources being different from the standards,
i.e. the rate (price) variance.
The main objective of variance analysis is to provide insights into the off-benchmark performance. It helps
management to improve the operations and correct the errors on a concurrent basis; and deploy the resources
more effectively and, thus, control and reduce costs and as also enhancing the revenues. An important feature
of variance analysis is that it drives the enterprise towards quantitative analysis of the inputs and outputs
whereby optimum productivity is achieved. Variance analysis is a tool that facilitates management by exception.
Further, by recalibrating costs and prices by means of variance analysis, manufacturers can sustain themselves
amidst uncertainties. In an era of global competition, Variance Analysis, certainly, continues to be an efficient
tool for cost control.
Revenue Variance: Revenue Variance is the difference between planned, budgeted or standard revenue vis-à-
vis the actual revenue generated. It is also known as Sales
Variance and, in simple terms, denotes the difference
between the Standard Revenue and the Actual Revenue. (Standard
The derivation may be expressed as: Revenue Revenue)
“Revenue Variance = (SR – AR) = (SQ × SP) – (AQ × AP)” Variance -
(Actual Revenue)
where
SR = Standard Revenue for the standard output;

AR = Actual Revenue for the actual output;

SQ = Standard Quantity of the output;
SP = Standard Price per unit;
AQ = Actual Quantity of the output; and
AP = Actual Price per unit.
Revenue Variance can be subdivided into Revenue Quantity Variance and Revenue Price Variance. Revenue
Quantity Variance denotes the difference between the standard quantity of the output vis-à-vis the actual quantity,
both at standard price. The derivation may be expressed as
“Revenue Quantity Variance = SP (SQ – AQ)”
where SP = Standard Price per unit;
SQ = Standard Quantity of the output; and
AQ = Actual Quantity of the output.
Revenue Price Variance denotes the difference between the standard price and the actual price for the actual
quantity of the output. The derivation may be expressed as
“Revenue Price Variance = AQ (SP – AP)”
where AQ = Actual Quantity of the output;
SP = Standard Price per unit; and
Cost Variance: Cost Variance is the difference between a planned, budgeted or standard cost vis-à-vis the actual
cost. In other words, it is the difference between the standard cost and actual cost.
Cost Variances may be categorized element-wise such
that as Direct Material Cost Variance, Direct Labour Cost
Variance, Direct Expense Variance, Production Overhead
Variance, Administration Overhead Variance, Selling (Standard Cost)
Cost
Overhead Variance and Distribution Overhead Variance. -
Variance
They can also be broken down behaviour-wise into (Actual Cost)
Variable Cost Variance and Fixed Cost Variance. For any
of these categorizations, the key consideration is the
convenience of cost control.
The general derivation for cost variance may be expressed as:
“Cost Variance = (SC – AC) = (SQ × SP) – (AQ × AP)”
where
SC = Standard Cost of the element for standard production;
AC = Actual Cost of the element for actual production;
SQ = Standard Quantity of the element for standard production;

AQ = Actual Quantity of the element for actual production; and

Cost Variance can be subdivided into Usage Variance and Price Variance. Usage Variance denotes the difference
between the standard quantity of the element specified for the actual production and the actual quantity used, both
at standard price. The derivation may be expressed as
“Usage Variance = SP (SQ – AQ)”
where
SQ = Standard Quantity of the element needed for the standard output; and
AQ = Actual Quantity of the element consumed.
Usage Variance brings out the deviations in the cost of an element arising from consumption of non-standard
elements. Usage Variance is, generally, impacted by the factors of input mix and yield.
Price Variance denotes the difference between the standard price and the actual price for the actual quantity of
the element consumed. The derivation may be expressed as
“Price Variance = AQ (SP – AP)”
where AQ = Actual Quantity of the element consumed;
Material Cost Variance: Material Cost Variance denotes the difference between the standard cost of the material
needed and the actual cost of the material consumed for the production achieved. The derivation may be expressed as:
Material Cost Variance = (SC – AC) = (SQ × SP) – (AQ × AP)
where
SC = Standard Cost of the material for standard production;
AC = Actual Cost of the material for actual production;
SQ = Standard Quantity of the material for standard production;
AQ = Actual Quantity of the material for actual production; and
Material Cost Variance can be subdivided into Material Usage Variance and Material Price Variance.
Material Usage Variance: Material Usage Variance denotes the difference between the standard quantity of the
material specified for the actual production and the actual quantity used, both at standard price. The derivation may
be expressed as
“Material Usage Variance = SP (SQ – AQ)”
where

SQ = Standard Quantity of the material needed for the standard output; and
AQ = Actual Quantity of the material consumed.
Material Usage Variance brings out the deviations in the material cost arising from consumption of non-standard
materials. Some of the reasons for the material usage variance may be listed as:
a. Variation in usage of materials due to inefficient or careless use, or economic use of materials.
b. Changes in the specification or design of the product.
c. Purchase of inferior materials or change in quality of materials
d. Inefficiency in production resulting in wastages
e. Use of substitute materials.
f. Theft or pilferage of materials.
g. Inefficient labour force leading to excessive utilisation of materials.
h. Yield from materials in excess of or less than that provided as the standard yield.
i. Inaccurate standards
j. Change in composition of a mixture of materials for a specified output.
Material Usage Variance is, generally, impacted by the factors of input mix and yield and hence can be subdivided
into Material Mix Variance and Material Yield Variance. The derivations may be expressed as:
Material Mix Variance = SP × (Revised Standard Quantity – Actual Quantity)
Material Yield Variance = SP × (Standard Yield – Actual Yield)
Material Price Variance: Material Price Variance denotes the difference between the standard price and the
actual price for the actual quantity of the material consumed. The derivation may be expressed as:
“Material Price Variance = AQ (SP – AP)”
where AQ = Actual Quantity of the material consumed;
Some of the reasons for the material price variance may be sated as:
a. Change in basic purchase price of material.
b. Change in quantity of purchase or uneconomical size of purchase order.
c. Rush order to meet shortage of supply, or purchase in less or more favourable market.
d. Transit losses and discrepancies.
e. Change in quality or specifications of material purchased.
f. Use of substitute material having a higher or lower unit price.
g. Change in the pattern or amounts of taxes and duties.
Labour Cost Variance: Labour Cost Variance denotes the difference between the standard cost of the

labour needed and the actual cost of the labour consumed for the production achieved. The derivation may be
expressed as:
Labour Cost Variance = (SC – AC) = (ST × SR) – (AT × AR)
where
SC = Standard Cost of the labour needed;
AC = Actual Cost of the labour consumed;
ST = Standard Time of the labour needed;
SR = Standard Rate per unit of time;
AT = Actual Time of the labour spent; and
AR = Actual Rate per unit of time.
Labour Cost Variance can be subdivided into Labour Rate Variance and Labour Efficiency Variance.
Labour Rate Variance: Labour Rate Variance denotes the difference between the standard rate per unit of time
and the actual rate for the actual time consumed. The derivation may be expressed as:
Labour Rate Variance = AT (SR – AR)
where
AT = Actual Time of the labour spent;
SR = Standard Rate per unit of time; and
AR = Actual Rate per unit of time.
Some of the reasons for the labour rate variance may be stated as:
a. Change in basic wage structure or change in piece-work rate.
b. Employment of workers of grades and rates of pay different from those specified, due to shortage of labour
of the proper category, or through mistake, or due to retention of surplus labour.
c. Payment of guaranteed wages to workers who are unable to earn their normal wages if such guaranteed
wages form part of direct labour cost.
d. Overtime and night shift work in excess of or less than the standard, or where no provision has been made
in the standard.
e. The composition of a gang as regards the skill and rates of wages being different from that laid down in the
standard.
Labour Efficiency Variance: Labour Efficiency Variance denotes the difference between the standard time
specified for the standard production and the actual time spent, both at the standard rate. The derivation may be
expressed as:
Labour Efficiency Variance = SR (ST – AT)
where
SR = Standard Rate per unit of time;
ST = Standard Time of the labour needed for the standard production; and
AT = Actual Time of the labour spent.

Some of the reasons for the labour efficiency variance may be stated as:
a. Lack of proper supervision.
b. Poor working conditions.
c. Delays due to waiting for materials, tools, instructions, etc.
d. Defective machines, tools and other equipments.
e. Machine break-down.
f. Basic inefficiency of workers due to low morale, insufficient training, faulty instructions, incorrect scheduling
of jobs, etc.
g. Use of non-standard material requiring more or less operation time.
h. Increase in labour turnover.
Labour Efficiency Variance can be subdivided into Mix Variance, Yield Variance and Idle Time Variance. The
derivations may be expressed as:
Labour Mix Variance = (Cost of Actual Hours at Standard Rate of Standard Gang) - (Cost
of Actual Hours at Standard Rate of Actual Gang)
or
SR × (Revised Standard Hours – Actual Hours)
Labour Yield Variance = Standard Cost Per Unit × (Standard Output for Actual Mix -
Actual Output)
or
SR × (Standard Hours – Revised Standard Hours)
Idle Time Variance = Standard Rate per Hour × (Actual Hours Paid for - Actual Hours
Worked)
or
(Standard Rate per Hour × Idle Time)
Overhead Cost Variance: Overhead Cost Variance denotes the difference between the standard overhead cost
specified for the production achieved and the actual overhead cost incurred. In other words, overhead cost variance
is under or over absorption of overheads. The derivation may be expressed as:
Overhead Variance = (SC – AC) = (SB × SR) – (AB × AR)
where
SC = Standard Overhead Cost specified for the standard production;
AC = Actual Overhead Cost incurred;
SB = Standard Quantum of the Overhead Base;
SR = Standard Overhead Rate per unit of the Base;
AB = Actual Quantum of the Overhead Base; and
AR = Actual Overhead Rate per unit of the Base.

Overhead Variance can be subdivided into Overhead Volume Variance and Overhead Expenditure Variance.
Overhead Volume Variance is quantitative in nature and denotes the difference between cost for the actual quantum
of the base at the standard overhead rate and the cost for the standard quantum at standard overhead rate. Overhead
Efficiency Variance denotes the difference between the cost for the production achieved at standard overhead
rate and the cost for the actual quantum of the base at the standards overhead rate. The relevant formulae may be
expressed as:
Overhead Volume Variance = Standard Rate × (Actual Units – Standard Units)
Overheard Expenditure Variance = Actual Units × (Standard Rate – Actual Rate)
Example 1
The computation of the variances is demonstrated by means of illustrative data relating to XPML. Monthly Data
of Production and Cost detailing the standards and actuals are furnished as follows.
XPML: Monthly Data of Production and Cost
Serial Item Standards Actuals
1 Working Days 30 29
2 Production in MT 1025 1060
3 Sale price in ` Per MT 40250 40000
4 Raw Material
A. Quantity in MT 1250 1285
B. Rate per MT (`) 20000 20250
5 Workers
A. Number of Workers 80 80
B. Man Days 2400 2320
C. Wage Rate in ` per Day 700 725
6 Power
A. KWH per MT of Production 650 640
B. ` Per KWH 7.10 7.10
7 Fuel
A. MT per MT of Production 0.60 0.58
B. ` Per MT 3000 3100

XPML: Monthly Data of Production and Cost
Serial Item Standards Actuals
8 Chemical Consumption (` Per MT) 1800 1750
9 Wire Clothing (` Per MT) 400 380
10 Packing Material (` per MT) 300 320
11 Fixed Expenses
A. Factory Expenses (` Lakhs Per Month) 12.00 11.50
B. Admn. Expenses (` Lakhs Per Month) 18.00 20.00
C. Selling Expenses (` Lakhs Per Month) 12.00 12.50
D. Sub Total 42.00 44.00
Computation of Variances:
1. Sales Variance
(Standard Revenue – Actual Revenue) = (1025 × 40250) – (1060 × 40000)

= (412.56 – 424.00)
= ` 11.44 Lakhs (F)
(a) Sales Quantity Variance

SP × (SQ – AQ) = 40250 (1025 -1060)
= ` 14.09 Lakhs (F)
(b) Sales Price Variance

AQ × (SP – AP) = 1060(40250 - 40000)
= ` 2.65 Lakhs (A)
(c) Check
Sales Variance = (Sales Quantity Variance + Sales Price Variance)
= 14.09 F + 2.65 A = ` 11.44 Lakhs (F)
2. Material Cost Variance
(Standard Cost– Actual Cost) = (1250 × 20000) – (1285 × 20250)

= (250.00 – 260.21)
= ` 10.21 Lakhs (A)

(a) Material Usage Variance

SP × (SQ - AQ) = 20000 (1250 -1285)
= ` 7.00 Lakhs (A)
(b) Material Price Variance

AQ (SP – AP) = 1285 (20000 - 20250)
= ` 3.21 Lakhs (A)
(c) Check
Material Cost Variance = (Material Usage Variance + Material Price Variance)
= 7.00 A + 3.21 A = 10.21 A
3. Labour Cost Variance
(Standard Cost– Actual Cost) = (2400 × 700) – (2320 × 725)

= (16.80 – 16.82)
= ` 0. 02 Lakhs (A)
(a) Labour Rate Variance

AT × (SR – AR) = 2320 (700 – 725)
= ` 0.58 Lakhs (A)
(b) Labour Efficiency Variance

SR × (ST – AT) = 700 (2400 – 2320)
= ` 0.56 Lakhs (F)
(c) Check
Labour Cost Variance = (Labour Rate Variance + Labour Efficiency Variance)
= 0.58 A + 0.56 F = 0.02 A
4. Power Cost Variance
(Standard Cost for Standard Production = (1025 × 650 × 7) – (1060 × 640 × 7.10)
– Actual Cost for Actual Production) = (46.63 – 48.16) = ` 1.53 Lakhs (A)
(a) Power Rate Variance

(Standard Cost for Actual Units – = (1060 × 650) (7.00 - 7.10)
Actual Cost for Actual Units) = (689000 × – 0.10) = ` 0.68 Lakhs (A)

(b) Power Volume Variance

(Standard Cost for standard units = 7 ((1025 × 650) – (1060 × 640))
of Standard Production – Standard = 46.64 – 47.49
Cost for Actual Production)
= ` 0.85 Lakhs (A)
(c) Check
Power Cost Variance = (Power Rate Variance + Power Volume Variance)
0.68 A + 0.85 A = 1.53 A
5. Fuel Cost Variance
(Standard Cost for Standard Production = (1025 × 0.60 × 3000) – (1060 × 0.58 × 3100)
– Actual Cost for Actual Production) = (18.45 – 19.06)
= ` 0.61 Lakhs (A)
(a) Fuel Rate Variance

(Standard Cost for Actual Units – = (1060 × 0.58) (3000 - 3100)
Actual Cost for Actual Units) = (614.8 × -100)
= ` 0.62 Lakhs (A)
(b) Fuel Volume Variance

(Standard Cost for standard units = 3000 (1025 × 0.60) – (1060 × 0.58)
of Standard Production – Standard = 3000(615.00 – 614.80)
Cost for Actual Production)
= ` 0.01 Lakhs (F)
(c) Check
Fuel Cost Variance = (Fuel Rate Variance + Fuel Volume Variance)
= 0.62 A + 0.01 F = 0.61 A
6. Chemical Cost Variance
(Standard Cost for Standard Production = (1025 × 1800) – (1060 × 1750)

– Actual Cost for Actual Production) = (18.45 – 18.55)
= ` 0.10 Lakhs (A)
(a) Chemical Rate Variance

AQ × (SR – AR) = 1060 (1800 – 1750)
= ` 0.53 Lakhs (F)

(b) Chemical Volume Variance

SR × (SQ – AQ) = 1800 (1025 -1060)
= ` 0.63 Lakhs (A)
(c) Check
Chemical Cost Variance = (Chemical Rate Variance + Chemical Volume
Variance) = 0.53 F + 0.63 A = 0.10 A
7. Wire Clothing Cost Variance

– Actual Cost for Actual Production) = (4.10 – 4.03) = ` 0.07 Lakhs (F)
(a) Wire Clothing Rate Variance

AQ × (SR – AR) = 1060 (400 - 380)
= ` 0.21 Lakhs (F)
(b) Wire Clothing Volume Variance

SR × (SQ – AQ) = 400 (1025 -1060)
= ` 0.14 Lakhs (A)
(c) Check
Wire Clothing Cost Variance = (Wire Clothing Rate Variance + Wire Clothing
Volume Variance)
= 0.21 F + 0.14 A = 0.07 F
8. Packing Material Variance

– Actual Cost for Actual Production) = (3.08 –3.39)
= ` 0.31 Lakhs (A)
(a) Packing Material Rate Variance

AQ × (SR – AR) = 1060 (300 - 320)
= ` 0.21 Lakhs (A)
(b) Packing Material Volume Variance

SR × (SQ – AQ) = 300 (1025 -1060)
= ` 0.10 Lakhs (A)

(c) Check
Packing Material Variance = (Packing Material Rate Variance + Packing Material
Volume Variance)
= 0.21 A + 0.10 A = 0.31 A
9. Fixed Cost Expenditure Variance
(Budgeted Cost – Actual Cost) = (12.00 + 18.00 + 12.00) – (11.50 + 20.00 + 12.50)
= ` 2.00 Lakhs (A)
Summary of the variance Analysis is as follows:

XPML: Summary of Variance Analysis
` in Lakhs
Serial Item Standard Actual Variance

1 Revenue 412.56 424.00 11.44
2 Variable Costs
a. Raw Material 250.00 260.21 -10.21
b. Direct Wages 16.80 16.82 -0.02
c. Variable Expenses
i. Power 46.63 48.16
ii. Fuel 18.45 19.06
iii. Chemicals 18.45 18.55
vi. Wire Clothing 4.10 4.03
v. Packing Material 3.08 3.39
vi. Sub Total (i..v) 90.71 93.19 -2.48
d. Total (a..c) 357.51 370.22 -12.71
3 Contribution 55.05 53.78 -1.27
4 Fixed Expenses 42.00 44.00 -2.00
5 Margin 13.05 9.78 -3.27
Note: F = Favourable; A = Adverse
It may be observed that XPML has planned for a standard revenue of ` 412.56 lakhs for the month with a targeted
margin of ` 13.05 lakhs. The company achieved a higher revenue of ` 424.00 lakhs, but fell short of the margin
by ` 3.27 lakhs, the primary reason being a disproportionate increase in costs. The computations furnished above,
would trace the causes element wise and enable decisions for corrective actions.
5.1.2 Investigation of Variances

Investigation of variances implies systematic examination of deviations undertaken for the purpose of initiating
corrective actions. As such, Variance analysis is the quantitative investigation of the difference between actual and
planned behaviour. Such an analysis is used to maintain control over a business through the investigation of areas
in which performance was unexpectedly off the mark. Since the analysis of variances consumes resources and

money not all variances need to be investigated. Management takes up only the significant variances for probing.
As a common practice, minor deviations from the propositions, such as standards or budgets or estimates and
random variances are not considered for investigation. The following factors need attention while deciding which
variances to investigate and which variances not to investigate.
1. Adverse or Favourable: Adverse variances tend to attract most attention as they indicate problems.
However, there is an argument for the investigation of favourable variances so that a business can learn from
its successes. At the same time, it must be noted that all adverse variances are not bad and all favourable
variances are not indicators of efficiency in operation. An adverse variance might result from something that
is good that has happened in the business. For example, a budget statement might show higher production
costs than budget (adverse variance). However, these may have occurred because sales are significantly
higher than budget (favourable budget). In a standard costing system, some favorable variances are not
indicators of efficiency in operations. For example, the materials price variance, the labour rate variance, the
manufacturing overhead spending and budget variances, and the production volume variance are generally
not related to the efficiency of the operations. On the other hand, the materials usage variance, the labour
efficiency variance, and the variable manufacturing efficiency variance are indicators of operating efficiency.
However, it is possible that some of these variances could result from standards that were not realistic. For
example, if it realistically takes 2.4 hours to produce a unit of output, but the standard is set for 2.5 hours,
there should be a favorable variance of 0.1 hour. This 0.1-hour variance results from the unrealistic standard,
rather than operational efficiency. Remember, it is the cause and significance of a variance that matters – not
whether it is favourable or adverse.
2. Materiality: The size of the variance may indicate the scale of the problem and the potential benefits arising
from its correction. Small variations in a single period are bound to occur and are unlikely to be significant.
Investigation of such variances is likely to be time-consuming and irritating from the manager concerned.
For such variations further investigation is not worth the effort.
3. Trends: One adverse variance may be caused by a random event; but a series of adverse variances would
definitely need investigation. If, say, an efficiency variance is ` 1,000 adverse in month 1, the obvious
conclusion is that the process is out of control and that corrective action must be taken. This may be correct
but what if the same variance is ` 1,000 adverse every month? The trend indicates that the process is in
control and the standard has been wrongly set. Suppose, though, that the same variance is consistently
` 1,000 adverse for each of the first six months of the year but the production has steadily fallen from 100
units in month 1 to 65 units by month 6. The variance trend in absolute terms is constant, but relative to the
number of units produced, efficiency has steadily worse.
4. Controllability: Controllability must also influence the decision whether to investigate further. If there is
general worldwide price increase in the price of an important raw material there is nothing that can be done
internally to control the effect of this. If a central decision is made to award all employees a 10% increase in
salary, staff costs will increase by this amount and variance is not controllable by manager. Uncontrollable
variances call for a change in the plan and not an investigation into past.
5. Interdependencies: Sometimes a variance in one area is related to a variance in another. For example, a
favourable raw material price variance resulting from the purchase of a lower grade of material may cause
an adverse labour efficiency variance because the lower grade material is harder to work with. These two
variances would need to be considered jointly before making an investigation decision.
6. Inherent Nature: The inherent variability of the cost or revenue. Some costs, by nature, are quite volatile
(oil prices, for example) and variances would therefore not be surprising. Other costs, such as labour rates,
are far more stable and even a small variance may indicate a problem.

7. Reliability: Reliability and accuracy of the figures warrant due consideration. For example, mistakes in
calculating budget figures or in recording actual costs and revenues could lead to a variance being reported
inaccurately.
Cost Benefit Analysis of Investigation

In order to decide as to whether a variance shall be investigated or not, it is worth to carry out a cost benefit
analysis. The costs of investigation would consist of:
(a) the cost of investigating the variance, and
(b) cost of corrective action (i.e., action needed to correct the process and to bring it back under control.
The benefit side would include the cost of allowing the process to continue as it is, i.e., in an out-of-control state.
Investigation is taken up only if the cost of allowing the present state to continue exceeds the costs of investigation
and correction.
The three important methods, that are in vogue to decide whether a variance should be investigated (or not), may
be sated as:
(i) Managerial Intuition and Judgment
(ii) Expected Value Method
(iii) Statistical Control Chart Method
(i) Managerial Intuition and Judgment: Most of the firms prescribe the limits of variances expressed in terms
of (a) absolute monetary amount, (for example ` 2,500/- per month in case stationery expenses) or (b) as
a percentage of the standard proposition, (for example 0.25% of the budget) or (c) both, as guidelines for
investigation. Variances falling within these limits are considered to be in-control state and hence are not
investigated. Variances beyond the limits are out-of-control variances and are taken up for investigation.
The practice in some firms is to prescribe such limits separately for each element of costs and for revenue.
The limits are fixed partly on historical experience and partly on intuition. The basic assumptions are that
variances falling within the limits fixed are under in-control and that the costs of investigation of such
variances and bringing back the process into control will be higher than the cost of allowing the present state
to continue. The intuition method is simple and inexpensive and, though not statistically justified like the
other two methods, if fixed with proper care, may be reasonably accurate.
(ii) Expected Value Method: In this method, the probabilities of a variance being in out-of-control and in-
control states are estimated and a payoff matrix is formed in the manner shown below:
Action State
In-control Out-of-control
Probability P1 P2
Investigate, ai Ci Ci + Cc
Do not investigate, a0 0 Cb
P1 = Probability associated with in-control state
P2 = Probability associated with out-of-control state
Cj = Cost of investigation
Cc = Cost of bringing back the process in-control

Cb = Cost of allowing the out-of-control state to continue

ai = Value of the action to investigate
a0 = Value of action not to investigate
From the pay-off matrix, we find that,

Expected value, ai = P1Ci + P2(Ci + Cc), and
Expected value, a0 = P1 × 0 + P2Cb,
If ai > a0, the decision will be not to investigate;
If ai < a0, the decision will be to investigate;
If ai = a0, the management will be indifferent, i.e. it is immaterial whether or not the variance is investigated.
When ai = a0, P1Ci + P2 (Ci + Cc) = P2Cb .

But P1 + P2 = 1, or P1 = 1 - P2
Therefore, (1 - P2) Ci + P2 (Ci + Cc) = P2Cb
Or P2 = [Ci ÷ (Cb - Cc)]
In the above situation, P2 becomes the break-even probability which indicates that the decision will be
to investigate only if the estimated probability of the out of - control state is greater than the break-even
probability, viz. [Ci ÷ (Cb - Cc)].
This may be illustrated by assigning numerical values to the symbols. Let us assume that,
P1 = 0.85, P2 = 0.15, Ci = ` 300, Cc = Rs 2,000, and Cb = Rs 5,000
P2 = [Ci ÷ (Cb - Cc)]

P2= [300 ÷ (5000 – 2000)] = 0.1
Since P2 (0.15) is higher than the break-even probability, the decision will be to investigate. This will be
evident from the following, where ai < ao;
Expected value, ai = P1Ci + P2(Ci + Cc) = 0.85 × 300 + 0.15 (300+2,000) = ` 600
Expected value, ao = P1 × 0 + P2Cb = 0 + 0.15 × 5,000 = ` 750
The limitation of the expected value method arises mainly from the following:
(i) Estimation of the value of probability distribution for out-of-control state is difficult.
(ii) It is difficult to calculate the value of Cb, the cost of allowing the out-of-control state to continue.
(iii) Statistical Control Chart method: Statistical Quality Control is based on the concept that repetitive
processes are subject to a certain amount of chance variability which has a stable pattern. A process is said
to be in- control if all measurements fall within this pattern of variability. Items outside the pattern are in
out-of-control state needing investigation. Thus. if we build up the parameters within which a standard or
budgeted cost item should vary, we can find out whether a variance should or should not be investigated.

5.1.3 Planning and Operating Variances
Introduction
May it be standard costing, may it be budgetary control or may it be any other system, explaining the causes of
variances is a key step in variance analysis. In some cases, the cause is due to poor budgeting and planning (e.g.,
the planners used an out-of-date price list when setting the standard cost of materials). In some cases, the cause is
purely operational (e.g., the price of raw materials went up
due to market shortages). Often causes are a mixture of
planning and operating factors. Some firms seek to make
these distinctions more explicit by separating out planning (Original Proposition)
Planning
and operating variances. The basic approach is to have -
Variance
two budgets - the original budget and a revised one that (Revised Proposition)
takes into account planning issues so that we can then
determine two sets of variances viz. planning variances
and operating variances.
Planning Variance denotes the deviation between the original proposition and the revised proposition whereas
Operating Variance denotes the deviation between the revised proposition and the actual incidence.
Planning variances seek to explain the extent to which
the original standard needs to be adjusted in order to
reflect changes in operating conditions between the current
(Revised Proposition) situation and that envisaged when the standard was
Operating
- originally calculated. In effect it means that the original
Variance
(Actual Incidence) standard is brought up to date so that it is a realistic
attainable target in current conditions. Operating variances
indicate the extent to which attainable targets (i.e., the
adjusted standards) have been achieved. Operating
variances would be calculated after the planning variances have been established and are thus a realistic way of
assessing performance.
Planning and Operating Variances for Sales

Sales volume variance as also the sales price variance can be sub-divided into a planning variance and operational
variance. The relevant formulae are as under.
Sales Quantity Planning Variance = Standard Price (Revised Sales Quantity – Original Sales Quantity)
(Market Size Variance) = (Revised Sales Quantity × Standard Price) – (Original Sales Quantity
× Standard Price)
Sales Quantity Operating Variance = Standard Price (Actual Sales Quantity - Revised Sales Quantity)
(Market Share Variance) = (Actual Sales Quantity × Standard Price) – Revised Sales Quantity
× Standard Price)
Sales Price Planning Variance = Actual Quantities Sold (Revised Sale Price – Original Sale Price)
= (Revised Sale Price × Actual Quantities Sold) – (Original Sale Price
× Actual Quantities Sold)

Sales Price Operating Variance = Actual Quantities Sold (Actual Sale Price –Revised Sale Price) =
(Actual Sale Price × Actual Quantities Sold) – Revised Sale Price ×
Actual Quantities Sold)
Illustration 1
The concepts of Sales Price Planning Variance and Sales Operating Variance are explained by means of the
following illustration.
Budget Sale Revised Sales Actual Sales Budget Sale Actual Sale
Product
Price (`) Price (`) Price (`) Units Units
P1 20 15 18 2000 1900
P2 25 30 25 2000 2300
P3 25 27 28 2000 2000
Sales Price Planning Variance = Actual Sale Units (Revised Sale Price – Budget Sale Price)
Actual Sale Revised Sales Price - Sales Price Planning

Product Nature
Units Budget Sale Price Variance
P1 1900 (15 -20) = -5 1900 × -5 = -9500 Adverse
P2 2300 (30 -25) = 5 2300 × 5 = 11500 Favourable
P3 2000 (27 -25) = 2 2000 × 2 = 4000 Favourable
Total 6000 Favourable
Sales Price Operating Variance = Actual Sale Units (Actual Sale Price – Revised Sale Price)
Actual Sale Actual Sales Price - Sales Price Planning

Product Nature
Units Revised Sale Price Variance
P1 1900 (18 - 15) = 3 1900 × 3 = 5700 Favourable
P2 2300 (25 - 30) = -5 2300 × - 5 = -11500 Adverse
P3 2000 (28 - 27) = 1 2000 × 1 = 2000 Favourable
Total -3800 Adverse
There are a number of factors causing a change in the product costs to change. These factors can be planned or
unplanned events. A change in the cost of any product will compel the management to change the selling price. The
budgeted or standard selling price will need to be revised; the difference in the selling price for actual number of
units sold will then give the variance in the sale price planning.
Causes for sales price planning variance include:
●● Change in the raw materials prices, compelling management to revise sale prices significantly
●● Inefficient operations or unskilled labour, causes the product prices to rise or conversely efficient production
to control the costs

●● Market competition, with fewer competitors likely to achieve favourable sale price variance and intense
competition to result in adverse
Competitive and attractive sales price for a product can be the difference between a successful and failed product
launch. Also, for market leaders, to maintain the market share it is important to keep the variances in check. A well-
planned sale price can help a company gain competitive advantage in the market.
Achieving the revised sales price is the responsibility of the operational managers, however, some controllable or
unforeseen factors can still cause the difference in the actual sale prices. The deviation in the revised sales price and
the actual sales price is operational sales price variance. Some external factors, such as new entrants in the market
can compel the management to sell the products at lower than revised prices. Some operational inefficiency such
as unavailability of important raw material components can cause an increase the production costs.
Here are some of the factors that contribute to budget revisions and sales price operating variances:
●● The threat of new competitors compelling management to lower the sales prices
●● Unavailability of input components or increase in the raw material prices
●● Inefficiency in operations leading to wastes and idle labour hours
●● Seasonal product demand or lack of competition may temp the management to increase sales prices
●● Operational efficiencies and economies of scale can also lead to favourable sales price variances
Revising the sales price budgets is inevitable for any management; however, closing the revised and actual sale
price gaps should be the real focus. A careful interpretation of the drivers behind the variances can help achieve
the desired goals. Sales price largely depend on the input components, securing long term supplier contracts, bulk
buying discounts, and regular supplies can help reduce costs. Efficient operations and labour can also contribute
towards lower product costs that can help achieving favourable sales price variance.
Planning and Operating Variances for Material and Labour Costs

In case of materials and labour, planning and operational variances can be calculated by comparing original and
revised budgets (planning) and revised budgets with actual results (operational). A material price planning variance
is really useful to provide feedback on just how skilled managers are in estimating future prices. The operational
variance is more meaningful as it measures the purchasing department’s efficiency given the market conditions that
prevailed at that time. It ignores factors which cannot be controlled by purchasing department.
When applying planning and operating principles to cost variances (material and labour), care must be taken
over flexing the budgets. One accepted approach is to flex both the original and revised budgets to actual
production levels.
Example 2: Revising the Budget

Rhodes Co manufactures Stops which it is estimated require 2 kg of material XYZ at ` 100/kg In week 21 only
250 Stops were produced although budgeted production was 300. 450 kg of XYZ were purchased and used in the
week at a total cost of ` 51,000/- Later it was found that the standard had failed to allow for a 10% price increase
throughout the material supplier’s industry. Rhodes Ltd carries no stocks.
Answer
(i) Actual Results
= 450 kgs for ` 51,000/-
(ii) Revised flexed budget
= 250 units @ 2 kg per unit and @ ` 110 per kg = ` 55,000/-

(iii) Operating Variance = (51,000 – 55,000) = 4000 (A)

(iv) Original flexed budget
= 300 units @ 2 kg per unit and @ ` 100 per kg = ` 60,000/-
(v) Planning Variance = (55,000 – 60,000) = 5000 (A)
Example 3: Revising the Budget
A transport business makes a particular journey regularly, and has established that the standard fuel cost for each
journey is 20 litres of fuel at ` 90/- per litre. New legislation has forced a change in the vehicle used for the journey
and an unexpected rise in fuel costs. It is decided retrospectively that the standard cost per journey should have
been 18 litres at ` 100/- per litre.
Required: Calculate the original and revised flexed budgets if the journey is made 120 times in the period.
Answer
Original flexed budget: 120 × 20 × 80 = ` 1,92,000/-
Revised flexed budget: 120 × 18 × 100 = ` 2,17,800/-
Direct materials form the largest chunk of the product cost. Careful planning for material usage and securing
favorable prices, can save costs and increase profitability. Total material costs can change due to a change in
raw material pricing or change in component usage. Material variance can be divided into the material price and
material usage variances. A material price variance is simply finding each unit of product cost in comparison to the
estimated cost. Material usage variance deals with the total input material component(s) usage per unit of product.
The planning and operational variances for any measure can be calculated as the difference between planned
budget and revised and actual results and revised budgets. Similarly, both material price and usage variance can be
analyzed in terms of planning and operating variances.
Labour variance is unique in the sense that labour hours cannot be procured or saved in advance as materials.
Top management can only plan using past data and forecasts to set standard labour hour rates and total labour
costs. During operations, many factors affect production, and results are often different from planned. Total direct
labour variance can also be divided into direct labour rate and direct labour efficiency variances. From planning
and operational point of view, each of the two components, can further be analysed as Direct labour Rate Planning
& Operational Variances and Direct labour Efficiency Planning & Operational Variances.
The following illustration demonstrates the computation and analysis of Material and Labour Variances.
Illustration 2
Green Chemicals produces agriculture fertilizers with following information provided. The management
analysed past data and set the budgeted rates as following:
Standard hours per unit of product = 1.1
Standard direct labour rate per hour = ` 18.50
Standard usage of material per unit = 1.2 kg per unit
Standard price of material per unit = ` 70
During production times, the management revised the budgets with updated information as:
Revised price of material per unit = ` 71
Revised labour rate per hour = ` 20 per hour

Revised hours per unit of product = 1.05

Revised usage of material per unit = 1.175 kg per unit
After the production period the company recorded the following actual results:
Actual Production = 15,400
Raw Material usage = 16,555 KGs
Actual cost of raw material = ` 11,91,960 or ` 72 per KG
Actual labour costs= 16,632 hours and ` 3,24,324 or ` 19.50 per hour.
Calculate the Raw Material and Direct labour Planning & Operational Variances.
Answer
(i) Calculation of Raw Material Price Variances
Raw Material Price Variance = Actual Quantity (Standard Price - Actual Price)
=16555 (70 – 72) = ` 33,110/- Adverse
Raw Material Price Planning variance
= Actual Quantity (Standard Price - Revised Price)
= 16555 (70 - 71) = ` 16,555/- Adverse
Raw Material Price Operational variance
= Actual Quantity (Revised Price – Actual Price)
= 16555 (71 – 70) = ` 16,555/- Adverse
Check
Raw Material Price Variance
= Sum of Planning Variance and Operational Variance
= (` 16,555/- Adverse + ` 16,555/- Adverse)
=
` 33,110/- Adverse
(ii) Calculation of Raw Material Usage Variances
Raw Material Usage Variance
= Standard Price (Standard Quantity – Actual Quantity)
=70 [(15400 × 1.2) - 16555]
= 70 (18480 - 16555) = ` 1,34,750/- Favourable
Raw Material Usage Planning Variance
= Standard Price (Standard Quantity - Revised Quantity)
=70 [(15400 × 1.2) - [(15400 × 1.175)]
= 70 (18480 - 18095) = ` 26,950/- Favourable
Raw Material Usage Operational Variance
= Standard Price (Revised Quantity - Actual Quantity)
=70 [(15400 × 1.175) -16555]
=70 (18095 -16555) = ` 1,07,800/- Favourable

Check
Raw Material Usage Variance
= (` 26,950/- Favourable + ` 1,07,800/- Favourable)
=
` 1,34,750/- Favourable
Raw Material Variance = Standard Cost – Actual Cost
= (15400 units × 1.2 kg × ` 70) – (11,91,960)
= (12,93,600 – 11,91,960) = ` 1,01,640/- Favourable
Or
Raw Material Variance = Sum of Price Variance and Usage Variance
= (` 33,110/- Adverse + ` 1,34,750/- Favourable)
=
` 1,01,640/- Favourable
(iii) Calculation of Labour Rate Variances
Direct Labour Rate Variance = Actual Hours (Standard Rate - Actual Rate)
=16632 (18.50 – 19.50) = ` 16,632/- Adverse
Direct Labour Rate Planning variance
= Actual Hours (Standard Rate - Revised Rate)
= 16632 (18.50 - 20.00) = ` 24,948/- Adverse
Direct Labour Rate operational variance
= Actual Hours (Revised Rate – Actual Rate
= 16632 (20.00 – 19.50) = ` 8,316/- Favourable
Check
Direct Labour Rate Variance
= (` 24,948/- Adverse + ` 8,316/- Favourable) = ` 16,632/- Adverse
(iv) Calculation of Labour Efficiency Variances
Direct Labour Efficiency Variance
= Standard Rate (Standard Hours – Actual Hours)
=18.50 [(15400 × 1.1) - 16632]
= 18.50 (16940 - 16632) = ` 5698/- Favourable
Direct labour Efficiency Planning Variance
= Standard Rate (Standard Hours - Revised Hours)
=18.50 [(15400 × 1.1) - [(15400 × .05)]
= 18.50 (16940 -16170) = ` 14,245/- Favourable
Direct Labour Efficiency Operational Variance

= Standard Rate (Revised Hours - Actual Hours)

= 18.50 [(15400 × 1.05) -16632]
= 18.50 (16170 -16632) = ` 8547/- Adverse
Check
Direct Labour Efficiency Variance
= (` 14,245/- Favourable + ` 8,547/- Adverse)
=
` 5698/- Favourable
Direct Labour Variance = Standard Cost – Actual Cost
= (15400 units × 1.1 hours × ` 18.50) – (16632 hours × 19.50)
= (3,13,390 – 3,24,324) = ` 10,934/- Adverse
Or
Direct Labour Variance
= Sum of Rate Variance and Efficiency Variance
= (` 16,632/- Adverse + ` 5698/- Favourable) = ` 10,934/- Adverse
(v) Summary
The summary of variances may be presented in a tabular form as follows:
Serial Description Planning Operational Total

1 Raw Material
a Raw Material Price 16,555 (A) 16,555 (A) 33,110 (A)
Variance
b Raw Material Usage 26,950 (F) 1,07,800 (F) 1,34,750 (F)
Variance
c Sub Total 10,395 (F) 91,245 (F) 1,01,640 (F)
2 Direct Labour
a Direct Labour Rate 24,948 (A) 8,316 (F) 16,632 (A)
Variance
b Direct Labour Efficiency 14,245 (F) 8547 (A) 5,698 (F)
Variance
c Sub Total 10,703 (A) 231 (A) 10,934 (A)
3 Total 308 (A) 91,014 (F) 90,706 (F)
(vi) Observations
(a) The planning variance consists of ` 10,395/- (Favourable) with respect to Raw Material and ` 10,703/-
(Adverse) in relation to Direct Labour, both together aggregating to ` 308/- (Adverse). Even though
the variance looks smaller at the aggregate level, it is substantial at the element level and hence needs
further probing as to the causes and effects.

(b) The operational variance consists of ` 91,245 (Favourable) with respect to Raw Material and ` 231
(Adverse) in relation to Direct Labour, both together aggregating to ` 91,014/- (Favourable). Favourable
Direct Labour Operational Variance of ` 8,316/- is neutralized by Adverse Direct Labour Efficiency
Operational Variance of ` 8,547/-. Therefore, all the elements of variance (material as also labour)
warrant further probing as to the causes and effects.
Assimilation
Revision of original proposition is the basic cause for the Planning and Operational variances to occur. The
analysis, as demonstrated in the earlier illustrations, can be extended to each and every element of revenue and
cost, both direct and indirect. Competitive markets demand responsive actions to adjust to the market trends. A
careful interpretation of the planning variances can help the planners to identify the reasoning for the change. Study
of operating variances encourages operational managers to achieve efficiency in production processes.
5.1.4 Controllable and Non-Controllable Variances

The variance may be classified as Controllable and Uncontrollable., depending upon the controllability of the
factors causing variances. Variance is said to be controllable if it is identified as the primary responsibility of a
particular person or department. It refers to the deviation caused by such factors which could be influenced by the
managerial/ executive action. For example, the excessive use of materials or labour hours than the standards can
be attributable to a particular person.
When the variations are due to the factors beyond the control of the concerned person or department, it is said to
be uncontrollable. The rise in prices of materials, increase in wage rates, Govt. restrictions etc., are the examples
of uncontrollable variance. These factors are not within the control of the management and the responsibility of the
variance cannot be assigned to any particular person or division. Revision of the standard becomes necessary to
avoid non-recurrence of such variance in future.
The division of variance into controllable and uncontrollable is important from the view point of management as
it can place more emphasis on controllable variance and thus facilitate the principle of management by exception.
Standard costing to be more realistic, sometimes the standards set are to be revised on account of changes in
uncontrollable factors like wages, materials etc. To take into account these factors into variance, a ‘revised variance’
is created and the basic standard is allowed to continue.
This revision variance is the difference between the standard cost originally set and the revised standard cost.
The size of controllable variance reflects the degree of efficiency of the person/department. It is the controllable
variance with which the management is concerned because it needs remedial measures. Finding variance is not the
ultimate objective of the cost management. But their analysis and finding the causes of variance is the ultimate aim
to control cost. Control of cost depends on the corrective action taken by the management. The analysis of variance
helps the management to locate deficiency and assign responsibility to particular person or cost centre. The next
step of the management is to find out the reason for the variance to pin points where necessary, corrective action
should be taken over.
5.1.5 Relevant Cost Approach to Variance Analysis

‘What is the relevancy?’ is a contextual question that keeps springing up in many a process of managerial
decision making. The term relevancy signifies, ‘the quality or state of being closely connected or appropriate’ with
respect to the contextual situation. The context could be revenues, costs or even variances.
In cost and management accounting, notion of relevant costing has a lot of significance because these costs
are pertinent with respect to a particular decision. A relevant cost for a particular decision is the one that changes

the result if an alternative course of action is chosen. Studies have demonstrated that relevant costs will make a
difference in decision making. And, therefore, a similar approach is advocated in variance analysis too.
The main intent of relevant costing is to determine the objective cost of a business decision. An objective measure
of the cost of a business decision is the degree of profit that shall result from its execution. The fundamental
principles of relevant costing are quite simple and managers can perhaps relate the concept relevancy to variance
analysis. Costs are relevant, if they direct the executive towards the decision. So also, whether particular variances
are relevant for decision making depends on decision circumstance and the options available.
Relevant variance analysis may be perceived as an incremental investigation which indicates that it considers
only relevant costs, that is the costs that vary between alternatives, and ignores sunk costs that is the costs which
have been incurred, which cannot be changed and therefore are inappropriate to the business situation.
The notion of the relevant variance is very helpful to eliminate irrelevant information from a particular
decision-making process. Variances arising from committed contractual obligations such as price escalations
in material costs; wage increases springing up from agreements with wage boards; power rates spiraling from
electricity boards; etc. could become irrelevant for operating controls. By eliminating irrelevant variances from
the process of decision making, management is prevented from focusing on information that might inaccurately
affect its decision.
Moving forward, conventional approach to variance analysis is to compute variances based on acquisition cost
and standard prices for the acquisition of the resources. This is misleading, when scarce resources exist. Failure
to use scarce resources efficiently leads not only to increased acquisition cost but also to a lost contribution.
Therefore, meaningful approach is to incorporate the lost contribution in variance analysis. For example, if scarce
material is used excessively, it will cause material costs to be high and in addition there will be lost contribution,
which should be attached to material usage variance. When this approach is used, price or expenditure variances
are not affected. Quantity variance is affected by how efficiently scarce resource is being used.
5.1.6 Variance Analysis under Marginal Costing and Absorption Costing
Absorption of Overheads
Under absorption costing we use single overhead absorption rate to absorb overheads, because of the fact that
overheads are not segregated into variable and fixed. Variances will occur if the absorption rate is incorrect (just
as we will get over/under-absorption). Under absorption costing we calculate the overhead expenditure variance
and the overhead volume variance. Overhead volume variance can, further, be split into a capacity variance and
efficiency variance.
Marginal Costing is a very important technique in solving managerial problems and contributing in various
areas of decisions. Marginal costing distinguishes between fixed costs and variable costs which in turn facilitates
the analysis of variances to their causes and points of incidence. In that it takes a leap forward, from the absorption
costing, and classifies overhead (indirect cost) variance into:
a. Variable Overhead Variance
b. Fixed Overhead Variance
Variable Overhead Variance: Variable Overhead Variance is the difference between the standard variable
overhead cost allowed for the actual output achieved and the actual variable overhead cost. This variance is
represented by expenditure variance only because variable overhead cost will vary in proportion to production
whereby only a change in expenditure can cause such variance. The derivation may be expressed as:
Variable Overhead Variance = (Actual Output × Standard Variable Overhead Rate)
– (Actual Variable Overheads)

Variable overhead variance can be sub divided into Variable Overhead Expenditure Variance and Variable
Overhead Efficiency Variance. The derivations may be expressed as:
Variable Overhead Expenditure = (Actual Units × Standard Variable Overhead Rate) –

Variance (Actual Units × Actual Variable Overhead Rate)
Or
AU × (SR – AR)
Variable Overhead Efficiency = Standard Variable Overhead Rate per unit × (Standard
Variance Units for Actual Production - Actual Units)
Variable overhead expenditure variance resembles the rate variance is calculated in a similar manner.
Fixed Overhead Variance: Fixed Overhead Variance is that portion of total overhead cost variance which is
due to the difference between the standard cost of fixed overhead allowed for the actual output achieved and the
actual fixed overhead cost incurred. The derivation may be expressed as:
Fixed Overhead Variance = Fixed Overheads Absorbed – Actual Fixed Overheads

Or
(SU × SR) – (AU × AR)
Fixed overhead variance can be sub divided into Fixed Overhead Expenditure Variance and Fixed Overhead
Volume Variance.
Fixed Overhead Expenditure Variance: Fixed Overhead Expenditure Variance is that portion of the fixed
overhead variance which is due to the difference between the budgeted fixed overheads and the actual fixed
overheads incurred during a particular period. The derivation may be expressed as:
Fixed Overhead Expenditure = Budgeted Fixed Overheads – Actual Fixed Overheads

Variance Or
AU × (SR - AR)
Expenditure variance may arise on account of rise in general price level, changes in production methods,
ineffective control, etc.
Fixed Overhead Volume Variance: Fixed Overhead Volume Variance is that portion of the fixed overhead
variance which arises due to the difference between the standard cost of fixed overhead allowed for the actual
output and the budgeted fixed overheads for the period during which the actual output has been achieved. The
derivation may be expressed as:
Fixed Overhead Volume Variance = Standard Rate (Actual Units - Budgeted Units)
Or
SR (AU – BU)
Volume variance shows the over or under absorption of fixed overheads during a particular period. If the
actual output is more than the budgeted output, there is over-recovery of fixed overheads and volume variance is
favourable and vice versa if the actual output is less than the budgeted output. This is so because fixed overheads
are not expected to change with the change in output. Volume variance can be further subdivided into Capacity
Variance, Calendar Variance and Efficiency Variance.

Capacity Variance: Capacity Variance is that portion of the volume variance which is due to working at higher
or lower capacity than the budgeted capacity. In other words, this variance is related to the under and over utilisation
of plant and equipment and arises due to idle time, strikes and lock-out, break-down of the machinery, power
failure, shortage of materials and labour, absenteeism, overtime, changes in number of shifts. In short, the variance
arises due to more or less working hours than the budgeted working hours. The derivation may be expressed as:
Fixed Overhead Capacity Variance = Standard Fixed Overhead Rate per Unit × (Budgeted
Units – Actual Units)
Calendar Variance: Calendar Variance is that portion of the volume variance which is due to the difference
between the number of working days in the budget period and the number of actual working days in the period to
which the budget is applicable. If the actual working days are more than the standard working days, the variance
will be favourable and vice versa if the actual working days are less than the standard days. The derivation may be
expressed as:
Fixed Overhead Calendar Variance = Standard Rate Per Hour or Per Day × Excess or
Deficit Hours or Days Worked
Fixed Overhead Efficiency Variance: Fixed Overhead Efficiency Variance is that portion of the volume variance
which is due to the difference between the budgeted efficiency of production and the actual efficiency achieved.
This variance is related to the efficiency of workers and plant. The derivation may be expressed as:
Fixed Overhead Efficiency = Standard Rate per Unit × (Actual Production in Units
Variance – Standard Production in Units)
or
SR × (AU – SU)
Reporting of Variances
In order that variance reporting should be effective, it is essential that the following requisites are fulfilled:
1. The variances arising out of each factor should be correctly segregated. If any part of a variance due to one
factor is wrongly attributed to or merged with that of another, the report submitted to the management would
be misleading and wrong conclusions may be drawn from it.
2. Variances, particularly the controllable variances, should be reported with promptness as soon as they occur.
Mere operation of Standard Costing and reporting of variances is of no avail. The success of a Standard
Costing system depends on the extent of responsibility which the management assumes in correcting
the conditions which cause variances from standard. In order to assist the management in assuming this
responsibility, the variances should be reported frequently and on time. This would enable corrective action
being taken for future production while work is in progress and before the project or job is completed.
3. For effective control, the line of organisation should be properly defined and the authority and responsibility
of each individual should be laid down in clear terms. This will avoid ‘passing on the buck’ and shirking of
responsibility and will enable the tracing of the causes of variances to the appropriate levels of management.
4. In certain cases, a particular variance may be the joint responsibility of more than one individual or
department. It is obvious that if corrective action has to be effective in such cases, it should be taken jointly.
5. Analysis of uncontrollable variances should be made with the same care as for controllable variances.
Though a particular variance may not be controllable at the lower level of management, a detailed analysis
of the off-standard situation may reveal far reaching effects on the economy of the concern. This should

compel the top management to take corrective action, say, by changing the policy which gave rise to the
uncontrollable variance.
Forms of Variance Reports:

The forms of reports for the different types of variances should be designed keeping in view the needs of the
management and the size of the concern, and no standard forms are, therefore, suggested. Variance Analysis
Reports prepared for the top management would obviously be more formal and would contain broad details only,
while those meant for presentation to the lower levels would contain details showing the causes of each variance
and the specific responsibilities of the individuals concerned.
5.1.7 Activity Cost Variance Ratios

Although absolute monetary terms show the extent of the variances, the information is insufficient if the
management wants to study the trend of variances from period to period. Absolute figures in themselves do not
give the full picture and it is only by comparison of one item with another that their correct relationship is obtained.
Variance Ratios serve this need and comparison of these ratios from one period to another can be gainfully made.
Another advantage of Variance Ratio is in regard to its applicability in the dual plan of standard cost accounting.
With the help of the Cost Variance Ratios, standard costs of production and the standard values of inventory can be
easily converted into actual costs for the purpose of incorporation in the financial accounts.
A number of ratios are used for reporting to the management with respect to the effective use of capacity,
material, labour and other resources. Some of these are listed below:
1. Efficiency Ratio.
2. Activity Ratio.
3. Calendar Ratio.
4. Capacity Usage Ratio
5. Capacity Utilization Ratio.
6. Idle Time Ratio.
1. Efficiency Ratio: Efficiency ratio reveals the input-output relationship. Input is available in terms of hours
worked. Output is converted into standard hours to determine the relationship of input and output.
Efficiency Ratio = (Standard Hours ÷ Actual Hours) × 100

It is a very important ratio and it reveals the extent of efficiency or inefficiency of production during the related
period. The student should bear in mind that standard hour is the media of expressing output in terms of hours. It
can be referred to as a hypothetical hour which measures the amount of work which should be performed in one
hour according to standard.
2. Activity Ratio: Activity Ratio is the number of standard hours equivalent to the output produced, expressed
as a percentage of the budgeted standard hours.
Activity Ratio = (Standard Hours for Actual Work ÷ Budgeted

Standard Hours) × 100
The following three steps are involved in determining this ratio:
a. Actual output should be expressed in terms of standard hours.
b. Budgeted output should be expressed in standard hours.
c. Percentage relationship of (a) and (b) should be expressed.

This ratio highlights the actual level of activity in comparison to budgeted activity level. This ratio reveals
how effectively or ineffectively actual efforts were made in comparison to budgeted estimates.
3. Calendar Ratio: Calendar Ratio is the relationship between the number of working days in a period and the
number of working days in the relative budget period.
Calendar Ratio = (Actual Working Days ÷ Budgeted Working Days) × 100
Calendar ratio indicates whether all the budgeted working days in a budgeted period have been available in
actual practice. If the ratio is more than 100% actual working days are more than the budgeted working days
and vice versa.
4. Capacity Usage Ratio: Capacity Usage Ratio is the relationship between the budgeted number of working
hours and the maximum possible number of working hours in a budget period.
Capacity Usage Ratio = (Budgeted Hours ÷ Maximum Possible Hours in Budget) × 100
Capacity usage ratio indicates the extent to which the budgeted hours have actually been utilised.
1. Capacity Utilisation Ratio: It is the relationship between actual hours in a budget period and the budgeted
working hours in the period.
Capacity Utilisation Ratio = (Actual Hours ÷ Budgeted Hours) × 100
2. Idle Time ratio: It is the ratio of idle time hours to the total hours budgeted.
Idle Time ratio = (Idle Time Hours ÷ Budgeted Hours) × 100
Example 3
Product X takes 5 hours to make and Product Y requires 10 hours. In a month of 25 effective days of 8 hours
a day, 1,000 units of X and 600 units of Y were produced. The company employs 50 workers in the production
department, and the budgeted hours for the year are 102,000.
Required: Calculate the following control ratios:
(a) Efficiency ratio
(b) Activity ratio
(c) Capacity ratio
Answer
Standard Hours = (1000 units of X × 5 hours) + (600 units of Y × 10 hours)
= 5,000 + 6,000 = 11,000
Actual Hours = 25 days × 8 hours × 50 workers = 10,000
Budgeted Hours for the Month = (1,02,000 ÷12) = 8,500
(a) Efficiency Ratio
= (Standard Hours ÷ Actual Hours) × 100
= (11,000 ÷ 10,000) × 100 = 110%

(b) Activity Ratio

= (Standard Hours for Actual Work ÷ Budgeted Standard Hours) × 100
= (11,000 ÷ 8,500) × 100 = 129.41%
(c) Capacity Ratio = (Actual Hours ÷ Budgeted Hours) × 100
= (10,000 ÷ 8,500) = 117.65%
Observation: All the ratios are greater than 100%. The performance may be considered as better than the
benchmarks.
5.1.8 Standard Costing and Budgetary Control
Standard Costing: Standard Costing is a control technique that reports variances by comparing actual costs to
pre-set standards thereby facilitating action through management by exception. A standard is a stipulated norm,
something set up and established by an authority as a rule for the measure of quantity, weight, extent, value, or
quality. Standards are set based on predetermined physical inputs of materials, labour, machine hours, power and
other resources which should be consumed while manufacturing a product. Accordingly, standard costs stand for
predetermined costs; they are the target costs, which should be incurred under the normative operating conditions.
In standard costing system, the standard costs for the standard and the actual output for a particular period are
traced to the functional managers who are responsible for the various operations of a responsibility centre. The
actual costs for the same period are also traced to the same responsibility centre. The two costs, the standard and
the actual, are then compared and the variance between the two is analysed and reported to the cost controllers. The
designated controllers keep initiating corrective actions, wherever needed on a continuous basis. The system, thus,
facilitates not only concurrent monitoring, but as also concurrent control of costs whereby competitive advantage
is gained. In principle, Standard Costing is Engineered Costing.
Budgetary Control: Budgetary Control is the process that facilitates effective implementation of the budgets.
The process allows continuous monitoring of actual results versus budget, either to secure by individual action the
budget objectives or to provide a basis for budget revision. Budgetary control refers to how well managers utilize
budgets to monitor and control costs and operations in a given budget period. In other words, budgetary control is
a process for managers to set financial and performance goals with budgets, compare the actual results, and adjust
performance, as it is needed.
Budget Centres provide a convenient means to exercise control on budgets. Budget Centre is often a responsibility
centre where the manager has authority over, and responsibility for, defined costs and (possibly) revenues. Budgetary
Control is the process whereby Budgets enable in authorising expenditure, communicating objectives and plans,
controlling operations, co-coordinating activities, evaluating performance, planning and rewarding performance.
Often, reward systems involve comparison of the actual with the budgeted performance.
Budget aids the planning of actual operations by forcing managers to consider how the conditions might change
and what steps should be taken to prevent the problems before they arise. It also helps to co-ordinate the activities
of the organization by compelling managers to examine relationships between their own operations and those of
other departments.
Similarities: Both Standard Costing and Budgetary Control are based on the principle that costs can be controlled
along certain lines of supervision and responsibility and focus on controlling costs by comparing actual performance
with the predefined parameters. However, the two systems are neither similar nor interdependent. Standard
Costing delineates the variances between actual cost and the standard cost, along with the reasons. On the
contrary, Budgetary Control comprises the creation of budgets, then comparing the actual output with the budgeted

one and taking corrective action immediately. Similarity between Standard Costing and Budgetary Control
are as follows:
i. Both aim at the determination of cost in advance.
ii. For both of them predetermined benchmarks are fixed.
iii. In both of them actual costs are compared with the benchmarks.
iv. Both require periodic cost reports.
v. Both aim at the maximum efficiencies and managerial costs.
Key Differences: Similarities apart, Standard Costing and Budgetary Control differ in scope and technique. The
following are the major differences between standard costing and budgetary control:
1. Standard Costing is a cost accounting system, in which performance is measured by comparing the actual
and standard costs. Budgetary Control is a control system in which actual and budgeted results are compared
continuously in order to achieve the desired results.
2. Standard Costing has a restricted scope, limited to costs only, whereas Budgets are complete in as much as
they are framed for all the activities and functions of a concern such as production, purchase, selling and
distribution, research and development, capital utilisation, etc.
3. Standard costing is a unit concept whereas budgetary control is a total concept.
4. Budgets are the ceilings or limits of expenses above which the actual expenditure should not normally
rise; if it does, the planned profits will be reduced. Standards are minimum targets to be attained by actual
performance at specified efficiency.
5. A more searching analysis of the variances from standards is necessary than in the case of variations from
the budget.
6. Budgets are indices, adherence to which keeps a business out of difficulties. Standards are pointers to further
possible improvements.
7. Standard costs do not change due to short-term changes in the conditions, but budgeted costs may change.
8. A system of Budgetary Control may be operated even if no Standard Costing system is in use in the concern.
Assimilation: Accurate cost information is fundamental to budgeting. Companies that use accurate cost
management techniques and provide budget developers with ready access to cost information improve both the
accuracy and the speed of their budget process. Standardizing the cost management system entity-wide is an
important step in improving the link between cost management and budgeting. As such, Standard Costing facilitates
better budgetary control.
5.1.9 Application of Standard Costing and Budgetary Control in Profit Planning
Profit Planning
Profit is considered as a significant element of a business activity. According to Peter Drucker, “profit is a
condition of survival. It is the cost of the future, the cost of staying in a business.” Therefore, profit should be
planned and managed properly. An organization should plan profits by taking into consideration its capabilities and
resources. Profit planning lays foundation for the future income statement of the organization.
Profit Planning aims to set a profit objective for a budgeting period. Also, it seeks to establish the main policy
decisions regarding how to achieve the objectives. The profit objectives, in principle, reflect the expected return on
capital employed. In profit planning, alternatives are evaluated to select the most likely option that will yield the
required profit objective. Managers can plan their budgets on this basis.

There are several outputs that may be expected from any profit planning exercise. These include:
~~ Setting the profit objectives for the budget period
~~ Specifying the policy decisions and course of action to be followed during the budget period
~~ Providing planning directives for the preparation of detailed operating plans
The key factors that are considered in profit planning are:
●● Changes needed in volume, price, and cost
●● Availability of funds for investment
●● Capital expenditure proposals
●● Changes needed in the level of working capital
●● Limits on discretionary expenditure (e.g., research and development)
●● Return Required on Capital Employed
The end result of this process is a statement of the profit objective and how it is to be achieved. This statement
is the starting point for budgeting.
The steps involved in profit planning process may be stated as follows:
i. Establishing Profit Goals
ii. Determining Expected Sales Volume
iii. Estimating Expenses
iv. Determining Profit
Establishing Profit Goals: Implies that profit goals should be set in alignment with the strategic plans of the
organization. Moreover, the profit goals of an organization should be realistic in nature based on the capabilities
and resources of the organization.
Determining Expected Sales Volume: Constitutes the most important step of the
profit planning process. An organization needs to forecast its sales volume so that it can Establishing Profit
achieve its profit goals. The sales volume can be anticipated by taking into account the Goals
market and industry trends and performing competitive analysis.
Estimating Expenses: Requires that an organization needs to estimate its expenses
for the planned sales volume. Expenses can be determined from the past data. If an Determining Expected
organization is new, then the data of similar organization in same industry can be taken. Sales Volume
The expense forecasts should be adjusted to the economic conditions of the country.
Determining Profit: Helps in estimating the exact value of profit. Estimated profit is
calculated as excess projected income over projected expenses. Estimating
After planning the profit successfully, an organization needs to control profit. Profit Expenses
control involves measuring the gap between the estimated level and actual level of profit
achieved by an organization. If there is any deviation, the necessary corrective measures
are taken by the organization. Profit control, thus, involves continuous and concurrent
Determining
comparison of the actuals with the estimates and initiating timely corrective actions.
Profit
And this is where standard costing as also budgetary control fit in as important tools in
profit planning.

Advantages of Standard Costing:

Standard Costing can be used for projecting the profit level of the business at any level of production. It is quite
useful to the management in its functions of planning, controlling performance evaluation and decision making.
The advantages derived from a system of standard costing may be stated as:
1. Standard Costing system establishes yard-sticks against which the efficiency of actual performances is
measured.
2. The standards provide incentive and motivation to work with greater effort and vigilance for achieving the
standard performance. This increases efficiency and productivity all round.
3. At the very stage of setting the standards, simplification and standardisation of products, methods, and
operations are ensured and waste of time and materials is eliminated. This assists in managerial planning for
efficient operation and benefits all the divisions of the concern.
4. Costing procedure is simplified. There is a reduction in paper work in accounting and a smaller number of
forms and records are required.
5. Costs are available with promptitude for various purposes like fixation of selling prices, pricing of inter-
departmental transfers, ascertaining the value of costing stocks of work-in-progress and finished stock and
determining idle capacity.
6. Standard Costing is an exercise in planning - it can be very easily fitted into and used for budgetary planning.
7. Standard Costing system facilities delegation of authority and fixation of responsibility for each department
or individual. This also tones up the general organisation of the concern.
8. Variance analysis and reporting is based on the principles of management by exception. The top management
may not be interested in details of actual performance but only in the variances form the standards, so that
corrective measures may be taken in time. When constantly reviewed, the standards provide means for
achieving cost reduction.
9. Standard costs assist in performance analysis by providing ready means for preparation of information.
10. Production and pricing policies may be formulated in advance before production starts. This helps in prompt
decision-making.
11. Standard costing facilitates the integration of accounts so that reconciliation between cost accounts and
financial accounts may be eliminated.
12. Standard Costing optimizes the use of plant capacities, current assets and working capital.
Limitations of standard costing:

1. Establishment of standard costs is difficult in practice.
2. In course of time, sometimes even in a short period the standards become rigid.
3. Inaccurate, unreliable and out of date standards do more harm than benefit.
4. Sometimes, standards create adverse psychological effects. If the standard is set at high level, its non-
achievement would result in frustration and build-up of resistance.
5. Due to the play of random factors, variances cannot sometimes be properly explained, and it is difficult to
distinguish between controllable and non-controllable expenses.
6. Standard costing may not sometimes be suitable for some small concerns. Where production cannot be
carefully scheduled, frequent changes in production conditions result in variances. Detailed analysis of all of
which would be meaningless, superfluous and costly.

7. Standard costing may not, sometimes, be suitable and costly in the case of industries dealing with
non- standardized products and for repair jobs which keep on changing in accordance with customer’s
specifications.
8. Lack of interest in standard costing on the part of the management makes the system practically ineffective.
This limitation, of course, applies equally in the case of any other system which the management does not
accept wholeheartedly.
Budgets and Budgetary Control:
A budget is a profit plan reflecting anticipated financial inflows and outflows. Budgeting helps all sorts of entities
to plan and control their operations, and to support their managerial strategies. A budget sets out the benchmark
against which performance will be measured. The main purposes of budgeting may be summed up as aiding the
achievement of strategic plans by:
a. Translating the long-term plans into an annual workable budget;
b. Communicating the plans to those who will be held accountable;
c. Coordinating with the various departments of the organisation to ensure that they are working in harmony;
and
d. Controlling the performance by continuous monitoring of the actual results with the budget and initiating
timely corrective measures.
Put in a nut shell, the role of the budget is to give focus to an organisation, help the co-ordination of activities
and enable control.
Advantages of the Budgetary Control System:

1. The use of budgetary control system enables the management of a business concern to conduct its business
activities in the efficient manner.
2. It is a powerful instrument used by business houses for the control of their expenditure. It, in fact, provides
a yardstick for measuring and evaluating the performance of individuals and their departments.
3. It reveals the deviations to management, from the budgeted figures after making a comparison with actual
figures.
4. Effective utilization of various resources like-men, material, machinery and money is made possible, as the
production is planned after taking them into account.
5. It helps in the review of current trends and framing of future policies.
6. It creates suitable conditions for the implementation of standard costing system in a business organization.
7. It inculcates the feeling of cost consciousness among workers.
Limitations of the Budgetary Control System:

1. Estimates: Budgets may or may not be true, as they are based on estimates. The assumptions about future
events may or may not actually happen.
2. Rigidity: Budgets are considered as rigid documents. Too much emphasis on budgets may affect day-today
operations and ignores the dynamic state of organizational functioning.
3. False Sense of Security: Mere budgeting cannot lead to profitability. Budgets cannot be executed
automatically. It may create a false sense of security that everything has been taken care of in the budgets.
4. Lack of co-ordination: Staff co-operation is usually not available during Budgetary Control exercise.

5. Time and Cost: The introduction and implementation of the system may be expensive.
Assimilation: Both standard costing and budgetary control aim at the objective of maximum efficiency and
managerial control.
5.1.10 Reconciliation of Actual Profit with Standard Profit and /or Budgeted Profit
Profit
Profit reflects the financial gains wherein benefits derived from a business activity exceed the costs. Profit,
therefore, is considered as the bottom-line for every entrepreneurial activity. Actual profit reflects the actual
accruals, budgeted profit reflects the budgeted accruals and the standard profit refers to the normative accruals.
There could be multiple reasons for actual profit being different from the budgeted or standard profit. Some of
the reasons may be listed as:
i. Differences between actual and expected units of sales
ii. Differences between actual and expected product pricing
iii. Changes in the cost of materials
iv. Changes in labour costs
v. Changes in the amount of overhead costs incurred
vi. Changes in the amount of scrap and wastages
vii. And so on.
Profit Variance: Profit Variance is the difference between planned, budgeted or standard profit vis-à-vis the
actual profit attained. In practical usage it represents the
difference between budgeted profit and actual profit.
Profit Variance can be subdivided into Profit Price Variance
and Profit Volume Variance. (Budgetted Profit)
Profit
-
Profit Price Variance: Profit Price Variance is Variance
(Actual Profit)
calculated with reference to the turnover. It represents the
difference of standard and actual profit on actual volume
of sales. The formula is:
Profit Price Variance = (Actual Quantity Sold) × (Actual Profit per Unit - Standard Profit per Unit)
Profit Volume Variance: Profit Volume Variance denotes the difference between the standard quantity of the
output vis-à-vis the actual quantity, both at standard price. The profit at the standard rate on the difference between
the standard and the actual volume of sales would be the amount of volume variance. The formula is:
Profit Volume Variance = (Budgeted Profit – Standard profit)

= (Standard Rate of Profit) × (Budgeted Quantity - Actual Quantity)
Profit Volume Variance can be subdivided into Mix Variance and Quantity Variance.
Profit Volume Mix Variance: When more than one product is manufactured and sold, the difference in profit can
result because of the variation of actual mix and budgeted mix of sales. The difference between revised standard
profit and the standard profit is the mix variance. The formula is:
Profit Volume Mix Variance = Revised Standard Profit – Standard Profit

Profit Volume Quantity Variance: It results from the variation in profit because of difference in actual quantities
sold and the budgeted quantities both taken in the same ratio. The actual quantities are to be revised in the ratio of
standard mixture. The formula is:
Profit Volume Quantity Variance = Budgeted Profit – Revised Standard Profit
Reconciliation
Reconciliation refers to the action of making one view or belief compatible with another. The purpose of
calculating variances is to identify the diverse reasons for the deviations and to analyse the effect of each item
of cost or income on actual profit in comparison to the expected profit. Reconciliation of actual profit with the
standard or budgeted profit, therefore, throws of the causes of variance and facilitates corrective steps.
Illustration 4
In a company operating on a standard costing system for a given four-week period budgeted sales of 10,000 units
at ` 50 per unit, actual sales were 9,000 units at ` 51.25 per unit. Costs relating to that period were as follows:
Standard (`) Actuals (`)

Materials 2,50,000 2,57,400
Wages 75,000 70,875
Fixed Overheads 20,000 18,810
Variable Overheads 10,000 9,250
Semi-Variable Overheads 2,700 2430

Standard Hours 50,000
Actual Hours 40,500
●● The Standard material content of each unit is estimated at 25 kg. at ` 1 per kg, actual figures were 26 kg at
` 1.10 per kg.
●● Semi-variable Overhead consists of FIVE - NINTHS fixed expenses and FOUR - NINTHS variable.
●● The Standard wages per unit are 5 hours at ` 1.50, per Unit actual wages were 4.5 hours at ` 1.75.
●● There were no opening stocks and the whole production for the period was sold.
●● The four-week period was normal period.
You are required:
(a) To compute the variances in Sales, Materials, Labour and Over heads due to all possible causes; and
(b) With the help of such a computation draw a statement reconciling the actual profit for the period with the
standard profit.
Answer
Step 1: Segregation of Overheads
Element Budget (`) Actual (`)

Fixed Overhead 20,000 18,810

Element Budget (`) Actual (`)

Share in Semi-Variable Overheads (5/9) 1,500 1,350
Total of Fixed Overheads 21,500 20,160
Variable Overheads 10,000 9,250
Share in Semi-Variable Overheads (4/9) 1,200 1,080
Total of Variable Overheads 11,200 10,330
Step 2: Computation of Variances:

(i) Sales Variances
(1) (2) (3)

AQAP AQSP SQSP
9000 × 51.25 9000 × 50 10000 × 50
` 4,61,250 ` 4,50,000 ` 5,00,000
AQAP = Actual value of sales = ` 4,61,250

AQSP = Actual sales at standard price = ` 4,50,000
SQSP = Standard value of sales = ` 5,00,000
(a) Sales Volume Variance = (AQSP - SQSP) = 50000 (A)
(b) Sales Price Variance = (AQAP – AQSP) =11250 (F)
(c) Sales Value Variance = (AQAP – SQSP) = 38750 (A)
(ii) Material Variances
AQ = 9000 × 26 = 234000
SQ = 9000 × 25 = 225000
(1) (2) (3)

SQSP AQSP AQAP
225000 × 1 234000 × 1 234000 × 1.1
2,25,000 2,34,000 2,57,400
SQSP = Standard cost of standard material = ` 225000

AQSP = Standard cost of actual material = ` 234000
AQAP = Actual cost of material = ` 257400
(a) Material Price Variance = (AQSP – AQAP) = 23400 (A)
(b) Material Usage Variance = (SQSP – AQSP) = 9000 (A)
(c) Material Cost Variance = (SQSP – AQAP) = 32400 (A)

(iii) Labour Variances

SH = 9000 units × 5 hours per unit= 45000
AH = ` 70,875 ÷ 1.75 per hour = 40,500
(1) (2) (3)

SRSH SRAH ARAH
1.5 × 45000 1.5 × 40500 1.75 × 40500
` 67500 ` 60750 ` 70875
SRSH = Standard cost of standard labour = ` 67500

SRAH = Standard cost of actual labour = ` 60750
ARAH = Actual cost of labour = ` 70875
(a) Labour Efficiency Variance = (SRSH – SRAH) = ` 6750 (F)
(b) Labour Rate Variance = (SRAH - ARAH) = ` 10125 (A)
(c) Labour Cost Variance = (SRSH - ARAH) = ` 3375 (A)
(iv) Variable Overhead Variances

SR = 11200 ÷ 50000 = ` 0.224
(1) (2) (3)

SRSH SRAH ARAH
0.224 × 45000 0.224 × 40500 10330
` 10080 ` 9072 ` 10330
SRSH = Standard cost of standard variable overheads = ` 10080

SRAH = Standard cost of actual variable overheads = ` 9072
ARAH = Actual cost of variable overheads = ` 10330
(a) Variable Overheads Efficiency Variance = (SRSH – SRAH) = ` 1008 (F)
(b) Variable Overheads Budget Variance = (SRAH – ARAH) = ` 1258 (A)
(c) Variable Overheads Cost Variance = (SRSH – ARAH) = ` 250 (A)
(v) Fixed Overhead Variances

SR = 21500 ÷ 50000 = ` 0.43
(1) (2) (3) (4)

SRSH SRAH SRBH ARAH
0.43 × 45000 0.43 × 40500 0.43 × 50000
` 19350 ` 17415 ` 21500 ` 20160
SRSH = Standard cost of standard fixed overheads = ` 19350

SRAH = Standard cost of actual fixed overheads = ` 17415

SRBH = Budgeted fixed overheads = ` 21500
ARAH = Actual fixed overheads = ` 20160
(a) Fixed Overheads Efficiency Variance = (SRSH – SRAH) = ` 1935 (F)
(b) Fixed Overheads Capacity Variance = (SRAH - SRBH) = ` 4085 (A)
(c) Fixed Overheads Volume Variance = (SRSH – SRBH) = ` 2150 (A)
(d) Fixed Overheads Budget Variance = (SRBH – ARAH) = ` 1340 (F)
(e) Fixed Overheads Cost Variance = (SRSH – ARAH) = ` 810 (A)
Step 3: Reconciliation
(i) Statement of Profit
Amount (`)
Serial Particulars Standard for
Budget Actual
Actual Quantity
A Sales
1. Number of Units 10,000 9,000 9,000
2. Selling Price per Unit 50.00 50.00 51.25
3. Value of Sales 5,00,000 4,50,000 4,61,250
B Costs
1. Material 2,50,000 2,25,000 2,57,400
2. Wages 75,000 67500 70,875
3. Variable Overheads 10,000 9,000 9,250
4. Semi-Variable Overheads 2,700 2,430 2,430
5. Fixed Overheads 20,000 18,000 18,810
6. Total Cost 3,57,700 3,21,930 3,58,765
C Profit (A – B) 1,42,300 1,28,070 1,02,485
Notes: Standard costs for actual quantity of sales (at actual price) have been calculated in the ratio of
9,000 to 10,000.
(ii) Statement showing reconciliation of Budgeted Profit, Standard Profit and Actual Profit
Element ` `
Budgeted Sales 5,00,000

Budgeted Costs 3,57,700
Budgeted Profit 1,42,300
(-) Sales Volume Variance (50,000)

Element ` `
(+) Diff. in Budgeted Costs & Standard Costs for Actual Quantity 35,770 (16,380)
Standard Profit for Actual Quantity 1,28,070
Add: Favourable Variances
Sales Price Variance 11,250
Labour Efficiency variance 6,750
Variable Overhead Efficiency Variance 1,008
Fixed Overhead Efficiency Variance 1,935
Fixed Overhead Budget Variance 1,340 22,283
Less: Adverse Variances
Material Usage Variance 9,000
Material Price Variance 23,400
Labour Rate Variance 10,125
Variable Overhead Budget Variance 1,258
Fixed Overhead Capacity Variance 4,085 47,868
Actual Profit 1,02,485
Take-home Pack: The illustration clearly demonstrates the multiple reasons that could lead to variances between
the budgets, standards and actuals. The reconciliation serves as a tool whereby efforts can be focused on the areas
that warrant attention. Variance Analysis is a concept of ‘Management by Exception’. The kinds and sorts of
variances discussed in this module are conceptual in nature. Scope always does exist to carve out one more type of
variance that would serve one more need. In the ultimate, it is the wisdom of decision makers that ensures effective
application.
Overview of Variances with Formulae
VARIANCES
Variable Fixed
Material Cost Labour Cost Sales Profit
Overhead Overhead
Variance Variance Variance Variance
Variance Variance

Material Mix Variance

SP × (RSQ - AQ)
Material Usage Variance
SP × (SQ - AQ)
Material Yield/Sub-Usage
Material Cost Variance
Variance
(SQ × SP) - (AQ × AP) SR × (SY - AY)
Material Price Variance
AQ × (SP - AP)
Labour Yield Variance

SR × (SH - SRH)
Labour Efficiency Labour Mix / Gang

Variance Variance
SR × (SH - AH SR × (RSH - AH)
Labour Cost Variance
(SH × SR) - (AH × AR)
Labour Rate Variance Idle Time Variance
AH × (SR - AR) Idle Time × SR/Hr.
Variable Overhead Variance

(AU × SR) - AVO
Variable Overhead Efficiency Variance Variable Overhead Expenditure Variance

SR × (SU for Actual Production - AU) AU × (SR - AR)

Fixed Overhead
Efficiency Variance
SR × (Standard Units
for Actual Production -
Actual Units)
Fixed Overhead Volume Fixed Overhead Capacity

Variance Variance
Fixed Overhead Variance SR × (SU - AU) SR × (AU - BU)
(Absorbed Overheads) -
(Actual Overheads)
(SR × SU) - (AR × AU) Fixed Overhead
Fixed Overhead Calender
Expenditure Variance
Variance
AU × (SR - AR)
(Standard Rate per Hour)
× (Excess or Deficit Hours)
Sales Price Variance

AQ × (SP - AP)
Sales Variance Sales Sub-Volume Variance
(Budgeted Sales - Actual SP × (SQ - RSQ)
Sales)
Sales Volume Variance
SP × (BQ - AQ)
Sales Mix Variance
SP × (RSQ - AQ)
Profit Variance due to

Selling Price
AQ × (SP - AP)
Profit Variance Profit Mix Variance
(Budgeted Profit - Actual SP × (AQ - RSQ)
Profit)
Profit Variance due to
Sales Volume
SP × (BQ - AQ)
Profit Sub-Volume
Variance
SP × (RSQ - SQ)

Illustration 5
S.V.Ltd. manufactures BXE by mixing three raw materials. For every batch of 100Kg. of BXE, 125 Kg. of
raw materials are used. In April 2021, 60 batches were prepared to produce an output of 5,600 Kg. of BXE. The
standard and actual particulars for April 2021 are as under:
Standard Actual
Price per Quantity of raw
Raw material Mix % Price per kg Mix %
kg materials purchased kg
A 50 20 60 21 5,000
B 30 10 20 8 2,000
C 20 5 20 6 1,200
Calculate relevant material variances.
Answer
Standard Production = (60 batches ×100 units per batch) = 6,000 units
Standard Raw Material for 6,000 units = (60 batches ×125 kg) = 7,500 kg
Standard Loss = (7,500 - 6,000) = 1,500 kg
Actual Production = 5,600 units
Standard Mix for 60 batches (i.e., 6,000 units)
Raw Material Mix (%) Quantity (Kg) Price (`) Value (`)
A 50 3,750 20 75,000
B 30 2,250 10 22,500
C 20 1,500 5 7,500
Total 7,500 1,05,000
Standard Loss @ 25 kg per batch 60 × 25 = 1,500
Production 6,000 1,05,000
Standard Mix for Actual Production of 5,600 units
Standard Price
Raw Material Mix (%) Quantity (Kg) Value (`)
(`)
A 50 3,500 20 70,000
B 30 2,100 10 21,000
C 20 1,400 5 7,000
Total 7,000 98,000

Actual Mix for 5,600 units
Raw Mix (%) Quantity Standard Actual Standard Actual Value

Material (Kg) Price (`) Price (`) Value (`) (`)
A 60 4,500 20 21 90,000 94,500
B 20 1,500 10 8 15,000 12,000
C 20 1,500 5 6 7,500 9,000
Total 7,500 1,12,500 1,15,500
Actual Loss = 7,500 – 5600 1,900
Production 5,600 1,12,500 1,15,500
Note: Purchased quantity is 8,200 kg; but consumed quantity is only 7,500 kg.
Material Cost Variance = Standard Cost – Actual Cost
= 98,000 – 1,15,500 = ` 17,500 (A)
Material Price Variance = AQ (SP-AP) = (1,12,500 - 1,15,500) = ` 3,000 (A)
Material Yield Variance = (Standard Price of Standard Mix for Actual Production
– Standard Price of Standard Mix for Standard Production)
= (98,000 – 1,05,000) = ` 7,000 (A)
Material Mix Variance = Standard Price of Standard Mix for Standard Production – Standard Price of Actual
Mix for Actual Production
= (1,05,000 – 1,12,500) = ` 7,500 (A)
Illustration 6
A brass foundry making castings which are transferred to the machine shop of the company at standards in regard
to material stocks which are kept at standard price are as follows:
Standard Mixture 70% Material C; 30% Material Z
Standard Price Material C ` 2,400 per ton; Material Z ` 650 per ton
Standard loss in melting 5% of input
Figures in respect of a costing period are as follows:
Commencing stocks Material C 100 tons

Material Z 60 tons
Finishing stocks Material C 110 tons
Material Z 50 tons
Purchases Material C 300 tons Cost ` 7,32,500

Material Z 100 tons Cost ` 62,500

Metal melted 400 tons
Casting produced 375 tons
Present figures showing: Material Price, Mixture, and Yield Variance.
Answer
Material C Material Z
Description
Quantity Value Quantity Value
Opening Stock at Standard Price 100 240000 60 39000
(+) Purchases (Actuals) 300 732500 100 62500
400 972500 160 101500
(-) Closing Stock (Standard Price) 110 264000 50 32500
Consumption 290 708500 110 69000
Standard Actual
Qty. Price Value Qty. Price Value
Material C 280 2400 672000 290 708500
Material Z 120 650 78000 110 69000
400 750000 400 777500
(-) Standard Loss @ 5% 20 25
380 750000 375 777500
Standard Mix for Actual Production of 375 tons

Standard Consumption = (400 ÷ 380) × 375 = 394.737 tons
Standard Price
Raw Material Mix (%) Quantity (Tons) Value (`)
(`)
Material C 70 276.316 2400 6,63,158
Material Z 30 118.421 650 76,974
Total 394.736 7,40,132
SQSP = ` 7,40,132
RSQSP = ` 7,50,000
AQSP = 7,67,500
AQAP = (7,08,500 + 69,000) = 7,77,500

Material Price Variance = (AQSP – AQAP) = (7,67,500 – 7,77,500) = ` 10,000 (A)

Material Mix Variance= (RSQSP – AQSP) = (7,50,000 – 7,67,500) = 17500 (A)
Material Yield Variance = (SQSP – RSQSP) = (7,40,132 – 7,50,000) = 9868 (A)
Illustration 7
A company manufacturing a special type of fencing tile 12” × 8” × 1/2” used a system of standard costing. The
standard mix of the compound used for making the tiles is:
1,200 kg. of material A @ ` 0.30 per kg.
500 kg. of Material B @ ` 0.60 per kg
800 kg. of Material C @ ` 0.70 per kg
The compound should produce 12,000 square feet of tiles of 1/2” thickness. During a period in which 1,00,000
tiles of the standard size were produced, the material usage was:-
Kg `
7,000 Material A @ ` 0.32 per kg. 2,240

3,000 Material B @ ` 0.65 per kg. 1,950
5,000 Material C @ ` 0.75 per kg. 3,750
15,000 7,940
Present the cost figures for the period showing Material price, Mixture, Sub-usage Variance.
Answer
Step (i): Number of tiles for 12,000 sq ft.
Area of one tile =12” × 8” = 96” = (96÷144) sq ft = 2/3 sq ft
Number of tiles that can be laid in 12000 sq ft is {12000 ÷ (2/3)} = 18000
Step (ii): Standard and Actual Material for 1,00,000 tiles
Standard Data Actual Data

Material
Quantity Price Value Quantity Price Value
A (1200 ÷ 18,000) × 1,00,000 0.30 2,000 7,000 0.32 2,240
= 6,666.67
B (500 ÷ 18,000) × 1,00,000 0.60 1,667 3,000 0.65 1,950
= 2,777.77
C (800 ÷ 18,000) × 1,00,000 0.70 3,111 5,000 0.75 3,750
= 4,444.44
Total 13,888.89 6,778 15,000 7,940

Step (iii): Revised Standard quantities (RSQ) for 1,00,000 tiles

RSQ for A = (15000÷13888.89) × 6666. 67 = 7200
RSQ for B = (15000÷13888.89) × 2777.77 = 3000
RSQ for C = (15000÷13888.89) × 4444.44 = 4800
Step (iv): Analysis of Computed Data
Material SQSP RSQSP AQSP AQAP

A 7,200 × 0.3 = 2,160 7,000 × 0.3 = 2,100
B 3,000 × 0.6 = 1,800 3,000 × 0.6 = 1,800
C 4,800 × 0.7 = 3,360 5,000 × 0.7 = 3,500
Total 6,778 7,320 7,400 7,940
Step (v): Computation of Variances

a. Material Sub-Usage Variance = (SQSP – RSQSP) = (6778 - 7320) = ` 542(A)
b. Material Mix Variance = (RSQSP – AQSP) = (7320 - 7400) = ` 80(A)
c. Material Usage Variance = (SQSP – AQSP) = (6778 - 7400) = ` 622(A)
d. Material Price Variance = (AQSP-AQAP) = (7400 - 7940) = ` 540(A)
e. Material Cost Variance = (SQSP – AQAP) = (6778 – 7940) = ` 1162(A)
Check:
Material Usage Variance = (Material Sub-Usage Variance + Material Mix Variance)
i.e., 622(A) = 542(A)+ 80(A)
i.e., 1162(A) = 622(A) + 540(A)
Illustration 8
One kilogram of product ‘K’ requires two chemicals A and B. The following were the details of product ‘K’ for
the month of June, 2021:
Standard mix Chemical ‘A’ 50% and Chemical ‘B’ 50%
Standard price per kilogram of Chemical ‘A’ ` 12 and Chemical ‘B’ ` 15
Actual input of Chemical ‘B’ 70 kilograms.
Actual price per kilogram of Chemical ‘A’ ` 15
Standard normal loss 10% of total input.
Materials Cost variance total ` 650 adverse.
Materials Yield variance total ` 135 adverse.

You are required to calculate:

Materials mix variance total
Materials usage Variance total
Materials price variance total
Actual loss of actual input
Actual input of chemical ‘A’
Actual price per kilogram of Chemical ‘B’
Answer
Let, actual input of chemical A be ‘a’ kgs
Actual price per Kg of chemical B be ` ‘b’
Standard input be 100Kgs
Actual output be 90Kgs
Standard Actual
Qty. Price Value Qty. Price Value
A 50 12 600 a 15 15a
B 50 15 750 70 b 70b
100 1350 70 + a 15a + 70b
(-) normal loss 10 -- -- (70 + a) -90 -- --
= a -20
90 1350 90 15a + 70b
(1) (2) (3) (4)
SQSP RSQSP AQSP AQAP
A 12 × (70 + a) × 50% 12 × a
= 420 + 6a
B 15 × (70 + a) × 50% 15 × 70
= 525 +7.5a
1350 945 + 13.5a 1050 + 12a 15a + 70b
Given Material Cost Variance

= (SQSP – AQAP) = [1350 – (15a + 70b)] = - 650
1350 -15a – 70b = -650
2000 = 15a +70b
15a + 70b = 2000

Given Material Yield Variance

= (SQSP – RSQSP = - 135
1350 – (945 +13.5a) = -135
405-13.5a = -135
540 = 13.5a
a = 40
15 a + 70 b = 2000
70 b = 2000 – 600 = 1400
b = 20
We, thus, have: a = 40 and b = 20
SQSP = ` 1350
RSQSP = 945 + (13.5 × 40) = ` 1485
AQSP = 1050 + (12 × 40) = ` 1530
AQAP = (15 × 40) + (70 × 20) = ` 2000
Material Mix Variance = (RSQSP- AQSP) = (1485 – 1530) = ` 45 (A)

Material Usage Variance = (SQSP- AQSP) = (1350 – 1530) = ` 180 (A)
Material Price Variance = (AQSP – AQAP) = (1530 – 2000) = ` 470 (A)
Actual loss of actual input = 20 Kgs

Actual input of chemical A = 40Kgs
Actual price per Kgs of chemical B = ` 20
Illustration 9
The standard labour component and the actual labour engaged in a week for a job are as under:
Skilled Semi-skilled Unskilled

Particulars
workers workers workers
Standard no. of workers in a gang 32 12 6
Standard wage rate per hour (`) 3 2 1
Actual no. of workers employed in the gang 28 18 4
during the week
Actual wage rate per hour (`) 4 3 2

During the 40-hour working week the gang produced 1800 standard labour hours of work. Calculate Labour
efficiency variance, Mix variance, wage rate variance and labour cost variance.
Answer
Step (i); Analysis of Given Data
Standard Data Actual Data

Particulars
Hours Rate Value Hours Rate Value
Skilled 32 × 40 = 1280 3 3840 28 × 40 = 1120 4 4480
Semi-Skilled 12 × 40 = 480 2 960 18 × 40 = 720 3 2160
Unskilled 6 × 40 = 240 1 240 4 × 40 = 160 2 320
Total 2000 5040 2000 6960
Step (ii): Computation of Standard Hours
Being given that during the 40-hour working week the gang produced 1800 standard labour hours of work (as
against revised hours of 2000), we may find out the standard hours by adopting the formula:
Standard Hours (SH) =

( Standard Hours
Total Std. Hrs (× Standard Hours for the Category
1800
SH for Skilled Workers = × 1280 = 1152
2000
1800
SH for Semi-Skilled Workers = × 480 = 432
2000
1800
SH for Unskilled Workers = × 240 = 216
2000
Step (iii): Analysis of Computed Data
Particulars SRSH SRRSH SRAH ARAH

Skilled 3 × 1152 = 3456 3 × 1280 = 3840 3 × 1120 = 3360 4 × 1120 = 4480
Semi-Skilled 2 × 432 = 864 2 × 480 = 960 2 × 720 = 1440 3 × 720 = 2160
Unskilled 1 × 216 = 216 1 × 240 = 240 1 × 160 = 160 2 × 160 = 320
Total 4536 5040 4960 6960
Step (iv): Computation of Variances
Labour Mix Variance = (SRRSH – SRAH) = 5040 - 4960 = ` 80 (F)
Labour Efficiency Variance = (SRSH – SRAH) = (4536 – 4960) = ` 424 (A)
Labour Rate Variance = (SRAH – ARAH) = 4960 – 6960 = ` 2000 (A)
Labour Cost Variance = (SRSH – ARAH) = 4536 – 6960 = ` 2424 (A)

Illustration 10
DM is a denim brand specializing in the manufacture and sale of hand-stitched jeans trousers. DM manufactured
and sold 10,000 pairs of jeans during a period. Information relating to the direct labour cost and production time
per unit is as follows:
Actual Hours Standard Hours Actual Rate Standard Rate

Per Unit Per Unit Per Hour Per Hour
Direct Labour 0.65 0.60 ` 120 ` 100
During the period, 800 hours of idle time was incurred. In order to motivate and retain experienced workers, DM
has devised a policy of paying workers the full hourly rate in case of any idle time. Find out:
(a) Idle Time Variance
(b) Labour Efficiency Variance
Answer
(a) Idle Time Variance:
Idle time variance = number of idle hours × standard rate
= 800 hours × Rs100 = ` 80,000 (A)
(b) Labour Efficiency Variance:

Total Hours = 10,000 units × 0.65 hours per unit = 6,500 hours.
Actual Hours (Active) = 6,500 hours - 800 idle hours = 5,700 hours.
Standard Hours = 10,000 units × 0.60 hours per unit = 6,000 hours.
Labour Efficiency Variance = Standard Rate × (Standard Hours – Actual Hours)
= (6,000 – 5700) × 100 = ` 30,000 (F)
Illustration 11
Calculate material and labour variances from the following:
Standard Actual
Input Material ` /Kg Total Input ` /Kg Total
400 A @ 50 20,000 420 @ 45 18,900
200 B @20 4,000 240 @ 25 6,000
100 C @15 1,500 90 @15 1,350
700 25,500 750 26,250
Labour Hours Labour Hours

100 @ ` 20 Per hour 2000 120 Hrs. @ ` 25 3000
200 Women @ ` 15 3000 5000 240 Women @ ` 16 3840 6840

Labour Hours Labour Hours

25 Normal Loss 75 Actual Loss
675 30,500 675 33,090
Answer
Calculation of Material Variances:
RSQ for
A = (400 ÷ 700) × 750 = 428.57
B = (200 ÷700) × 750 = 214.29
C = (100÷700) × 750 = 107.14
SQSP RSQSP AQSP AQAP

A 428.57 × 50 = 21429 420 × 50 = 21000
B 214.29 × 20 = 4286 240 × 20 = 4800
C 107.14 × 15 = 1607 90 × 15 = 1350
` 25500 ` 27322 ` 27150 ` 26250
SQSP = Standard Cost of Standard Material = ` 25,500

RSQSP = Revised Standard Cost of Material = ` 27,325
AQSP = Standard Cost of Actual Material = ` 27,150
AQAP = Actual Cost of Material = ` 26,250
Material Yield Variance = (SQSP - RSQSP) = (25,500 – 27,322) = ` 1822 (A)
Material Mix Variance = (RSQSP - AQSP) = (27,322 – 27,150) = ` 172 (F)
Material Usage Variance = (SQSP - AQSP) = (25,500 - 27,150) = ` 1650 (A)
Material Price Variance = (AQSP – AQAP) = (27,150 - 26,250) = ` 900 (F)
Material Cost Variance = (SQSP – AQAP) = (25,500 - 26,250) = ` 750 (A)
Check
Material Usage Variance = (Material Yield Variance + Material Mix Variance)
= [1822 (A) + 172 (F)] = ` 1650 (A)
= [(1650 (A) + 900 (F)] = ` 750 (A)
Calculation of Labour Variances:
RSH for
Men = 100 ÷ 700 × 750 = 107.14
Women = 200 ÷ 700 × 750 = 214.28

SRSH SRRSH SRAH ARAH

Men 20 × 107.14 = 2143 20 × 120 = 2400
Women 15 × 214.28= 3214 15 × 240 = 3600
` 5000 ` 5357 ` 6000 ` 6840
SRSH = Standard Cost of Standard Labour = ` 5000

SRRSH = Revised Standard Cost of Labour = ` 5357
SRAH = Standard Cost of Actual Labour = ` 6000
ARAH = Actual Cost of Labour = ` 6840
Labour Yield Variance = (SRSH - SRRSH) = (5000 -5357) = ` 357 (A)

Labour Mix variance = (SRRSH - SRAH) = (5357 – 6000) = ` 643 (A)
Labour Efficiency Variance = (SRSH - SRAH) = (5000 – 6000) = ` 1000 (A)
Labour Rate Variance = (SRAH - ARAH) = (6000 – 6840) = ` 840 (A)
Labour Cost Variance = (SRSH - ARAH) = (5000 – 6840) = ` 1840 (A)
Check
Labour Efficiency Variance = (Labour Yield Variance + Labour Mix Variance)
= [357 (A) + 634 (A)] = ` 1000 (A)
Labour Cost Variance = (Labour Efficiency Variance + Labour Rate Variance)
= [(1000 (A) + 840 (A)] = ` 1840 (A)
Illustration 12
Item Budget Actual
No. of working days 20 22
Output per man hour 1.0 Units 0.9 Units
Overhead cost ` 1,60,000 ` 1,68,000
Man-hours per day 8,000 8,400

Calculate Overhead Variances.
Answer
Step1: Computations
SR = Budgeted FOH ÷ Budgeted Hours
= 160000 ÷ (20 working days × 8000 man hours)
= 160000 ÷ 160000 = 1

RBH = (22 working days × 8000 man hours) = 176000

AH = (22 working days × 8400 man hours) = 184800
AQ = 184800 × 0.9 = 166320
SH = (AQ ÷ Units per hour) = (166320 ÷ 1unit per hour) = 166320
(1) (2) (3) (4) (5)

SRSH SRAH SRRBH SRBH ARAH
1 × 166320 1 × 184800 1 × 176000
` 166320 ` 184800 ` 176000 ` 160000 ` 168000
SRSH = Standard Cost of Standard Fixed Overheads = ` 1,66,320

SRAH = Standard Cost of Actual Fixed Overheads (or)
Fixed Overheads absorbed or recovered = ` 1,84,800
SRRBH = Revised budgeted Fixed overheads = ` 1,76,000
SRBH = Budgeted Fixed overheads = ` 1,60,000
ARAH = Actual Fixed Overheads = ` 1,68,000
Step2: Computations
FOH Efficiency Variance = (SRSH – SRAH) = (166320 – 184800) = ` 18480(A)
FOH Capacity Variance = (SRAH – SRRBH) = (184800 – 176000) = ` 8800(F)
FOH Calendar Variance = (SRRBH- SRBH) = (176000 – 160000) = ` 16000(F)
FOH Volume Variance = (SRSH – SRBH) = (166320 – 160000) = ` 6320(F)
FOH Budget Variance = (SRBH – ARAH) = (160000 – 168000) = ` 8000(A)
FOH Cost Variance = (SRSH – ARAH) = (166320 – 168000) = ` 1680(A)
Illustration 13
X uses traditional standard costing system. The inspection and setup costs are actually ` 1,760 against a budget of
` 2,000. ABC system is being implemented and accordingly, the number of batches is identified as the cost driver
for inspection and setup costs. The budgeted production is 10,000 units in batches of 1,000 units, whereas actually,
8,800 units were produced in 11 batches.
a. Find the volume and total fixed overhead variance under the traditional standard costing system.
b. Find total fixed overhead cost variance under the ABC system.
Answer
(a) Calculation of volume and total fixed overhead variances under Traditional Standard Costing System
Budgeted overhead cost per unit = ` 2,000 ÷ 10,000 units = ` 0.20
Actual overhead cost per unit = ` 1,760 ÷ 8,800 units = ` 0.20
Total fixed overhead variance = Absorbed budgeted overhead - Actual overhead
= (` 0.20 × 8,800 units) – ` 1,760 = Nil

Fixed overhead expenditure variance = Budgeted overhead - Actual overhead

= 2,000 – 1,760 = 240(F)
Fixed overhead volume variance = {(Standard absorption rate) × (Budgeted units - Actual units)}
= {` 0.20 × (10,000 units - 8,800 units)} = ` 240(A)
Check
Total fixed overhead variance = (Expenditure Variance + Volume Variance)
= 240(F) + 240(A) = Nil
(b) Calculation of fixed overhead cost variance under ABC System
Under ABC 8,800 units should have been produced in standard batch size of 1,000 units per batch, i.e. 9
batches. Further, under ABC, variability is to be considered with respect to batches and not units
Budgeted cost per batch = ` 2,000 ÷ 10 batches = ` 200/-
Absorbed overheads under ABC = (Budgeted cost per batch × ABC standard number of batches)
= 200 × 9 = ` 1,800
Overhead Cost Variance = Absorbed overheads – Actual Overheads
= (1800-1760) = 40(F)
Illustration 14
Compute the missing data indicated by the Question marks from the following.
Product ‘R’ Product ‘S’

Sales quantity
Std.(units) ? 400
Actual (Units) 500 ?
Price (Unit)
Standard ` 12 ` 15
Actual ` 15 ` 20
Sales price variance ? ?

Sales volume variance ` 1,200 F ?
Sales value variance ? ?
Sales mix variance for both the products together was ` 450 F. ‘F’ denotes Favorable.
Answer
Let the standard units of product R be r
Actual units of product S be s
Standard Actual
R R 12 12r 500 15 7500

Standard Actual
S 400 15 6000 s 20 20s
400 + r 6000 + 12r 500 + s 7500 + 20s
Given sales volume variance for R = ` 1200(F)
i.e., AQSP –SQSP = ` 1200
[(500 × 12) - 12 r] = 1200 or 6000 - 12r = 1200
r = ` 400
AQSP RSQSP
R 12 × 500 12 × {(500+s)/(400+r)} × 400 = 3000 + s
S 15 × s 15 × {(500+s)/(400+r)} × 400 = 3750 +s
6000 + 15s 6750 + 13.5s
Given, Sales Mix Variance = (AQSP – RSQSP) = ` 450(F)
(6000 + 15s – 6750 -13.5s) = 450
-750 +1.5 s = 450
Then s = 800
We, thus, have
Standard units of product R, r = ` 400
Actual units of product S, s = ` 800
Sales price variance for R = AQ (AP - SP) = ` 1500(F)
Sales price variance for S = AQ (AP – SP) = 4000(F)
Sales volume variance for S = SP (AQ – SQ) = ` 6000(F)
Sales value variance for R = (AQAP – SQSP) = ` 2700(F)
Sales value variance for S = (AQAP – SQSP) = ` 10000(F)
Illustration 15
GLOBAL Ltd. is engaged in marketing of wide range of consumer goods. A, B, C and D are the zonal sales
officers for four zones. The company fixes annual sales target for them individually. You are furnished with the
followings.
●● The standard costs of sales target in respect of A, B, C, D are ` 5,00,000, ` 3,75,000, ` 4,00,000 and `
4,25,000 respectively.
●● A, B, C, D respectively earned ` 29,900, ` 23,500, ` 24,500 and ` 25,800 as commission at 5% on actual
sales effected by them during the previous year.
●● The relevant variances as computed by a qualified cost accountant are as follows.

A B C D
` ` ` `
Sales price variance 4000(F) 6000(A) 5000(A) 2000(A)
Sales volume variance 6000(A) 6000(F) 15000(F) 8000(F)
(A) = Adverse variance and (F) = Favorable variance
You are required to compute the amount of target sales and margin fixed in case of each of the zonal sales officers.
Answer
Particulars A B C D
Commission Earned 29,900 23,500 24,500 25,800
Actual Sales (29,900 ÷ 5%) (23,500 ÷ 5%) (24,500 ÷ 5%) (25,800 ÷ 5%)
(Commission Earned ÷ 5%) = 5,98,000 = 4,70,000 = 4,90,000 = 5,16,000
Sales Price Variance 4000(F) 6000(A) 5000(A) 2000(A)
Sales Volume variance 6000(A) 6000(F) 15000(F) 8000(F)
Sales Value Variance 2000 A 0 10000 F 6000 F
(+4000 - 6000) (-6000F + 6000) (-5000 +15000) (-2000 + 8000)
Budgeted Sales 6,00,000 4,70,000 4,80,000 5,10,000
(598000 + 2000) (470000 - 0) (490000 - 10000) (516000 - 6000)
Standard Costs 5,00,000 3,75,000 4,00,000 4,25,000
Budgeted Margin 1,00,000 95,000 80,000 85,000
(600000 - 500000) (470000 - 375000) (480000 - 400000) (510000 - 425000)
Illustration 16
(` In Lakhs)
31-03-2020 31-03-2021
Sales 120 129.60
Prime Cost of Sales 80 91.10
Variable Overheads 20 24
Fixed expenses 15 18.50
Profit 5 (4)
During 2020-21, average prices increased over those of the previous years
(1) 20% in case of sales
(2) 15% in case of prime cost
(3) 10% in case of Overheads.
Prepare a profit variance statement from the above data.

Answer
Step 1: Calculation of Variances:
1. Sales Price Variance = 129.60 – (129.60 × 100/120) = ` 21.60 (F)
(Increase in sale price by 20%)
2. Sales Volume Variance = (129.60 × 100/120) - 120 = ` 12 (A)
(Reduction in sales volume = 10%)
3. Sales Value Variance = 129.60 – 120 = ` 9.60 (F)
4. Prime Cost Price Variance = (91.10 × 100/115) – 91.10 = ` 11.88 (A)
5. Prime Cost Volume Variance = 80 × 10/100 = ` 8 (F)
(Reduction corresponding to Sales)
6. Prime Cost Usage or Efficiency Variance = (80 × 90/100) - (91.10 × 100/115)
=
` 7.22 (A)
7. Prime Cost Variance = 80 – 91.1 = ` 11.1 (A)
8. Variable Overhead Price Variance = (24 × 100/110) - 24 = ` 2.18 (A)
9. Variable Overhead Volume Variance = 20 × 10/100 = ` 2 (F)
10. Variable Overhead Efficiency Variance = (20 × 90/100) - (24 × 100/110)
=
` 3.82 (A)
11. Variable Overhead Cost Variance = 20 – 24 = ` 4 (A)
12. Fixed Overhead Price Variance = (18.50 × 100/110) – 18.50 = ` 1.68 (A)
13. Fixed Overhead Efficiency Variance = 15 - (18.50 × 100/110) = ` 1.82 (A)
14. Fixed Overhead Cost Variance = 15 – 18.50 = ` 3.5 (A)
Step 2: Profit Variance Statement
Budgeted Profit 5.00

Add: Sales price variance 21.60
Prime cost volume variance 8.00
Variable overhead variance 2.00 31.60
36.60
Less: Sales volume variance 12.00
Prime cost price variance 11.88
Prime cost usage variance 7.22
Variable overhead price variance 2.18
Variable overhead efficiency variance 3.82

Fixed overhead price variance 1.68

Fixed overhead efficiency variance 1.82 40.60
Actual Loss 4.00
Illustration 17
The assistant management accountant of your company has been preparing the profit and loss account for the
week ended 31st October. Unfortunately, he has had a traffic accident and is now in a hospital. So, as senior cost
analyst you have been asked to complete this statement. The uncompleted statement and relevant data are shown
below.
Week ended 31st October
` `
Sales 50,000
Standard Cost:
Direct Materials
Direct Wages
Overheads --- ---
Standard Profit
Variances Fav. /(Adv.) Fav. /(Adv.)
` `
Direct Material:
Price Variance (400)
Usage Variance (300)
Total Direct Material Variance (700)
Direct Labour:
Rate Variance
Efficiency Variance
Total Direct Labour Variance ---
Overhead Expenditure Variance
Overhead Volume Variance
Total Overhead Variance ---
Total Variance ---
Actual Profit ---
Standard Data
The standard price of direct material used is ` 600 per ton. From each tone of material, it is expected that
2,400 units will be produced. A forty-hour week is operated. Standard labour rate per hour is ` 40. There are 60

employees working as direct labour. The standard performance is that each employee should produce one unit of
product in 3 minutes. There are 4 working weeks in October. The budgeted fixed overhead for October is ` 76,800.
Actual data
Materials used during the week were 20 tones at ` 620 per ton. During the week 4 employees were paid of ` 42
per hour and 6 were paid ` 38 per hour and remaining were paid at standard rate. Overheads incurred was ` 18000.
You are required to complete the P & L Statement for the week ended 31st Oct.
Answer
`
Actual Cost of Material 620 × 20 12400
(-) direct material:
price variance 400
usage variance 300 (700)
11700
Production from one ton of direct material of ` 600 = 2400 units
Proportionate production for direct material of ` 11700/-
= (2400 ÷600) × 11700 = 46800 units
Standard Labour Hours = (46800 units × 3 minutes) ÷ 60 = 2430 hours
Labour variances
(1) (2) (3)
SRSH SRAH ARAH
4 × 2340 4 × (40 × 60) [(4 × 4.20) + (6 × 3.80) + (50 × 4)] × 40 hrs
` 9360 ` 9600 ` 9584
Labour Rate Variance = (SRAH – ARAH) = (9600-9584) = 16(F)

Labour Efficiency Variance: (SRSH – SRAH) = (9360 -9600) = 240(A)
Overhead variances:
Standard Hours per Week = 40 ×60 = 2400 hours
Budgeted Overheads per Week = ` 76,800 ÷ 4 weeks = ` 19,200/-
Standard Overhead Recovery Rate = (19,200 ÷ 2400) ` 8 per hour
(1) (2) (3) (4)

SRSH SRAH SRBH ARAH
8 × 2340 8 × 2400
` 18720 ` 19200 ` 19200 ` 18000

OH Expenditure Variance = (SRBH – ARAH) = (19200 – 18000) = 1200(F)

OH Volume Variance = (SRSH – SRBH) = (18720 – 19200) 480(A)
P&L statement for the week ended 31st October:
` `
Sales 50000
Standard cost
Direct material 11700
Direct wages 9360
Overheads 18720 39780
Standard Profit 10220
Variance F/(A) F/(A)
Direct material:
Price (400)
Usage (300)
Total (700)
Direct Labour:
Rate 16
Efficiency (240)
Total (224)
Overheads:
Expenditure 1200
Volume (480)
Total 720
Total variance (204)
Actual Profit 10016
Illustration 18
A Company manufactures two products X and Y. Product X requires 8 hours to produce while Y requires 12
hours. In April, 2021, of 22 effective working days of 8 hours a day. 1,200 units of X and 800 units of Y were
produced. The company employs 100 workers in production department to produce X and Y. The budgeted hours
are 1,86,000 for the year. Calculate Capacity, Activity and Efficiency ratios and establish their relationship
Answer
(Hours)
Standard hours of production
Product X (1,200 units × 8 hrs.) 9,600

(Hours)
Product Y (800 units × 12 hrs.) 9,600
Total standard hours 19,200
Actual hours worked (100 workers × 8 hrs. × 22 days) 17,600
Budgeted hours per month (1,86,000 hrs./ 12 months) 15,500
Actual Hours Worked 17,600

Capacity Ratio = × 100 = = 113.55%
Budgeted Hours p.m. 15,500
Standard Hours of Production 19,200

Efficiency Ratio = × 100 = = 109.09%
Actual Hours Worked 17,600
Standard Hours of Production 19,200

Activity Ratio = × 100 = = 123.87%
Budgeted Hours p.m. 15,500
Relationship of Ratios
109.09 × 113.55
Activity Ratio = Efficiency Ratio × Capacity Ratio = 123.870 =
100
Illustration 19
The following is a flexible budget of FB Co. Ltd. For a production department.
Level of Activity
Direct Labour Hours 4000 5000 6000

Number of Units 8000 10000 12000
Fixed Overhead (Rs) 5000 5000 5000
Variable Overhead (Rs) 800 1000 1200
Total Overheads (Rs) 5800 6000 6200
Normal Level of activity was 5000 direct labour hours.

Actual Results were:
Direct Labour hours - 4800
Variable Overhead – Rs 900
Output in Units - 10400
Fixed Overhead - Rs 5100
Compute Fixed overhead cost, volume and expenditure variances, variable overhead cost, efficiency and
expenditure variances, efficiency, capacity and activity ratios.

Solution
Step 1: Initial Workings
Normal level of activity has been expressed in terms of direct labour hours. Accordingly:
Standard Labour Hours per unit of Output = (10,000 ÷ 5,000) = 2 hours per unit
Standard Labour Hours for Actual Output = (10,400 ÷ 2) = 5,200 hours
Standard Rate of Recovery for FOH = (5,000 ÷ 5,000) = Re.1 per labour hour
Standard Rate of Recovery for VOH = (1,000 ÷ 5,000) = Re.0.20 per labour hour
Step 2: FOH Variances
Description Formula Workings Variance

FOH Cost Variance SRSH – AOH (1 × 5200) – 5100 = 100 (F) ` 100 (F)
FOH Volume Variance SR (SH – BH) 1 × (5200 – 5000) = 200 (F) ` 200 (F)
FOH Expenditure Variance SRBH – AOH (1 × 5000) – 5100) = 100 (A) ` 100 (A)
Step 3: VOH Variances
Description Formula Workings Variance

VOH Cost Variance SRSH – AOH (0.2 × 5200) – 900 = 140 (F) ` 140 (F)
VOH Volume Variance SR (SH – BH) 0.2 × (5200 – 4800) = 80 (F) ` 80 (F)
VOH Expenditure Variance SRAH – AOH (0.2 × 4800) - 900 = 60 (F) ` 60 (F)
Step 4: Ratios
Description Formula Workings Ratio

Efficiency Ratio SH ÷ AH 5200 ÷ 4800 108.33%
Capacity Ratio AH ÷ BH 4800 ÷ 5000 96 %
Activity Ratio SH ÷ BH 5200 ÷ 5000 104%
Illustration 20
ABC Ltd adopts a standard costing system. The standard output for a period is 20,000 units and the standard cost
and profit per unit is as under:
Direct Material (3 units @ ` 1.50) 4.50

Direct Labour (3 Hrs. @ ` 1.00 ) 3.00
Direct Expenses 0.50
Factory Overheads : Variable 0.25

Fixed 0.30
Administration Overheads 0.30
Total Cost 8.85
Profit 1.15
Selling Price (Fixed By Government) 10.00
The actual production and sales for the period were 14,400 units. There has been no price revision by the
Government during the period. The following are the variances worked out at the end of the period.
Direct Material Favorable (Rs) Adverse (Rs)

Price 4,250
Usage 1,050
Direct labour
Rate 4,000
Efficiency 3,200
Factory Overheads
Variable – Expenditure 400
Fixed – Expenditure 400
Fixed – Volume 1,680
Administration Overheads
Expenditure 400
Volume 1,680
a. Ascertain the details of actual costs and prepare a Profit and Loss Statement for the period showing the actual
Profit/Loss. Show the workings clearly.
b. Reconcile the actual Profit with standard profit.
Answer
(a) Statement showing the actual profit and loss statement
Serial Particulars Amount (`) Amount (`)

A Sales (14400 × 10) 1,44,000
B Cost


1 Material Cost
Standard Material Cost (14400 × 4.50) 64800
Add: Price Variance 4250
Deduct: Usage Variance (1050)
Actual Material Cost 68000
2 Labour Cost
Standard Labour Cost (14400 × 3) 43200
Add: Rate Variance 4000
Deduct: Efficiency Variance (3200)
Actual Labour Cost 44000
3 Direct Expenses (14400 × 0.50) 7200
4 Factory Overhead
5 Variable Overhead
Standard Variable Overhead (14400 × 0.25) 3600
Deduct: Expenditure Variance (400)
Actual Variable Overhead 3200
6 Fixed Overhead
Standard Fixed (14400 × 0.30) 4320
Add: Volume Variance 1680
Deduct: Expenditure Variance (400)
Actual Fixed Overhead 5600
7 Administration Overhead
Standard Administration Overhead (14400 × 0.3) 4320
Add: Volume Variance 1680
Add: Expenditure Variance 400
Actual Administrative Overhead 6400
8 Total Cost 134400
C Profit (144000 – 134400) 9600
(b) Statement showing reconciliation of standard profit with actual profit

1 Standard Profit (14400 × 1.15) 16560


2 Add:
Add: Material usage variance 1050
Labour efficiency variance 3200
Variable overhead expenditure variance 400
Fixed overhead expenditure variance 400
Sub Total 5050
3 Deduct:
Material price variance 4250
Labour rate variance 4000
Fixed overhead volume variance 1680
Administration expenditure variance 400
Administration volume variance 1680
Sub Total 12010
4 Actual Profit (1 + 2 -3) 9600
Illustration 21
X Ltd. produces and sells a single product. Standard cost card per unit of the product is as follows: (`)
Direct materials: A (10 kg.@ 5 per kg.) 50

B (5 kg. @ 6 per kg.) 30
Direct wages (5 hours @ 5 per hour) 25
Variable production overheads (5 hours @ 12 per hour) 60
Fixed production overheads 25
Total standard cost 190
Standard gross profit 35
Standard selling price 225
Fixed production overhead has been absorbed on the expected annual output of 25,200 units produced evenly
throughout the year. During the month of December, 2018, the following were the actual results for an actual
production of 2,000 units.
(Rs)
Sales (2,000 units @ 225) 4,50,000
Direct materials: A 18,900 kg. 99,225
B 10,750 kg. 61,275
Direct wages 10,500 hours (actually worked 10,300 hours) 50,400

Variable production overheads 1,15,000

Fixed production overheads 56,600
Total 3,82,500
Gross profit 67,500
The material price variance is extracted at the time of receipt of materials. Material purchases were Material A
20,000 kg. @ ` 5.25 per kg & B 11,500 kg. @ ` 5.70 per kg.
Required:
i. Calculate all variances.
ii. Prepare an operating statement showing standard gross profit, variances and actual gross profit.
iii. Explain the reason for the difference, if any, in actual gross profit given in the question and calculated in (ii)
above.
Answer
(i) Calculation of variances
Material Variances
Sl Description Workings Derivation

1 Material Variances
a Standard Quantity for actual output A = 2,000 × 10 = 20,000 20,000 kg.
B = 2,000 × 5 = 10,000 10,000 kg
b Revised Standard Quantity A = 20,000 / 30,000 × 29,650 19,766.67 kg.
(Actual Quantity prorated in = 19,766.67 9,883.33 kg.
proportion to standard consumption) B = 10,000 / 30,000 × 29,650
= 9,883.33
c Standard yield (2,100/31,500) × 29,650 = 1,976.67 1,976.67
(Standard Output ÷ Standard
Consumption) × Actual Consumption
d Material price variance (on receipt (SP - AP) AQ
basis) A = (5 - 5.25)× 20,000 = 5,000 (A)
B = (6 - 5.7) × 11,500 = 3,450 (F) ` 1,550 (A)
e Material usage variance (SQ- AQ) SP

A = (20,000 - 18,900) × 5 = 5,500 (F)
B = (10,000 - 10,750) × 6 = 4,500 (A) ` 1,000 (F)
f Material mix variance SP (RSQ - AQ)

A = (19,766.67-18,900) × 5 = 4,333.35 (F)
B = (9,883.33 -10,750) × 6 = 5,200.02 (A) 866.67 (A)

Sl Description Workings Derivation

g Material yield variance SC (AY - SY) ` 1,866.40 (F)
= 80 × (2,000 - 1,976.67) = 1,866.67 (F)
2 Labour Variances
a Labour rate variance (SR - AR) × AH
= (5 - 4.8) × 10,500 = 2,100 (F) ` 2,100 (F)
b Labour efficiency variance SR (SH - AH)

= 5 × (10,000 - 10,300) = 1,500(A) ` 1,500(A)
c Labour idle time variance Idle hours × SR

= 200 × 5 = 1,000 (A) ` 1,000 (A)
3 Variable Overhead Variances

A Recovered VOH 2000 × 60 = 1,20,000
Standard VOH 10300 × 12 = 1,23,600
B VOH Cost Variance Recovered overhead - Actual overhead ` 5,000 (F)
= (1,20,000 - 1,15,000) = 5,000 (F)
C VOH Expenditure Variance Standard VOH - Actual VOH ` 8,600 (F)
= (1,23,000 - 1,15,000) = 8,600 (F)
D VOH Efficiency Variance Recovered VOH - Standard VOH ` 3600 (A)
= 1,20,000 - 1,23,600 = 3600 (A)
4 Fixed Overhead Variances
A Recovered FOH 2000 × 25 = ` 50,000
Budgeted FOH (25,200 × 25) / 12 = ` 52,500
B FOH Cost Variance Recovered overhead - Actual overhead ` 6,600 (A)
= (50,000 - 56,600) = 6,600 (A)
C FOH Expenditure Variance Budgeted overhead- Actual overhead ` 4,100 (A)
= (52,500 - 56,600) = 4100(A)
D FOH Volume Variance Recovered overhead - Budgeted overhead ` 2 ,500 (A)
= (50,000 - 52,500) = 2,500 (A)
(ii) Reconciliation Statement

(`)
Serial Description Favourable Adverse Rupees
1 Standard profit (35 × 2,000) 70,000
2 Variances

A Material
Price 1550.00
Mix 866.67
Yield 1866.67
Sub Total 550 (A)
B Labour
Rate 2100
Efficiency 1500
Idle Time 1000
Sub Total 400 (A)
C Variable Overheads
Expenditure 8600
Efficiency 3600
Sub Total 5000 (F)
D Fixed Overheads
Expenditure 4100
Volume 2500
Sub Total 6600 (A)
E Total 12566.67 15116.67 2550 (A)

3 Actual Profit (70,000 – 2550) 67,450
(iii) Explanation for the difference

Actual gross profit given in the question is 67,500 while calculated profit in statement is ` 67,450. The difference
amount of ` 50/- is due to material price variance that is calculated at the time of receipt of material instead of
consumption of material.
Material price variance on (SP - AP) AQ

consumption basis A = (5 - 5.25) × 18,900 = 4,725 (A)
B = (6 - 5.7) × 10,750 = 3,225 (F) ` 1,500 (A)
Material price variance on consumption basis works out to ` 1,500(A) instead of ` 1,550(A) considered in the
reconciliation statement whereby the difference of ` 50/- arises. Actual Profit stands revised to ` 67,500/-, i.e.
(67450 + 50) after adding the difference.
Illustration 22
The summarized results of a company for the two years ended 31st December 2014 and 2015 are given below: -
2015 2014
` lacs ` lacs

Sales 770 600

Direct Materials 324 300
Direct Wages 137 120
Variable Overheads 69 60
Fixed Overheads 150 80
Profit 90 40
As a result of re-organization of production methods and extensive advertisement campaign use, the company
was able to secure an increase in the selling prices by 10% during the year 2015 as compared to the previous year.
In the year 2014, the company consumed 1,20,000 Kgs. of raw materials and used 24, 00,000 hours of direct
labour. In the year 2015, the corresponding figures were 1, 35,000 kgs of raw materials and 26,00,000 hours of
direct labour.
Use information given for the year 2014 as the base year information to analyze the results of the year 2015 and
to show in a form suitable to the management the amount each factor has contributed by way of price, usage and
volume to the change in profit in 2015.
Answer
(v) Statement of Variances
Sl Description Workings ` lacs
1 Sales Variances
a Sales price variance 770 – {770 × (100/110)} = 70(F) 70 (F)
b Sales volume variance {770 × (100/110)} - 600 = 100(F) 100(F)
c Sales value variance 770 – 600 = 170(F) 170(F)

d % of increase in Volume = (100÷600) × 100 = 16.67%
2 Material Variances
a Key computations
Material price in 2014 = (30000000)/120000 = ` 250/-
Material expected to be used in 2015 = (120000/600) × 700 = 140000 Kgs
Standard Material Cost for 2015 = 140000 × ` 250 = ` 350 Lacs
Material price in 2015 = (32400000)/135000 = ` 240/-
b Material cost variance 350 – 324 = 26 (F) 26(F)
c Material volume variance 16.67% of Consumption for 2014 50(A)
= 300 × 16.67% = 50(A)

Sl Description Workings ` lacs
d Material usage variance SP (SQ-AQ)

250(140000-135000) = 12,50,000 12.50(F)
e Material price variance AQ(SP-AP)
135000(250-240) = 1350000 13.50(F)
3 Labour Variances
a Key computations
Labour hours expected to be used in 2015 = (2400000/600) × 700 = 2800000
Labour rate of 2014 = (12000000)/(2400000) = ` 5/- per hour
Standard labour cost for 2015 = 2800000 × 5 = ` 140 lacs
Labour rate of 2015 = (13700000)/(2600000) = ` 5.269 per hour
b Labour cost variance 140 -137 = 3 (F) 3(F)
c Labour volume variance 16.67% of Consumption for 2014 20(A)
= 120 × 16.67% = 20(A)
d Labour efficiency variance SR (SH-AH)
5(2800000-2600000) = 10,00,000 10.00(F)
e Labour rate variance AH(SR-AR)
2600000(5 - 5.269) 7.00(A)
= 6,99,400(A) i.e. say 7 lacs(A)
4 Variable Overhead Variances
a Key computations
Standard variable overheads = ` 60 + (` 60 × 16.67%) = ` 70
Standard variable overheads rate per labour hour = ` 60 /24 = ` 2.5
VOH rate of 2015 = (6900000)/(2600000) = ` 2.65/- per hour
b VOH cost variance 70 - 69 = 1(F) 1(F)
c VOH volume variance 16.67% of Consumption for 2014 10(A)
= 60 × 16.67% = 20(A)
d VOH efficiency variance SR (SH-AH)
2. 5(2800000 - 2600000) = 5,00,000 5(F)
E VOH expenditure variance AH(SR-AR)
2600000(2.50 – 2.65) 4(A)
= 3,90,000(A) i.e. say 4 lacs(A)
5 FOH cost variance 150 – 80 = 70(A) 70(A)

(ii) Reconciliation Statement

(` lacs)
Serial Description Favourable Adverse Rupees

1 Profit for 2014 40.00
2 Variances
A Sales
Price 70.00
Volume 100.00
Sub Total 170.00 170.00(F)
B Material
Volume 50.00
Usage 12.50
Price 13.50
Sub Total 26.00 50.00 24.00(A)
C Labour
Volume 20.00
Efficiency 10.00
Price 7.00
Sub Total 10.00 27.00 17.00(A)
D Variable Overheads
Volume 10.00
Efficiency 5.00
Expenditure 4.00
Sub Total 5.00 14.00
9.00(A)
E Fixed Overheads 70.00 70.00(A)
F Total 211.00 161.00 50.00(F)
3 Profit for 2015 90.00
5.2 Uniform Costing and Inter-firm Comparison
Introduction
Uniform Costing may be defined as the application and use of the same costing principles and procedures by
different organisations under the same management or on a common understanding between members of an
association. It is the application of the same costing principles, methods or procedures uniformly by various
undertakings in the same industry. It is neither a separate method of cost accounting like specific order costing or

operation costing nor a separate technique of costing like marginal costing, or standard costing but is only a particular
system of costing which takes the help of both methods and techniques of costing. It is a technique which applies
the usual costing techniques like standard costing, marginal costing, and budgetary control uniformly in a number
of concerns in the same industry, or even in different but similar industries. Amalgamation and closer working
arrangements between groups of manufacturers in particular industries, and organisation for nationalization have
necessitated, to a certain extent, the establishment of some degree of uniform costing by industries.
The principles and methods adopted for the accumulation, analysis, apportionment and allocation of costs vary
so widely from concern to concern that comparison of costs is rendered difficult and unrealistic. Uniform Costing
attempts to establish uniform methods so that comparison of performances in various undertakings can be made
to the common advantage of all the constituent units. Uniform Costing, thus, enables cost and accounting data of
the member undertakings to be compiled on a comparable basis so that useful and crucial decisions can be taken.
Scope of Uniform Costing

Uniform Costing methods may be advantageously applied:
(a) In a single enterprise having a number of branches or units, each of which may be a separate manufacturing
unit,
(b) In a number of concerns in the same industry bound together through a trade association or otherwise, and
(c) In industries which are similar in nature such as gas and electricity, various types of transport, and cotton,
jute and woolen textiles.
The need for application of Uniform Costing System exists in a business, irrespective of the circumstances
and conditions prevailing therein. In concerns which are members of a trade association, the procedure for
Uniform Costing may be devised and controlled by the association or by any other central body specially formed
for the purpose.
Need for Uniform Costing:

The need for uniform costing arises from the fact that different units use different cost procedures and principles
for costing. The need also arises because of differences in size of the organisation, wage structure, methods of
production, degree of automation, and so on. The basic reasons for the differences may be as follows:
(a) Size and organisational set up of the business: The number and size of the departments, sections and
services also vary from one concern to another according to their size and organisation. The difficulty in
operating Uniform Cost Systems for concerns which vary widely in regard to size and type of business may
to some extent be overcome by arranging the various units in a number of size or type ranges, and applying
different uniform systems for each such type.
(b) Methods of production: The use of different types of machines, plant and equipments, degree of
mechanization, difference in materials mix and sequence and nature of operations and processes are mainly
responsible for the difference in costs.
(c) Methods and principles of cost accounting applied: It is in this sphere that the largest degree of difference
arises. Undertakings manufacturing identical or similar products and having the same system of cost
accounting would generally employ different methods of treatment of expenditure on buying, storage and
issue of materials, pricing of stores issues, payment to workers, basis of classification and absorption of
overhead, calculation of depreciation, charging rent on freehold or leasehold assets etc.
In the application of Uniform Costing, the fundamental requirement is to locate any kind of differences and to
eliminate or overcome, as far as practicable, the causes giving rise to such differences.

Requisites for Installation of a Uniform Costing System

The organizational set up for implementing the principles and methods of Uniform Costing may take different
forms. It may range from a small association of a number of concerns who agree to have uniform information
regarding a few specific cost accounting respects, to a large organisation which has a fully developed scheme
covering all the aspects of costing. The success of a uniform costing system will depend upon the following:
(a) There should be a spirit of mutual trust, co-operation and a policy of give and take amongst the participating
members.
(b) There should be a free exchange of ideas and methods.
(c) The bigger units should be prepared to share improvements, achievements of efficiency, benefits of research,
know-how, etc. with the smaller ones,
(d) There should not be any hiding or withholding of information.
(e) There should be no rivalry or sense of jealousy amongst the members.
Fields covered by Uniform Costing:

There is no system of Uniform Costing which may be found to fit in all circumstances. The system to be installed
should be tailored to meet the needs of each individual case. The essential points on which uniformity is normally
required may be summarized as follows:
(a) Whether costs are required for the individual products i.e., for the cost units or for cost centres.
(b) The method of costing to be applied.
(c) The technique employed such as Standard Costing, Marginal Costing.
(d) Items to be excluded from costs.
(e) The basis of departmentalization.
(f) The basis of allocation of costs to departments and/or service department costs to production departments.
(g) The methods of application administration, selling and distribution overhead to cost of sales.
(h) The method of valuation of work-in-progress.
(i) Methods of treating cost of spoilage, defective work, scrap and wastage.
(j) Methods of accounting of overtime pay bonus and other miscellaneous allowances paid to workers.
(k) Whether purchase, material handling and upkeep expenses are added to the cost of stores or are treated as
overhead expenses.
(l) The system of materials control, pricing of issues and valuation of stock.
(m) The system of classification and coding of accounts.
(n) The method of recording accounting information.
Advantages of Uniform Costing:

Main advantages of a Uniform Costing System are summarised below:
i. It provides comparative information to the members of the organisation / association and helps to reduce
or eliminate the evil effects of competition and unnecessary expenses arising from competition.
ii. Uniform Costing is a useful tool for management control. Performance of individual units can be measured
against norms set for the industry as a whole.

iii. It enables the member concerns to compare their own cost data with that of the others, detect the weakness
and to take corrective steps for improvement in efficiency.
iv. It avoids cut-throat completion by ensuring that competition among member units proceeds on healthy
lines.
v. The process of pricing policy becomes easier when Uniform Costing is adopted.
vi. By showing the one best way of doing things, Uniform Costing creates cost consciousness and provides
the best system of cost control and cost presentation in the entire industry.
vii. The benefits of research and development can be passed on to the smaller members of the association
which, in turn, leads to economic prosperity of the industry as a whole.
viii. It enables the industry to submit the statutory bodies reliable and accurate data which might be required to
regulate pricing policy or for other purposes.
ix. It serves as a prerequisite to Cost Audit and inter firm comparison.
x. Uniform costing simplifies the work of wage boards set up to fix minimum wages and fair wages for an
industry.
Limitations of Uniform Costing:

(i) Uniform costing presumes the application of same principles and methods of Costing in
each of the member firms. But individual units generally differ in respect of certain key
factors and methods.
(ii) For smaller units the cost of installation and operation of Uniform Costing System may be
more than the benefits derived by them.
(iii) Uniform costing may create conditions that are likely to develop monopolistic tendencies
within the industry. Prices may be raised artificially and supplies curtailed.
(iv) If complete agreement between the members is not forthcoming, the statistics presented
cannot be relied upon. This weakens the Uniform Costing System and reduces its
usefulness.
Inter-firm Comparison
Concept of Inter-firm Comparison: Inter-firm comparison as the name denotes means the techniques of
evaluating the performances, efficiencies, deficiencies, costs and profits of similar nature of firms engaged in the
same industry or business. It consists of exchange of information, voluntarily of course, concerning production,
sales, costs, prices, profits, etc., among the firms who are interested and willing to make the device a success. The
basic purposes of such comparison are to find out the weak points in an organisation and to improve the efficiency
by taking appropriate measures to wipe out the weakness gradually over a period of time.
Need for Inter-firm Comparison: Every Progressive management, all over the world. has always asked itself
the question—how is my company performing in comparison to that of others? The published trading and profit
and loss accounts and the balance sheets along-with the annual reports provide scanty data for any purposeful study
and assessment of the performance of a company. The figures available from these reports just indicate, in a general
way, the profitability, stability, solvency and growth of an organisation; but they do not throw light on whether a
company has really made the optimum use of all the available resources in men, materials, etc.

The answer, therefore, depends fully on the availability of more detailed data, and the possibility of comparison
with the competitive units in the same line of manufacture.
It is the inter-firm comparison that provides the management with a vivid comparative picture of how its operating
performance, financial results, and product cost structure compare with those of other firms of similar size, nature,
industry or trade.
Pre-Requisites for Inter-firm Comparison: The following are the main requirements while installing a scheme
of inter-firm comparison.
1. Adaption of Uniform Costing: There must be a sound system of uniform costing in the firm where inter-
firm comparison scheme is to be implemented. A uniform manual should also be prepared and distributed
among the member units to enable the function of the system efficiently.
2. Responsible Organisation: An organisation must be established to run the system efficiently and for better
results. Firms of different sizes in an industry should become members of the organization. In industrially
advanced countries independent agencies such as British Centre for Inter-firm Comparison, European
Productivity Agency and U.S. Bureau of Labour Statistics are responsible for collection, coordination and
presentation of information. In India some undertakings such as National Productivity Council, the Trade
Development Authority, the Bureau of Industrial Costs and Pricing, the Tariff Commission have undertaken,
in a limited way, the task of inter-firm comparison. In some cases, trade associations, holding company or
parent organisation are doing the work of interfirm comparison.
3. Collection of Relevant Information: The information to be collected must be relevant. The nature
of information to be collected from the participating firms depends upon the needs of the management,
comparative importance of the information and the efficiency of the central body responsible for the
collection of the information. Information is generally collected relating to costs and cost structure, labour
or machine efficiency and utilisation, raw material consumption, wastage, inventory, return on capital
employed, liquidity, reserves and appropriation of profit, methods of production, creditors and debtors,
technical aspects, etc.
4. Methods of Collection: The time and the form in which the information is to be submitted by the member
units must be decided in advance. Multiple statistical tools can be used for the purpose of collection of data,
its editing, classification, presentation, drawing conclusions and inferences. Ratio analysis for measuring
profitability, efficiency and productivity etc. can also be used.
Benefits of Inter-firm Comparison: The benefits derived from Inter-firm Comparison are as below:
(a) Inter-firm Comparison makes the management of the organisation aware of its strengths and weakness in
relation to the other organisations in the same industry.
(b) As only the significant items are reported to the Management, substantial time and efforts are saved.
(c) The management is able to keep up-to-date information of the trends and ratios and, therefore, it becomes
easier for them to take the necessary steps for improvement.
(d) It develops cost consciousness among the members of the industry.
(e) Information about the organisation is made available freely without the fear of disclosure of confidential data
to outside market or public.
(f) Specialized knowledge and experience of professionally run and successful organisations are made available
to smaller units who can take the advantage, as otherwise it may not be possible for them to have such an
infrastructure.

(g) The industry, as a whole, benefits from the process due to increased productivity, standardization of products,
elimination of unfair comparison and the trade practices.
(h) Reliable and correct data enhance the organisation’s power in dealing in with various authorities and
Government bodies.
(i) Inter firm comparison assists in a big way in identifying industry sickness and gives a timely warning so that
effective remedial steps can be taken to save the organisation.
Limitations of Inter-firm Comparison: The practical difficulties that are likely to arise in the implementation
of a scheme of inter-firm comparison are:
(a) The top management may not be convinced of the utility of inter-firm comparison.
(b) Reluctance to disclose data which a concern considers to be confidential.
(c) A sense of complacence on the part of the management who may be satisfied with the present level of profits.
(d) Absence of a proper system of Cost Accounting because of which the costing figures supplied may not be
relied upon for comparison purposes.
(e) Non-availability of a suitable base for comparison.
These difficulties may be overcome to a large extent by taking the following steps:
(a) ‘Selling’ the scheme through education and propaganda. Publication of articles in journals and periodicals,
and lecturers, seminars and personal discussions may prove useful.
(b) Installation of a system which ensures complete secrecy.
(c) Introduction of a scientific cost system.
Illustration 23
The share of total production and the cost-based fair price computed separately for each of the four units in
industry are as follows:
` Per unit
Share of Production 40% 25% 20% 15%

Material cost 150 180 170 190
Direct labour 100 120 140 160
Depreciation 300 200 160 100
Other overheads 300 300 280 240
Total Cost 850 800 750 690
20% Return on Capital employed 630 430 350 230
Fair price 1,480 1,230 1,100 920
Capital employed per unit is worked out as follows:
Net Fixed Assets 3,000 2,000 1,600 1,000

` Per unit
Working Capital 140 150 150 150

Total 3,140 2,150 1,750 1,150
Suggest an Uniform Price that may be adopted by the industry.
Answer
Computation of Uniform Price:
Weighted Average Cost = [850 × 40%] + [800 × 25%] + [750 × 20%] + [690 × 15%]
= 340 + 200 + 150 + 103.5
=
` 793.50
Weighted Average Return (Profit) on Capital Employed
= [630 × 40%] + [430 × 25%] + [350 × 20%] + [230 × 15%]
= 252 + 107.5 + 70 + 34.5
=
` 464
Suggested Uniform Price = 793.5 + 464 = ` 1,257.50
Terms to Master
Variance: Variance denotes the deviation between the standard proposition and the actual incidence. The
proposition could be a pre-set benchmark, budget or estimate and so on.
Revenue Variance: Revenue Variance is the difference between planned, budgeted or standard revenue vis-à-
vis the actual revenue generated.
Cost Variance: Cost Variance is the difference between a planned, budgeted or standard cost vis-à-vis the actual
cost.
Investigation of Variances: Investigation of variances implies systematic examination of deviations undertaken
for the purpose of initiating corrective actions.
Planning Variance: Planning Variance denotes the deviation between the original proposition and the revised
proposition
Operating Variance: Operating Variance denotes the deviation between the revised proposition and the actual
incidence.
Controllable Variance: Variance is said to be controllable if it is identified as the primary responsibility of a
particular person or department.
Uncontrollable Variance: When the variations are due to the factors beyond the control of the concerned person
or department, it is said to be uncontrollable.
Standard Costing: Standard Costing is a control technique that reports variances by comparing actual costs to
pre-set standards thereby facilitating action through management by exception.
Budgetary Control: Budgetary Control is the process that facilitates effective implementation of the budgets.

Profit Variance: Profit Variance is the difference between planned, budgeted or standard profit vis-à-vis the
actual profit attained.
Uniform Costing: Uniform Costing may be defined as the application and use of the same costing principles
and procedures by different organisations under the same management or on a common understanding between
members of an association.
Inter-firm Comparison: Inter-firm Comparison means the techniques of evaluating the performances,
efficiencies, deficiencies, costs and profits of similar nature of firms engaged in the same industry or business.
1. ‘The main objective of variance analysis is to provide insights into the off-standard performance’. Discuss.
2. State the primary reasons for cost variances.
3. Highlight the significance of investigation of Variances. What are the methods of Investigation?
4. Write a note on Planning and Operating Variances.
5. What do you understand by Controllable and Non-controllable Variances?
6. Write a note on Cost Variance Ratios.
7. Distinguish between Standard Costing and Budgetary Control.
8. What are the merits and demerits of Standard Costing?
9. What are the merits and demerits of Budgetary Control?
10. Write a note on Profit Variance.
11. What are the advantages of Uniform Costing?
12. What is the need for Interfirm Comparison?
Multiple Choice Questions
QQ1 A manufacturing company uses two types of materials, X and Y, for manufacture of a standard product. The
following information is given:
Standard Mix Actual Mix

Material X 120 kg @ ` 5 ` 600 Material X 112 kg @ ` 5 ` 560
Material Y 80 kg @ ` 10 ` 800 Material Y 88 kg @ ` 10 ` 880
200 kg 200 kg
Less 30% Loss 60 Kg Less 25% Loss 50 Kg
Final Product 140 kg ` 1400 Final Product 150 kg ` 1440
Direct Materials Mix Variance is:

A. ` 40 (fav.)
B. ` 40 (unfav.)
C. ` 80 (fav.)
D. ` 80 (unfav.) Answer: B

Workings
Formula for Direct Materials Mix Variance = SP (SQ – AQ)
Direct Materials Mix Variance for X = 5(120-112) = 40 F
Direct Materials Mix Variance for Y = 10(80- 88) = 80 UF
Total = 40F + 80UF = 40 UF
QQ2 The information relating to the direct material cost of a company is as follows:
Standard price per unit ` 7.20
Actual quantity purchased in units 1600
Standard quantity allowed for actual production in units 1450
Material price variance on purchase (Favourable) ` 480 What is the actual purchase price per unit?
A. ` 7.50
B. ` 6.40
C. ` 6.5
D. ` 6.90 Answer: D
Workings
Material Price Variance (MPV) = Standard cost of Actual Quantity - Actual Cost
480 = 7.20 × 1,600 - Actual Cost
or, Actual Cost = 11,520 - 480 = 11,040
Actual Price per Unit = 11,040 ÷ 1,600 = ` 6.90.
QQ3 In a factory where standard costing system is followed, the production department consumed 1100 kgs of a
material @ ` 8 per kg for product X resulting in material price variance of ` 2200 (Fav) and material usage
variance of ` 1000 (Adv). What is the standard material cost of actual production of product X?
A. 11,000
B. 20,000
C. 14,000
D. 10,000 Answer: D
Workings
Actual Cost = 1100 kgs × ` 8 = 8,800
Material Cost Variance = 2200 F + 1000 A = 1200F
Standard Cost = Actual Cost + Material Cost Variance
= 8,800 + 1,200 = 10,000
QQ4 AB Ltd. uses standard cost system. The following information pertains to direct labour for Product X for the
month of March, 2020:
Standard rate per hour = ` 8/-
Actual rate per hour = ` 8.40

Standard hours allowed for actual production = 2000 hours

Labour Efficiency variance = ` 1,600 (Adverse)
What were the actual hours worked?
A. 1,800
B. 1,810
C. 2,200
D. 2,190 Answer: C
Workings
Labour Efficiency Variance = (ST – AT) × SR
or
(–) ` 1,600 = (2,000 – AT) × ` 8
(-) 1600 = 16000 – 8AT
(-) 17,600 = (-) 8 AT
AT = 17,600 ÷ 8 = 2,200 hours
QQ5 Aderholt uses activity-based costing to allocate its overheads. The budgeted cost/expected for the Supervisor
cost pool was:
Budgeted units 5,000

Number of employees 75
Budgeted Cost ` 7,500
The actual costs incurred were:

Actual Units 5,500
Actual Employees 77
Actual cost ` 8,085
What was the total variance for the pool?

A. ` 585 Adverse
B. ` 165 Favourable
C. ` 5550 Favourable
D. ` 385 Adverse Answer: B
Workings
Standard Quantity (SQ) = 75 employees ÷ 5,000 units × 5,500 units = 82.5 employees
Standard Price (SP) = 7500 ÷75 employees = 100
Standard Cost (SQ × SP) = 82.5 × 100 = 8,250
Actual cost = 8,085
Variance = 8250-8085=165 F

QQ6 The following figures are extracted from the books of a company:
Budgeted O/H ` 10,000 (Fixed ` 6,000, Variable ` 4,000)
Budgeted Hours 2000
Actual O/H ` 10,400 (Fixed ` 6,100, Variable ` 4,300)
Actual Hours 2100
Variable O/H cost variance and Fixed O/H cost variance will be:
A. 100 (A) and 200 (A)
B. 100 (F) and 200 (F)
C. 100 (A) and 200 (F)
D. 200 (A) and 100 (F) Answer: C
Workings
Overhead Recovery Rate = Budgeted OH ÷ Budgeted Hours = ` 2 per hour
Variable O/H Cost variance = Recovered O/H - Actual O/H
= 4200 – 4300 = 100(A)
Fixed O/H Cost variance = 6300 - 6100 = 200 (F)
QQ7 XYZ Ltd is a manufacturing company involved in the production of automobiles. Information from its last
budget period is as follows:
Actual production 2, 75,000 Units
Budgeted Production 2, 50,000 Units
Actual fixed production Overheads ` 52, 60, 00,000
Budgeted fixed production Overheads ` 50, 00, 00,000
Then fixed overhead volume variance and expenditure variance will be:
A. ` 5,00,00,000 (A)
B. ` 5,00,00,000 (F)
C. ` 5,00,00,000 (F)
D. ` 5,00,00,000 (A) Answer: C
QQ8 A company uses standard absorbing costing. The following information is recorded by the company for
October:
Budget Actual
Output and sales 8700 8200
Selling Price per unit ` 26 ` 31
Variable Cost per unit ` 10 ` 10
Total Fixed Overheads ` 34800 ` 37000
The sales price variance for October was:

A. 38500(A)

B. 38500(F)
C. 41000(A)
D. 41000(F) Answer: D
Workings:
Sales Price Variance =Actual Quantity × (Actual Price – Standard Price)
= 8200 (31-26) = ` 41000 (F)
QQ9 Which of the following may be the cause of Material Price Variance?
A. Change in quantity of purchase or uneconomical size of purchase order.
B. Failure to take advantage of off-season price or failure to purchase when price is cheaper.
C. Change in basic purchase price of material.
QQ10 Variance analysis involves breaking down and analysing the total variance to explain
A. How much of the variance is caused by using the resources that are different from the standards, i.e., the
quantity variance.
B. How much of the variance is caused by using the cost of the resources being different from the standards,
i.e., the rate variance.
C. All of the Above.
D. None of the above Answer: C
QQ11 A standard costing system consists of the following key elements

A. Setting standards for each of the operations.
B. Comparing the actual performance with the standard performance.
C. Analyzing and reporting variances arising from the difference between actual and standard performance.
D. All of the Above. Answer: D
QQ12 Which of the following statements is correct?

A. Standard costing facilitates the integration of accounts so that reconciliation between cost accounts and
financial accounts may be eliminated.
B. Standard costs are planned costs determined on a scientific basis and they are based upon certain assumed
conditions of efficiency and other factors.
C. Standard costing is defined as the preparation and use of standard cost, their comparison with actual cost and
the measurement and analysis of variances to their cause and points of incidence.
D. All of the above. Answer: D
QQ13 Which of the following statements is true?

A. If the actual cost is more than the standard, we call it adverse variance and if the difference is less than the
standard, we call it favourable variance.
B. In case of sales and profit, if the standard is more than actual, it is adverse variance and if the standard is less
than the actual, it is favourable variance.
C. Both (A) and (B).
D. None of the above. Answer: C

QQ14 Standard cost and budgeted cost are

A. Interrelated but not interdependent.
B. Interdependent but not interrelated.
C. Interrelated and interdependent.
D. None of the above. Answer: A
QQ15 Efficiency Ratio is

A. Available working days ÷ Budgeted working days × 100
B. Budgeted hours ÷ Maximum hours in budgeted period × 100
C. Standard hours ÷ Actual hours × 100
D. None of the above Answer: B
QQ16 Uniform Costing may not be successfully applied in the following case:
A. In a single enterprise having a number of branches, each of which manufactures the same set of products
with the same facilities.
B. In a number of entities in the same industry bound by a trade association.
C. In a number of units across different geographical locations manufacturing one or more of a given set of
products.
D. In different branches of the same company, each branch making a different product using a unique process.
Answer: D
Explanatory Comment
Though the entity is the same, different products using different (unique) process cannot follow uniform costing.

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Introduction to Strategic Cost Management

Introduction to Strategic Cost

This Study Note Includes

The Institute of Cost Accountants of India 1

Introduction to Strategic Cost Management 1

Strategic Cost Management (SCM)

2 The Institute of Cost Accountants of India

The need for SCM may be summarised as:

The Institute of Cost Accountants of India 3

Elements in Porter’s Value Chain

4 The Institute of Cost Accountants of India

Human Resource Technological

Value chain analysis (VCA)

Five Steps to developing a value chain analysis (Illustrative)

Step 1: Identify all value chain activities

Step 2: Calculate the cost of each activity

The Institute of Cost Accountants of India 5

Step 3: Look at what your customers perceive as value

Step 4: Look at your competitors’ value chains

6 The Institute of Cost Accountants of India

Step 5: Decide on a competitive advantage

Apple’s Primary Activities

Apple’s Support Activities

Example of Pizza Hut

8 The Institute of Cost Accountants of India

1.2 Cost Control and Cost Reduction – Contemporary Techniques

The Institute of Cost Accountants of India 9

Key points for exercising effective Cost Control

Advantages of cost control

10 The Institute of Cost Accountants of India

(e) Economic use of limited resources of production

Five steps to Strategic Cost reduction

The Institute of Cost Accountants of India 11

Tools & Techniques

Cost Reduction Practices

Case Study 1: How EY assisted a Client in Cost Reduction

12 The Institute of Cost Accountants of India

The Institute of Cost Accountants of India 13

Case Study 3: Ichalkaranji Power-Loomers minimise their Fixed Cost Burden

Case Study 4: MEC multiplies its profit through Outsourcing

14 The Institute of Cost Accountants of India

Case Study Learnings

Difference between Cost Control and Cost Reduction

Sl Nomenclature Cost Control Cost Reduction

1.3 Value Analysis and Value Engineering -Business Process Re-engineering

The Institute of Cost Accountants of India 15

16 The Institute of Cost Accountants of India

Focus of Value Analysis

The Institute of Cost Accountants of India 17

18 The Institute of Cost Accountants of India

Value Engineering (VE)

Case Study (Illustrative)

The Institute of Cost Accountants of India 19

Business Process Reengineering

20 The Institute of Cost Accountants of India

Example of Business Process Reengineering:

Example 1: Credit Card Approval

The Institute of Cost Accountants of India 21