Chapter 1 MARGINAL COSTING AND DECISION MAKING BASIC ...primevisionclasses.in/wp-content/uploads/2018/10/Theory.pdf · 1 Chapter 1 MARGINAL COSTING AND DECISION MAKING – BASIC CONCEPTS

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Chapter 1 MARGINAL COSTING AND DECISION MAKING – BASIC CONCEPTS & PROFITABILITY STATEMENTS

Q.1. Distinguish between “marginal cost” and “differential cost”.

Ans. Marginal cost represents the increase or decrease in total cost which occurs with a small change in output say, a unit of output. In Cost Accounting variable costs represent marginal cost.

Differential cost is the change (increase or decrease) in the total cost (variable as well as fixed) due to change in the level of activity, technology or production process or method of production.

In other words, it can be defied as the cost of one unit of product or service which would be avoided if that unit was not produced or provided.

The main point which distinguishes marginal cost and differential is that of change in fixed cost when volume of production increases or decreases by a unit of production. In the case of differential cost variable as well as fixed cost i.e. both costs change due to change in the level of activity, whereas under marginal costing only variable cost changes due to change in the level of activity.

Q.2. Distinguish between Cost Control and Cost Reduction.

OR

What are the differences between Cost Control and Cost Reduction? Discuss.

Ans. The main difference between Cost Control and Cost Reduction are as follows:

Cost Control Cost Reduction

1. It aims at achieving the established cost standards.

It aims at achieving a reduction in cost by using any suitable technique like value analysis, work study, standardisation, simplification, etc.

2. It is a preventive function. Costs are optimized before they are incurred.

It is a corrective function. It operates even when efficient cost control systems exist. There is room for reduction in achieved costs.

3. The main stress is on the present and past behaviour of costs.

The emphasis here is partly on the present costs and largely on future costs.

4. It starts from established cost standards and attempts to keep the costs of operation of a process in line with the standards.

It challenges the standards forthwith and attempts to reduce cost on a continuous basis.

PRIME VISION / C.A. FINAL / STRATEGIC COST MANAGEMENT & PERFORMANCE EVALUATION

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5. It attempts to achieve the best possible results at the least cost under given conditions.

Under cost reduction, no condition is considered to be permanent, where a change will secure a lowest cost figure.

6. This process undertakes the competitive analysis of actual results with established norms.

This process finds out the substitutes by finding new ways and means.

7. It has limited applicability to those items of cost for which standards can be set.

It is universally applicable to all areas of business. It does not depend on standards though target amounts may be set.

8. Cost control sometimes lacks dynamic approach.

It is a continuous process involving dynamic approach.

Q.3. Distinguish between ‘Cost reduction’ and ‘Cost management’.

Ans. Cost reduction is the achievement of real and permanent reduction in the unit cost of goods manufactured or services rendered without impairing their suitability for the use intended or diminution in the quality of the product. It uses the techniques like value analysis, work study, standardisation, simplification, etc. It is a continuous process of critical cost examination, analysis and challenges of established standards. Each aspect of the business namely products, processes, methods, procedures is critically examined and reviewed with a view to improving the efficiency and effectiveness so that costs are reduced. It presumes the existence of concealed potential savings in norms or standards. It is a corrective action.

Cost management is a broader concept. It aims at optimal utilization of resources to enhance the operating income of the firm. It does not consider product attributes as given. It does not focus on costs independent of revenue. Cost management systems establishes linkage between costs and revenues. It relates costs and revenues with product attributes to have an insight into how various attributes generate revenue and create demand on resources. It provides information to manage product attributes to optimize resource utilisation.

Traditional cost reduction systems focus on products, while cost management systems focus on products, markets, and customers.


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Q.4. What is margin of safety? How can margin of safety be improved?

Ans. Margin of Safety:

Margin of safety is the excess of sales over the break even sales. It may also be considered as the excess of production over break even point. It can be expressed in value as well as in percentage. The size of margin of safety shows the strength of the business. Small size of margin of safety indicates that the firm has large fixed expenses and is more vulnerable to changes in sales. In other words, if the margin of safety is large, a slight fall in sales may not affect the business very much but when it is small then a slight fall in sales may adversely affect the business. The margin of safety is calculated by using the following formula:

Margin of Safety = ratioV/P

ofitPror

= )Sales/onContributi(

ofitPr

Margin of safety is also immensely useful for making inter-firm comparison. This is being done by calculating their margin of safety ratio. This ratio can be calculated by using the following formula:

Margin of Safety = 100Sales

SafetyofinargM

= 100Sales

salesevenBreakSalesActual

Measures or improving margin of safety:

Margin of safety can be improved by taking the following measures:

1. Increasing the selling price, provided the demand is inelastic so as to absorb the increased prices.

2. Reduction in fixed expenses.

3. Reduction in variable expenses.

4. Increasing the sales volume provided capacity is available.

5. Substitution or introduction of a product mix such that more profitable lines are introduced.


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Q.5. Briefly explain the terms “product cost” and “period cost”.

Ans. Product Cost:

Product costs are those costs which are associated with and directly identifiable with the product. In other words, costs which are assigned to the product are product costs. Under marginal costing variable manufacturing costs and under absorption costing total manufacturing costs constitute product costs.

A product cost is thus the sum of the costs assigned to a product for a specific purpose.

Period cost:

Period costs are costs that are reported as expenses of the period in question. These are costs which are not assigned to the product but are charged against revenue costs of the period in which they are incurred. All non manufacturing costs such as general and administrative expenses, selling and distribution expenses are examples of period costs. In marginal costing, fixed factory overheads are treated as period costs but under absorption costing they are considered as product costs.

Q.6. What are the limitations of a break even chart?

Ans. Limitations of break-even chart:

The limitations of break-even chart are as follows:

1. While preparing a break-even chart, it is assumed that revenue and costs can be represented with the help of straight lines. It may not always be true.

2. The preparation of a break-even chart requires the segregation of semi-variable costs into fixed and variable components. It may not always be possible to segregate semi-variable costs into fixed and variable elements accurately. There may be situations when semi-variable costs cannot be split.

3. A break-even chart assumes that selling price and variable cost per unit are constant at all levels of activity. It may not always be true. Selling price as well as variable cost may either increase or decrease with the change in volume. Fixed costs also tend to vary beyond a certain output.

4. When a firm produces a number of products the apportionment of fixed expenses over various products may be difficult and often it may be done arbitrarily.

5. A break-even chart assumes that business conditions will not change. This is hardly so.

6. A break-even chart does not consider the amount of capital employed in the business, a very important factor for determining profitability of a concern.


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Q.7. Discuss the relationship between Angle of Incidence, Break-even Level and Margin of Safety.

OR Draw and explain the angle of incidence in a break-even chart. What is its significance to the management?

Ans. Angle of Incidence:

It is the angle between total sales line and total cost line drawn in the case of break-even chart. It provides useful information about the rate at which profits are being made. The larger the angle, the higher the rate of profit or vice-versa.

Break-even Level:

It is that level of sales (or production) at which the sales revenue exactly equals total costs, both variable and fixed. In other words, it is the level of activity at which the firm neither earns a profit nor suffers a loss.

Margin of Safety: It is the difference between total sales and sales at break-even point. In other words, margin of safety is the amount of sales above the break-even point. If there is a fall in the sales to the extent of margin of safety, the firm will not be in the red.

Relationship between Angle of Incidence, Break-even Level and Margin of Safety:

1. If the break-even point is low and angle of incidence is large. The margin of safety is large and the business enjoys financial stability. A low break-even point indicates that the business could be run profitably even if there is a fall in sales, unless the sales are very low.

2. If the break-even point is low and angle of incidence is small, the conclusions are the same as in 1 above except that the rate of profit earning capacity is not so high as in 1.

3. If the break-even point is high and angle of incidence is small. The margin of safety is low. The business is very vulnerable, even a small reduction in activity may result in a loss.

4. If the break-even point is high and angle of incidence is large. This shows that the margin of safety is low. The business is likely to incur losses through a small reduction in activity. However, after the break-even point, the business makes the profit at a high rate.

Q.8. Mention any four important factors to be considered in Marginal Costing Decisions.

Ans. Important factors to be considered in ‘Marginal Costing Decisions’ are as follows:

(i) Whether the product or production makes a contribution. (ii) In the selection of alternatives, additional fixed costs if any should be considered.

(iii) The continuity of demand after expansion and its impact on selling price are to be considered.

(iv) Non-cost factors such as the need to keep labour force intact and governmental attitude are also to be taken into account.


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Q.9. Explain the concept of discretionary costs. Give three examples.

Ans. Discretionary costs can be explained with the help of following two important features:

(i) They arise from periodic (usually yearly) decisions regarding the maximum outlay to be incurred.

(ii) They are not tied to a clear cause and effect relationship between inputs and outputs.

Examples of discretionary costs includes:

Advertising, public relations, executive training, teaching, research, health care and management consulting services. The note worthy feature of discretionary costs is that managers are seldom confident that the “correct” amounts are being spent.

Q.10. Discuss, how control may be exercised over discretionary costs.

Ans. Control over discretionary costs:

To control discretionary costs control points/parameters may be established. But these points need to be devised individually. For research and development function to control discretionary costs, dates may be established for submitting major reports to management. For advertising and sales promotion, such costs may be controlled by pre-setting targets. In the case of employees union and making them aware that the company would meet only the fixed costs and the variable costs should be met by them.

Q.11. “The diverse use of routinely recorded cost data give rise to a fundamental danger information prepared for one purpose can be grossly misleading in another context.”

Discuss to what extent the above statement is valid and explain your conclusion.

Ans. A database should be maintained with costs appropriately coded and classified so that relevant cost information can be extracted to help managers make better decisions. Future costs rather than past costs are required for decision making. Therefore, costs extracted from the data base should be adjusted to make it relevant for that purpose. For example, consider a situation where a company is negotiating a contract for the sale of one of its products with a customer in an overseas country which is not part of the normal market. If the company has temporary excess capacity and the contract is for 100 units for the month only, then the direct labour cost will remain the same irrespective of whether the contract is undertaken or not. The direct labour cost will therefore be irrelevant. Let us now assume that the contract is for 100 units per month for three years and the company has excess capacity. For long term decisions, direct labour will be relevant cost because if the contract is not undertaken, direct labour will be relevant cost because if the contract is not undertaken, direct labour can be deployed or made redundant Undertaking the contract will result in additional labour costs.


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Q.12. Briefly explain the methods of separating semi-variable costs into their fixed and variable elements.

Ans. Semi-variable costs as the name suggests are partly fixed and partly variable. The methods used for separating the semi-variable costs into their fixed and variable elements have been discussed briefly as under:

(i) Graphical method:

Under this method, a large number of observations regarding the total costs at different levels of output are plotted on a graph with the output on the X-axis and the total cost on the Y-axis. Then, by judgement, a line of “best fit”, which passes through all or most of the points is drawn. The point at which this line cuts the Y-axis indicates the total fixed cost component in the total cost. If a line is drawn at this, point parallel to the X-axis, this indicates the fixed cost. The variable cost at any level of output, is derived by deducting this fixed cost element from the total cost. The following diagram illustrates this.

(ii) High points and low points method:

Under this method, the difference between the total cost at highest and lowest volume is divided by the difference between the sales value at the highest and lowest volume. The quotient thus obtained gives the rate of variable cost in relation to sales value. The fixed cost is the remainder, i.e. total cost minus variable cost.

(iii) Comparison by period or level of activity method:

Under this method, the variable cost per unit may be determined by comparing two levels of output with the amount of expenses at those levels. Since the fixed element does not change, therefore the variable element of cost may be ascertained with the help of the following formula:

output of quantity the in Change

expeness of amount the in Change

Variable cost for the output

Fixed costs

Output ‘000 units

Semi-variable costs ‘000 ₹

40

30

20

40


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(iv) Least square method: This is the best method of separating semi-variable costs into their fixed

and variable elements. It is a statistical method and is based on finding out a line of best fit for a number of observations. The method uses the lower equation y = mx + c; where m represents the variable element of cost per unit, ‘c’ represents the total fixed cost, ‘y’ represents the total cost, ‘x’ represents the volume of output. The total cost is thus split into fixed and variable elements by solving this equation.

(v) Analytical method: An attempt is made under this method to judge empirically the proportion

of semi-variable cost and fixed cost. The degree of variability is determined for each item of semi-variable cost. Once this has been done, the method is easy to apply.

Q.13. “In Job order costing the costs of specific normal spoilage are charged to specific jobs.” Do you agree? Explain.

OR Define defectives and state their treatment in Cost Accounts?

OR “Key objectives in accounting for spoilage are determining the magnitude

of costs of spoilage and distinguishing between the costs of normal and abnormal spoilage”. Discuss the statement.

Ans. 1. Wastage: The term wastage represents that portion of materials is lost in storage,

handling and in manufacturing process. It does not have any recoverable value. It may be invisible (unsaleable remnants, residues etc.) or invisible (smoke, gases etc.) form.

Control of wastage: For control of wastage, allowance for normal waste should be made on the

basis of technical factors, special features of the material, nature of process and product and past experience, if any. Actual yield and wastage should be compared with anticipated figures of yield and wastage. Appropriate action should be taken to rectify the situation in the case of variation. Responsibility should be fixed on storage, purchasing, maintenance, production and inspection and inspection staff to maintain standards. A systematic procedure of feedback of achievement against standards laid down be established.

Cost accounting treatment: Waste may be classified as normal and abnormal and their accounting

treatment is as under: (i) Normal wastage: It being a normal feature and inherent in the manufacturing

operations. Therefore it should be regarded as part of the production cost. It is absorbed in the production cost of good units.


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(ii) Abnormal wastage: This wastage is in excess of the standard percentage of wastage set

up to establish normal waste. Since it indicated excessive loss caused by unexpected or abnormal conditions so its cost is transferred to the costing P & L A/c.

2. Scrap:

It is the incidental residue from certain types of manufacture usually of small quantity and low value, recoverable without further processing. Trimmings, off-cuts from metals, saw dusts, etc. are examples of scrap. Some scrap may be unavoidable and inherent in the process. It may also arise from the use of non-standard material. Scrap can be sold off or reused.

Control:

Scrap Reports are the basis of control. For effective scrap control standards should be set and responsibility fixed. At regular intervals, actual should be compared with standards and remedial action taken in appropriate cases.

It may be noted that excessive scrap may indicate inefficiency if it adversely affects output.

Cost accounting treatment:

(i) Where the value of scrap is negligible, it may be excluded from costs. In other words, the cost of scrap is to be borne by good units and income from scrap is treated as other income.

(ii) If the scrap value is considerable, the net sale proceeds of scrap (gross sales proceeds of scrap-the cost of selling scrap) is deducted from the cost of factory overhead. Under this method, the material cost or factory overhead recovery rate is reduced on account of sale proceeds of scrap.

(iii) Where the various jobs or processes give rise in varying amount of scrap, the scrap from each job or processes is recorded separately and the sale proceeds from the same credited to the particular job or process. This method is useful where scrap is of considerable value and does not arise uniformly. However, this would necessitate the scrap being identified with various jobs or processes. For this purpose detailed records for scrap will be required.

3. Spoilage: It consists of output damaged beyond rectification in course of

manufacturing process and is disposed off without reprocessing. Some spoilt work is sold as scrap, or even treated as waste depending on

the nature. Some spoilt work could be sold off as “Seconds”. Control: Spoilage Report forms the basis of control. Actual spoilage is compared

with normal spoilage and remedial action is taken. To control spoilage, allowance for normal spoilage should be fixed. A systematic procedure of reporting would help in controlling spoilage.


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Cost accounting treatment: Normal spoilage is uncontrollable in the short run. Cost of normal spoilage

is borne by good output. Cost of abnormal spoilage is transferred to costing profit and account. Any value realised from spoilage is credited to job order or overheads as the case may be.

4. Defectives:

Defectives represent that portion of production which is not of requisite quality but can be rectified and turned out as good units by the application of additional material, labour or other sources. Rectification of defectives may be taken up when the cost of rectification is low and it is more profitable to sell the rectified product that defectives sold as ‘seconds’ without rectifying them.

Control:

Control is exercised through the Defective Work Report. Rectification costs are accumulated against the Rectification Work. Steps should be taken to keep defectives within limits. It may be noted that defectives may arise due to various reasons such as sub standard materials, bad workmanship, carelessness in designing and planning, laxity in inspection, etc., steps should be taken to remove the causes of defectives as far as possible.

Cost accounting treatment:

1. When defectives are normal and it is not beneficial to identify them jobwise, the following methods are generally used:

(a) Charged to good products:

The cost of rectification of normal defectives is charged to good units.

(b) Charged to general overheads:

Where the department responsible for defectives cannot be correctly identified, because defectives caused in one department are reflected only on further processing, the rework costs are charged to general overheads.

(c) Charged to departmental overheads:

If the department responsible for defectives can be correctly identified, the rectification costs should be charged to that department.

2. Where normal defectives are easily identifiable with specific jobs, the rework costs are debited to the jobs.

3. When defectives are abnormal and are due to causes within the control (beyond the control) of the organisation the rework cost should be charged to the costing profit and loss account.


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Q.14. State three application of direct costing.

Ans. Three applications of direct costing are as follows:

(i) Stock valuation

(ii) Minimum quantity to be produced to recover pattern or mould cost

(iii) Close down decisions – like closing down of a department or shop

Q.15. Enumerate the factors involved in decisions relating to expansion of capacity. Ans. The factors involved in decisions relating to expansion of capacity are

enumerated as below: (i) Additional fixed overheads involved should be considered. (ii) Possible decrease in selling price due to increase production capacity. (iii) Whether the demand is sufficient to absorb the increased production.

Q.16. Enumerate the limitations of using the marginal costing technique. Ans. Marginal costing is defied as the ascertainment of marginal cost and of the effect

on profit of changes in volume or type of output by differentiating between fixed costs and variable costs.

1. Marginal costing assumes that all costs can be classified into fixed and variable. But it is not so, as there are costs which are neither fixed or variable. For example, various amenities provided to workers may have no relation either to volume of production or time factor.

2. Contribution of a product itself is not a guide for optimum profitability unless it is linked with the key factor.

3. Marginal costing ignores time factor and investment. For example, the marginal cost of two jobs may be the same but the time taken for their completion and the cost of machines used may differ. The true cost of a job which takes longer time and uses costlier machine would be higher. This fact is not disclosed by marginal costing.

4. The overheads of fixed nature cannot altogether be excluded particularly in large contracts while valuing work-in-progress. In order to show the correct position, fixed overheads have to be included in work-in-progress.

5. In the long run, the selling prices should be based on total cost i.e. inclusive of fixed cost also. In the short run or in special situations when a product is sold below the total cost, customers may insist on the continuation of reduced prices forever which may not be possible in all cases. Further, sales staff may mistake marginal cost for total cost and sell at a price which will result in loss or low profit. Hence, sales staff should be cautioned while giving marginal cost.

6. The main assumptions regarding behaviour of costs are not true. The variable costs do not remain constant per unit of output. There may be changes in the prices of raw materials, wage rates etc., after a certain level of output has been reached due to shortage of material, shortage of skilled labour, concessions of bulk purchases etc. Similarly, the fixed costs does not remain static. They may change from one period to another. For example, salaries bill may go up because of annual increments or due to change in pay rate etc.


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Q.17. Discuss the role of costs in product-mix decisions.

Ans. All types of cost involved in cost accounting system are useful in decision making. The cost which plays a major role in product mix decision is the relevant cost. Costs to be relevant should meet the following criteria:

(i) The costs should be expected as future costs.

(ii) The costs differ among the alternatives courses of action.

While making decision about product mix using the facilities and other available resources, the end results should always aim at profit minimisation. Variable costs are relevant costs in product mix decisions and consequently contribution plays a major role in minimisation of profit. In addition to the relevancy of costs, the other factors and costs that should be taken into account at the time of deciding the products mix are:

(i) The available production capacity

(ii) The limiting factor (s)

(iii) Contribution per unit of the limiting factor

Q.18. State the distinction between Marginal Costing and Absorption Costing.

OR

Distinguish Marginal Costing and Absorption Costing.

Ans. Main points of distinction between marginal costing and absorption costing are:

Marginal Costing Absorption Costing

(i) Only variable costs are considered for pricing and inventory valuation.

Both fixed and variable costs are considered for product pricing and inventory valuation.

(ii) Fixed costs are regarded as period costs. The profitability of different products is judged by their P/V ratio.

Fixed costs are charged to the cost of production. Each product bears a reasonable share of fixed costs and thus the profitability of a product is influenced by an apportionment of fixed costs.

(iii) Costs data presented highlight the total contribution and contribution of each product.

Cost data are presented on a conventional pattern. Net profit of each product is determined after subtracting the fixed costs along with the variable costs.

(iv) The difference in the magnitude of opening stock and closing stock does not affect the unit cost of production.

The difference in the magnitude of opening and closing stock affects the unit cost of production due to the impact of the related fixed cost.


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(v) The classification of expenses is based on behaviour of expenses as fixed and variable.

The difference in the magnitude of opening and closing stock affects the unit cost of production due to the impact of the related fixed cost.

(vi) Contribution from various products is used as a fund which fixed are deducted to get profit & hence there will be no under or over absorption of fixed overheads.

Fixed expenses are distributed over products on a pre-determined basis and as expenses fixed expenses are constant this procedure will lead to under or over recovery of fixed overheads.

(vii) Marginal costing aids decision making.

Absorption costing distort decision making.

Q.19. “Use of absorption costing method for the valuation of finished goods inventory provides incentive for over-production. Elucidate the statement.

Ans. When absorption costing method is used, production fixed overheads are charged to products and are included in product costs. Consequently, the closing stocks are valued on total cost (including fixed overheads) basis. The net effect is that the charge of fixed overheads to P/L account gets reduced, if the closing stock is greater than the opening stock. This situation has the effect of inflating the profit for the period.

Where stock levels are likely to fluctuate significantly, profits may be distorted if calculated on absorption costing basis. If marginal costing is used, since the fixed costs are charged to P/L account as period cost, such a situation will not arise. The impact of using absorption costing on profits can be summarized as under:

- When sales are equal to production, profits will be the same under absorption costing and marginal costing.

- If production is higher than sales, the absorption costing will post higher profits than marginal costing.

- If sales are in excess of production, absorption costing will show lower profits than marginal costing.

Since profit calculation in absorption costing can produce strange result, the managers may deliberately alter the stock levels to influence the profits if absorption costing is used. Hence, it is true to say that if absorption costing method is used managers have the incentive to over produce to show better result.


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Q.20. Differentiate between ‘cost difference point’ and ‘break-even point’.

Ans. Cost indifference point:

It is the point at which total cost lines under the two alternatives intersect each other.

Cost indifference point is calculated as under:

Difference in fixed costs/Difference in variable costs or

Difference in fixed costs/Difference in PV ratio

Break-even point:

It is the point where the total cost line and total revenue line for a particular alternative intersect each other.

Break-even point is calculated as under:

Fixed costs/Contribution per unit or the Fixed costs/PV ratio.

The following are the main points of distinction between cost indifference point and break-even point.

(i) The cost indifference point is the activity level at which total cost under two alternatives are equal. Whereas break-even point is the activity level at which the total revenue from a product or product mix is equal to its total cost.

(ii) Cost indifference point is used to choose between two alternative processes for achieving the same objective. The choice depends on the estimated activity level. Break even point is used for profit planning.

Q.21. Critically examine “It is prudent to hold large inventories in an inflationary economy”.

Ans. In an inflationary economy, prices rise rapidly. Holding large inventories will affect the inventory carrying cost including interest on funds blocked. However, there are other risks like obsolescence, deterioration in quality, limited shelf-life in case of certain materials etc. In addition to these risks, cheaper substitutes may be available at a later date. New sources of supply may be available at competitive rate or else price may fall. Hence speculation should be avoided.

The funds so blocked may be invested for expansion or diversification, which may result into higher profitability than the benefit arising from holding large inventory. Hence normal level of inventory may be held to avoid stock-out leading to loss of production. In view of above points all inventory control techniques may be applied for deciding the amount to be invested in inventory. Inflationary economy is one factor. There are several other considerations for deciding the quantum of inventory.


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Q.22. “The use of absorption costing method in decision-making process leads to anomalies. Discuss.

Ans. In absorption costing, fixed overheads are assigned to products by establishing overhead absorption rates based on budgeted or normal output. By using absorption costing principles, it is possible for profit to decline when sales volume increases. If the stock levels fluctuate significantly, profits may be distorted because stock changes will significantly affect the amount of fixed overheads allocated to a period. If profits are measured on, monthly or quarterly or on periodical basis, seasonal variations in sales may cause significant fluctuations in profits.

Internal profit statements on monthly or quarterly basis are used for measuring the managerial performance. In the circumstances, managers may deliberately alter inventory levels to influence profit, if absorption costing is used. When sales are less and the closing inventory increases, a part of the fixed overheads contained in the value of the closing stock is reduced from the fixed costs allocated to production for the period. Thus, if sales are reduced, inventories will increase and absorption cost will post higher profits. Similarly, if sales are increased as compared to production, inventories will be reduced and absorption costing will return lower profits.

Q.23. How has the composition of manufacturing costs changed during recent years? How has this change affected the design of cost accounting systems?

Ans. Traditionally, manufacturing companies classified the manufacturing costs to be allocated to the products into (a) direct materials (b) direct labour and (c) indirect manufacturing costs. In the present day context, characterised by intensive global competition, large scale automation of manufacturing process, computerization and product diversification to cater to the changing consumer tastes and preferences has forced companies to refine their costing systems to provide better measurement of the overhead costs used by different cost objects. Accordingly, manufacturing costs are classified into three broad categories as under:

1. Direct Cost: As many total costs relating to cost objects as feasible are classified into direct

cost. The objective is to trace as many costs as possible into direct and to reduce the amount of costs classified into indirect because the greater the proportion of direct costs the greater than accuracy of the cost system.

2. Indirect cost pools: Increase the number of indirect cost pools so that each of these pools is more

homogeneous. In a homogeneous cost pool, all the costs will have the same cause-and-effect relationship with the cost allocation base.

3. Use cost-and-effect criterion for identifying the cost allocation base for each indirect cost pool.

The change in the classification of manufacturing costs as above has lead to the development of Activity Based Costing (ABC). Activity Based Costing refines a costing system by focusing on individual activities as the fundamental cost objects. An activity is an event, task or unit of work with a specified purpose as for example, designing, set up, etc. ABC system calculates the costs of individual activities and assigns costs to cost objects such as products or services on the basis of the activities consumed to produce the product or provide the service.


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Q.24. Discuss with examples, the basic costing methods to assign costs to services.

Ans. (i) Job Costing Method:

The cost of a particular service is obtained by assigning costs to a distinct identifiable service.

Job costing method is used in service sectors – like Accounting firm, Advertisement campaign.

(ii) Process Costing Method:

Cost of service is obtained by assigning costs to masses of similar unit and then computing cost per unit on an average basis.

Areas where process costing is used. Retail banking, postal delivery, credit card, etc.

(iii) Hybrid Method:

Combination of both (i) and (ii) above.


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Chapter 2 MARGINAL COSTING AND DECISION MAKING – RELEVANT COST CONCEPTS

Q.1. Give any three examples of opportunity cost.

Ans. Examples of opportunity cost

Opportunity cost has been defined as “prospective change in cost following the adoption of an alternative machine, process, raw materials, specification or operation”. In other words, it is the cost of opportunity lost by diversion of an input factor from one use to another. It is the measure of the benefit of opportunity foregone. Examples of opportunity cost are as follows:

(i) The opportunity cost of using a machine to produce a particular product is the earning foregone that would have been possible if the machine was used to produce other products.

(ii) The opportunity cost of funds invested in a business is the interest that could have been earned by investing the fund in bank deposit.

(iii) The opportunity cost of one’s time is the earning which he would have earned from his profession.

Q.2. What are the applications of incremental cost techniques in making managerial decisions?

Ans. Incremental cost technique

It is a technique used in the preparation of ad-hoc information in which only cost and income differences between alternative courses of action are taken into consideration. This technique is applicable to situations where fixed costs alter.

The essential pre-requisite for making managerial decisions by using incremental cost technique is to compare the incremental costs with incremental revenues. So long as the incremental revenue is greater than incremental costs, the decision should be in favour of the proposal”.

Applications of incremental cost techniques in making managerial decisions.

The important areas in which incremental cost analysis could be used for managerial decision making are as under:

(i) Introduction of a new product.

(ii) Discontinuing a product, suspending or closing down a segment of the business.

(iii) Whether to process a product further or not.

(iv) Acceptance of all additional order from a special customer at lower than existing price.

(v) Opening of new sales territory and branch.

(vi) Optimizing investment plan out of multiple alternatives. (vii) Make or buy decisions.

(viii) Submitting tenders.

(ix) Lease or buy decisions. (x) Equipment replacement decisions.


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Q.3. Explain with one example each that sunk cost is irrelevant in making decisions, but irrelevant costs are not sunk costs.

OR

Explain ‘relevant costs and benefits’ in the context of decision-making.

OR

“Sunk cost is irrelevant in decision-making, but irrelevant costs are not sunk cost”. Explain with example.

Ans. Relevant costs are those expected future costs which are essential to a decision. The two key aspect of these costs are as follows:

(i) They must be expected future costs.

(ii) They must be different among the alternative courses of action.

For example, in a decision relating to the replacement of an old machine, the written down of the existing machine is not relevant but its sale price is relevant.

Relevant cost analysis helps in drawing the attention of managers to those elements of costs which are relevant for the decision. Two common pitfalls in relevant cost analysis are as under:

First pitfall in relevant cost analysis is to assume that all costs are relevant: All variable costs are not relevant. Even among future costs, those variable costs which will not differ under various alternatives are irrelevant. For example, a company proposes to rearrange plant facilities and estimates its future costs under two alternatives, as under:

Particulars Do not re-arrange

₹

Re-arrange

₹

Direct material cost/unit 10 10

Direct labour cost/unit 5 4

In the above example, the direct material cost (variable cost) remains constant under both alternatives, hence it is irrelevant to the decision as to whether plant facilities are to be re-arranged or not.

Second pitfall is to assume that all fixed costs are irrelevant: All fixed costs are not irrelevant. If fixed expenses remain unchanged under different alternatives such expenses are only irrelevant to the decision at hand but if they are expected to be altered they should be considered as relevant.

For example, if the plant capacity 50,000 units and additional 10,000 units can only be manufactured by expanding capacity which entails additional fixed expenses of ₹ 50,000. This increase in fixed expenses is relevant to the decision whether the firm should accept order for additional 10,000 units or not.


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Sunk cost is a historical cost incurred in the past. In other words, it is a cost of a resource already acquired. Future decisions in respect of this resource will not be affected by it. For example, book value of machinery. Hence sunk costs are irrelevant in decision making.

Irrelevant costs are necessarily sunk costs. For example, when a comparison of two alternative production methods using the same material quantity is made, then direct material cost is not affected by the decision but this material cost is not sunk cost.

Examples of relevant costs are:

- Past costs are not relevant costs.

- Historical costs or sunk costs are not relevant.

- Variable costs are not relevant.

- Fixed costs are not relevant.

- Book value of an equipment is not relevant.

- Disposal value of an equipment is relevant.

- Fixed costs which differ by decision becomes relevant.

- Variable costs which do not differ by a decision are not relevant.

Q.4. Comment on the use of opportunity cost for the purpose of:

(i) Decision-making; and

(ii) Cost control

Ans. Opportunity cost is primarily an economic concept. In Economics, the opportunity cost of a designated alternatives is the greatest net benefit lost by selecting an alternative. It is the benefit given by rejecting one alternative and selecting another.

Accounting takes the same view and defines it as the benefits foregone by rejecting the second best alternative in favour of the best. Opportunity costs represent the measurable value of opportunity bypassed by rejecting an alternative use of resources. It is the value in its best alternative use-the profit that is lost by the diversion of an input factor from one use to another. It is defined as the maximum contribution that is foregone using limited resources for a particular purpose.

Opportunity cost concept is helpful to the management in making profitability calculations when one or more of the inputs required by one or more of the alternative courses of action is already available.


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Opportunity cost has been defined as “Prospective change in cost following the adoption of an alternative machine, process, raw materials, specification or operation”. In other words, it is the cost of opportunity lost by diversion of an input factor from one use to another. It is the measure of the benefit of opportunity foregone. Examples of opportunity cost are as follows:

(i) The opportunity cost of using a machine to produce a particular product is the earning foregone that would have been possible if the machine was used to produce other products.

(ii) The opportunity cost of funds invested in a business is the interest that would have been earned by investing the fund in bank deposit.

(iii) The opportunity cost one’s time is the earning which he would have earned from his profession.

(i) Decision making:

Opportunity costs apply to the use of scarce resources, where resources are not scarce, there is no sacrifice from the use of these resources.

Where a course of action requires the use of scarce resources, it is necessary to incorporate the lost profit, which will be foregone from using scarce resources.

If resources have no alternative use only the additional cash flow resulting from the course of action should be included in decision making as relevant cost.

(ii) Cost control:

The conventional variance analysis will report an adverse usage variance and adverse sales volume variance. However, the failure to achieve the budgeted optimum level of output may be due to inefficient usage of scarce resources. The foregone contribution should therefore be charged to the manager responsible for controlling the usage of scarce resources and not to the sales manager because the failure to achieve the budgeted sales is due to the failure to use scarce resources efficiently.

Thus if resources are scarce, the usage variance should reflect the acquisition cost plus budgeted contribution per unit of the scarce resources.

If the lost sales is made good in subsequent periods, the real opportunity cost will consist of lost interest arising from delay in receiving the net cash-flows and not the foregone contribution.


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Q.5. State the non-cost factors to be considered in make/buy decisions.

OR

State the relative economics of the “make vs. buy” decision in management control.

Ans. (i) Cost considerations in make or buy decisions

Cost considerations: Cost considerations to decide whether a component should be manufactured internally or purchased from outside is based on the following factors under different situations.

Situation 1: When there is idle plant capacity

Under this situation the fixed overhead costs are not relevant. Here variable costs/out of pocket costs are relevant for decision making. Therefore, a comparison between the variables costs of manufacturing and buying (from outside) be made. Final decision with regard to manufacturing or buying depends upon minimum variable costs.

Situation 2: When there is no idle plant capacity

The full utilisation of plant capacity earns a contribution towards fixed overheads and profit when existing product is to be discontinued to make a component, some contribution would be lost. Therefore, in this case, decision whether to make or buy can be made by making a comparison between the contribution lost by discontinuing internal production with the savings arising from manufacturing components as compared to buying. In case, savings are more than the contribution lost by discontinuing internal production then making of components may be recommended.

(ii) Non-cost factors in make/buy decisions

(1) Possible use of released production capacity and facility as a result of buying instead of making.

(2) Sources of supply should be reliable and they are capable of meeting uninterruptedly the requirement of the concern.

(3) Assurance about the quality of goods supplied by outside supplier.

(4) Reasonable certainty, from the side of suppliers about, meeting the delivery dates.

(5) The decision of buying the product/component from outside suppliers should be discouraged, if the technical know how used is highly secretive.

(6) The decision of buying from outside sources should not result in the laying off of workers and create industrial relation problems. In fact, an buying from outside the resources freed should be better utilised else where in the concern.


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(7) The decision of manufacturing product/component should not adversely affect the concern’s relationship with suppliers.

(8) Ensure that more than one supplier of product/component is available to reduce the risk of outside buying.

(9) In case the necessary technical expertise is not available internally then it is better to buy the requirements from outside.

(10) The profitability of the main product may be reduced in the case of any future escalation in the price of components. The supplier may increase the component price knowing the dependence of the concern on him.

The relative economics of the “make vs buy” decision in management control.

Generally for taking a make vs. buy decision comparison is made between the supplier’s price and the marginal cost of making plus the opportunity cost. Make vs. buy decision is a strategic decision, and, therefore, both short-term as well long-term thinking about various cost and other aspects needs to be done.

(iii) A company generally buy a component instead of making it under following situations:

1. If it costs less to buy rather than to manufacture it internally;

2. If the return on the necessary investment to be made to manufacture is not attractive enough;

3. If the company does not have the requisite skilled manpower to make;

4. If the concern feels that manufacturing internally will mean additional labour problem;

5. If adequate managerial manpower is not available to take charge of the extra work of manufacturing.

6. If the component shows much seasonal demand resulting in a considerable risk of maintaining inventories;

7. If transport and other infrastructure facilities are adequately available.

8. If the process of making is confidential or patented;

9. If there is risk of technological obsolescence for the component such that it does not encourage capital investment in the component.


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Chapter 3 MARGINAL COSTING AND DECISION MAKING – COST VOLUME PROFIT ANALYSIS

Q.1. In what circumstances it may be justifiable to sell at a price below marginal cost?

OR Is it justifiable to sell at a price below marginal cost at any time? Mention

the circumstances in which it is justifiable.

Ans. It may be justifiable to sell at a price below marginal cost for a limited period under the following circumstances:

(i) Where materials are of perishable nature

(ii) Where stocks have been accumulated large quantities and the market prices have fallen.

(iii) To popularize a new product.

(iv) Where such reduction enables the firm to boost the sale of other products having larger profit margin.

(v) To capture foreign markets

(vi) To obviate shut down costs

(vii) To certain future market

Q.2. Explain, how Cost Volume Profit (CVP) based sensitivity analysis can help managers cope with uncertainty.

OR State the assumptions of cost-volume-profit analysis.

Ans. Sensitivity analysis focuses on how a result will be changed if the original estimates or the underlying assumptions change.

Lost Volume Profit (CVP) – based sensitivity analysis can help managers to provide answers to the following questions to cope with uncertainty.

1. What will be the profit if the sales mix changes from that originally predicted?

2. What will be the profit if fixed costs increase by 10% and variable costs decline by 5%?

The use of spreadsheet packages has enabled managers to develop CVP computerised models which can answer the above questions. Managers can now consider alternative plans by keying the information into a computer, which can quickly show changes both graphically and numerically. Thus managers can study various combinations of changes in selling prices, fixed costs, variable costs and product mix, and can react quickly without waiting for formal reports from the accountant. In this manner the use of CVP based sensitivity analysis can help managers to cope up with uncertainty.


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The assumptions underlying cost-profit-volume-analysis are as follows:

(i) All costs can be segregated into fixed and variable elements.

(ii) Variable costs vary in proportion to output and fixed costs remain constant.

(iii) The behaviour of total revenues and total costs is linear in relation to output units within the relevant range.

(iv) Costs and revenues are influenced only by volume.

(v) The analysis either covers a single product or assumes that a given sales mix of product will remain constant as the level of total units sold changes.

(vi) All revenues and costs can be added and compared without taking into account the time value of money.

(vii) profits are calculated on variable cost basis.

(viii) The analysis applies only to short-term horizon.

Q.3. Briefly discuss on curvilinear CVP analysis.

Ans. In CVP analysis, the usual assumption is that the total sales line and variable cost line will have linear relationship, that is, these lines will be straight lines. However, in actual practice it is unlikely to have a linear relationship for two reasons, namely:

1 After the saturation point of existing demand, the sales value may show a downward trend.

2 The average unit variable cost declines initially, reflecting the fact that, as output increases the firm will be able to obtain bulk discounts on the purchase of raw materials and can also benefit from division of labour. When the plant is operated at further higher levels of output, due to bottlenecks and breakdowns the variable cost per unit will tend to increase. Thus the law of increasing costs may operate and the variable cost per unit may increase after reaching a particular level of output.

In such cases, the contribution will not increase in linear proportion i.e. based on the phenomenon of diminishing marginal productivity, the total cost line will not be straight, as assumed but will be of curvilinear shape. This situation will give rise to two break even points. The optimum profit is earned at the point where the distance between sales and total cost is the greatest.


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Q.4. “Cost can be managed only at the point of commitment and not at the point of incidence. Therefore it is necessary to manage cost drivers to manage cost”. Explain the statement with reference to structural and executional cost drivers.

Ans. (1) A firm commits costs at the time of designing the product and deciding the method of production. It also commits cost at the time of deciding the delivery channel (e.g. delivery through dealers or own retail stores). Costs are incurred at the time of actual production and delivery. Therefore, no significant cost reduction can be achieved at the time when the costs are incurred. Therefore, it is said that costs can be managed at the point of commitment.

(2) Cost drivers are factors that drive consumption of resources. Therefore, management of cost drivers is essential to manage costs.

(i) Structural cost drivers:

These are those which can be managed by effecting structural changes. Examples of structural cost drivers are scale of operation, scope of operation (i.e. degree of vertical integration), complexity, technology and experience or learning. Thus, structural cost drivers arise from the business model adopted by the company.

(ii) Executional cost drivers:

These can be managed by executive decisions. Examples of executional cost drivers are capacity utilization, plant layout efficiency, product configuration and linkages with suppliers and customers. It is obvious that cost drivers can be managed only at the point of structural and operating decisions, which commit resources to various activities.

Q.5. What are the major areas of decision-making in which differential costing is used?

Ans. Cost information is required both for short-term and long-run managerial problems. Differential costs are of particular use in short-term problems which are non-repetitive, one-time, ad-hoc problems. The following are the most common short-term problems and areas where differential cost analysis may be deployed.

1. Accept – or – reject special order decisions. [i.e. Export sale etc.]

2. Make – or – buy decisions.

3. Sell – or – process decisions. [or Expand or Contract decision]

4. Reduce – or – maintain price decisions. [or price mix decision]

5. Add – or – drop product decisions. [or product mix decision]

6. Operate – or shut down decisions.


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Chapter 4 MARGINAL COSTING AND DECISION MAKING – PRICING DECISION AND TRANSFER PRICING

Q.1. Enumerate the circumstances which are favourable for the adoption of penetrating pricing policy.

OR

What is penetration pricing? What are the circumstances in which this policy can be adopted?

OR

In what circumstances can penetration pricing policy be adopted?

OR

Outline the features of penetration pricing strategy.

OR

What is penetrating pricing? What are the circumstances in which this policy can be adopted?

Ans. It means a pricing policy for penetrating mass market as quickly as possible through lower price offers. This method is also used for pricing a new product. In order to popularize a new product penetrating pricing policy is used initially. The company may not earn profit by resorting to this policy during the initial stage. Lager on, the price may be increased as and when the demand picks up. Penetrating pricing policy can also be adopted at any stage of the product life cycle for products whose market is approached with low initial price. The use of this policy by the existing concerns will discourage the new concerns to enter the market. This pricing policy is also known as “stay-out-pricing”.

Favourable circumstances:

The three circumstances favourable for resorting to penetrating pricing policy are as under:

(i) When demand of the product is elastic to price. In other words, the demand of the product increases when price is low.

(ii) When there are substantial savings on large scale production. Here increase in demand is sustained by the adoption of low pricing policy.

(iii) When there is threat of competition, the prices fixed at a low level will act as an entry barrier to the prospective competitors.


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Q.2. What should be the basis of Transfer Pricing, if unit variable cost and unit selling price are not constant.

OR

Enumerate the main objectives of Transfer Pricing.

OR

Briefly describe the different methods of Transfer Pricing.

Ans. Pricing under different market structures:

The determination of optimal price can be considered under the following market structures:

(1) Pure competition:

Under pure competition a firm has no pricing policy of its own as it has to accept the prevalent market price and at this price, it can sell all of its production if it so desires. But at any higher price it can sell nothing. There is no control over market price which will equate the quantities available with the quantities which the buyers are willing to buy. The firm has to take a decision in favour of the quantity to sell. The firm can continue to produce so long as its marginal cost is less than or equal to its selling price. Upto the point at which the marginal cost is equal to price, increase in output will add to revenue and thereafter the increase will add to cost.

(2) Monopoly:

It is a business situation which is characterised by:

(i) one seller of a particular good or serivce

(ii) competition from the producers of substitutes is almost insignificant.

Q.3. “Transfer pricing is a widely debated and contested topic.” Discuss.

Ans. Usually a conflict between division of the company and the company as a whole is faced by the management of decentralised units when products or services are exchanged among different divisions of the company. such a conflict becomes more significant in the case of those concerns where profitability is used as a criteria for evaluating the performance of each division.

The essence of decentralisation is reflected in the freedom to make decisions. Under such a set up it is expected that the top management should not interfere with the decision making process of its subordinates heading different units. In other words, management of decentralised units is given autonomy with regard to decision making. In this system top management is expected to preserve ‘autonomy in decision making’. The management of such companies also expects that each division should not only achieve its own objective necessary for evaluating the performance but should also achieve the objective of goal congruence.


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A divisional head in a company under aforesaid setup is free to use a price as a transfer price for goods and services, which may provide incentive. Such a transfer price may fail to achieve the objective of ‘Goal congruence’ (which means a perfect congruence between division’s goal and the goal of the company). In case of failure of a division to achieve the objective of ‘goal congruence’ the management of the company is usually the main basis of conflict between a division and the company as a whole.

Further this conflict is aggravated if the management advocates the transfer of goods and services at cost. As such the transfer price will not reflect a good picture about the performance of the transferring division. The profitability of the transferring division will not be known by the use of such a transfer price.

Each division appreciates the transfer of its goods/serviced at usual selling price/market price so as to arrive at the correct return/profitability figure, used for measuring the performance. There is no incentive to the transferring division if goods and services are transferred at variable cost.

Q,4. Explain the concept of cost plus pricing. What are its advantages and disadvantages?

Ans. The concept of cost plus pricing:

Meaning:

It is the most widely used method of pricing a product as it ensures that the selling price is greater than the total cost of a product. This method helps business firms to generate profits and survive in the future.

Under cost plus pricing the selling price of the product is determined by adding a percentage of mark-up to the estimated unit cost of the product.

The unit cost of the product can be determined by using different methods viz., total cost; manufacturing cost or variable/incremental cost. The percentage of mark-up to be added to estimated cost also vary and depends upon the cost figure used. For example, if total cost is used, the mark up will be added to provide an acceptable profit per unit.

Alternatively if total manufacturing cost is used, the ‘plus’ that is added must be sufficient to cover non-manufacturing overheads and provide an acceptable profit per unit.

The advantages and disadvantages of cost plus pricing are as under:

Advantages:

(i) It is a fair method and recovery of full costs is assured under it.

(ii) It leaves out scope for any uncertainty.

(iii) After arriving at full cost, the profit percentage can be flexibly adjusted to take care of market competition.


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Disadvantages: (i) Covering full cost all the time may ignore the competition. (ii) It can lead to distorted price fixation unless the cost is determined in a

scientific manner. (iii) It ignores the concepts of Marginal Costing, Incremental Costing, etc. (iv) It is difficult to predetermine capacity utilization. Competitive pricing

Where a company sets its price mainly on the consideration of what its competitors are charging, its pricing under such situation is called competitive pricing. Two types of competitive pricing are:

(i) Going rate pricing: Under this method, the firm tries to keep its price at the average level

charged by the industry. Such pricing is useful where it is difficult to measure costs. Adoption of such pricing will not only yield fair return but would be least disruptive for industry’s harmony. Under highly competitive conditions in homogeneous product market (such as food, raw materials and textiles) the company has no pricing decision to make.

(ii) Sealed bid pricing: Competitive pricing is adopted in situations where firms compete for jobs

on the basis of bids. The bid is the firms offer price, and it is a prime example of pricing based on the expectations of how competitors will price rather than on a rigid relation based on the concerns own costs or demand. The objective of the firm in bidding situation is to get the contract and therefore it tries to set its prices lower than the other bidding firms.

Q.5. What will be the marketable transfer pricing procedure regarding the goods transferred under the following conditions (each condition is independent of the other)?

(i) When divisions are not captives of internal divisions and the divisions are free to do business both internally and externally and when there are reasonably competitive external markets for the transferred products.

(ii) If the external market for the transferred good is not reasonably competitive external markets for the transferred products.

(iii) If the external market for the transferred good is not reasonably competitive.

Ans. Bargained/Negotiated prices method:

Each decentralised unit is treated as an independent unit and such units decide the transfer price by bargaining or negotiations. Divisional Managers have full freedom to purchase their requirement from outside if the prices quoted by their sister unit are not acceptable to them. A system of negotiated prices develops business like attitude amongst divisions of the company. The buying division may be tempted to purchase from outside sources if the outside prices are lower than the internal division’s price. In order to avoid any reduction in overall profits of the company, the top management may impose restrictions on the external purchase/sale of goods.


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Limitations of negotiated method of transfer pricing:

Limitations of negotiated method of transfer pricing are as follows:

1. A system of negotiated prices develops business like attitude amongst divisions of a company. This attitude may tempt the managers to purchase their requirements from outside sources, even by ignoring the overall interest of the company.

2. Agreed transfer price between divisions of a company, will depend on the negotiating skills and bargaining power of the managers involved and the final outcome may not be close to optimal level.

3. Conflict between divisions of a company may arise while negotiating about transfer price and the resolution of such conflicts may require sufficient management time.

4. Measurement of divisional profitability may depend on the negotiating skills of the managers who have unequal bargaining power.

5. Deciding about negotiated transfer price between the divisions of a company, is time-consuming exercise for the managers involved.

Q.6. Discuss the potential for maximization of income by a multinational through the use of transfer pricing mechanism.

Ans. The potential for maximisation of income by a multinational through the use of transfer pricing mechanism is based on the successful implementation of the following steps:

(i) Transfer pricing may be set relatively higher for affiliates in relatively high-tax countries that purchase inputs from affiliates located in relatively low-tax countries.

(ii) Transfer prices to affiliates in countries which are subject to import duties for goods or services purchase may be set low so as to avoid host country taxes.

(iii) Transfer of prices to an affiliate in a country that is encountering relatively high inflation may be set relatively high to avoid some of the adverse effects of local currency devaluation that are related to the high inflation.

(iv) Transfer prices may be set high for goods and services purchased by an affiliate operating in a country that has imposed restrictions on the repatriation of income to foreign companies.

(v) Transfer prices may be set low for an affiliate that is trying to establish a competitive advantage over a local company either to break into a market or to establish a higher share of the company’s business.


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Q.7. Describe two pricing practices in which non-cost reasons are important, when setting prices.

Ans. Pricing practices in which non-cost reasons are important, when setting prices.

Two pricing practices in which non-cost reasons are important when setting prices are: (i) Price discrimination and (ii) Peak load pricing.

(i) Price discrimination:

This is the practice of charging to some customers a higher price than that charged to other customers e.g. Airlines tickets for business travelers and LTC travelers are priced differently.

(ii) Peak load pricing:

This pricing system is based on capacity constraints. Under this pricing system a higher price for the same service or product is demanded when it approaches physical capacity limits e.g. telephones, telecommunications, hotel, car tental and electric utility industries are charged higher price at their peak load.

Q.8. Indicate the possible disadvantages of treating decisions as profit centres.

Ans. The possible disadvantages of treating divisions as profit centres are as follows:

1. Divisions may compete with each other and may take decisions to increase profits at the expense of other divisions thereby overemphasizing short term results.

2. It may adversely affect co-operation between the divisions and lead to lack of harmony in achieving organisational goals of the company. Thus it is hard to achieve the objective of goal congruence.

3. It may lead to reduction in the company’s overall total profits.

4. The cost of activities which are common to all divisions may be greater for decentralised structure than for centralized structure. It may thus result in duplication of staff activities.

5. Top management loses control by delegating decision making to divisional managers. There are risks of mistakes committed by the divisional managers which the top management, may avoid.

6. Series of control reports prepared for several departments may not be effective from the point of view of top management.

7. It may underutilize corporate competence.

8. It leads to complications associated with transfer pricing problems.

9. It becomes difficult to identify and define precisely suitable profit centres.

10. It confuses division’s results with manager’s performance.


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Q.9. Explain the usefulness of Pareto Analysis and its applicability to business situations.

OR

How Pareto Analysis is helpful in pricing of product in the case of firm dealing with multi products?

OR

What is Pareto Analysis? Name some applications.

Ans. Pareto analysis is based on the 80:20 rule that was a phenomenon observed by Vilfredo Pareto. According to him 80% of wealth of Milan in Italy was owned by 20% of its citizens. The phenomenon can be observed in many different business situations and the management can follow it in various circumstances to direct management attention to the key control mechanism or planning aspects.

Usefulness of Pareto Analysis:

It helps to establish top priorities and to identify both profitable and unprofitable targets.

It helps to:

(a) Prioritize problems, goals and objectives

(b) Identify root causes

(c) Select and define key quality improvement programs

(d) Select key customer relations and service programs

(e) Select key employee relations improvement programs

(f) Select and define key performance improvement programs

(g) Maximise research and product development time

(h) Verify operating procedures and manufacturing processes

(i) Product or services sales and distribution

(j) Allocate physical, financial and human resources

Applicability of Pareto analysis to business situations:

The Pareto analysis is generally applicable to the, following business situations:

(i) Pricing of product:

In practice, it has been observed that 20% of products of a firm may account for 80% of total sales revenue. Under such circumstances the firm can adopt more sophisticated pricing method for small portion of products that jointly accounts for approximately 80% of total sales revenue. For the remaining 80% of the products the firm may use cost based pricing method. Pareto analysis thus helps the management of the firm to delegate the pricing decision for about 80% of its products to lower levels of management.


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(ii) Customer profitability:

Customers can also be analysed instead of products, for their relative profitability. It has been often found that 20% of customers may generate 80% of sales revenue profit. Such an analysis is useful for the evaluation of portfolio of customer profile.

(iii) Stock control:

Approximately 20% of the total investment in quantity of stock may account for about 80% of its investment. Since the number of items is small therefore the management of a firm may be able to control most of the monetary investment in them.

(iv) Applicability in activity based costing:

In ABC it is often said that 20% of an organisation cost drivers are responsible for 80% of the total overhead cost. By analyzing, monitoring and controlling those cost drivers that cause most cost a better control and understanding of overheads may be obtained.

(v) Quality control:

Pareto analysis seeks to discover from an analysis of defect report or customer complaints which “vital few” cause are responsible for most of the reported problems. Often 80% of underlying problems can usually be traced to 20% of the various underlying causes.

Q.10. Explain different types of competitive pricing?

Ans. Where a company sets its price mainly on the consideration of what its competitors are charging, its pricing under such situation is called competitive pricing. Two types of competitive pricing are:

(i) Going rate pricing:

Under this method, the firm tries to keep its price at the average level charged by the industry. Such pricing is useful where it is difficult to measure costs. Adoption of such pricing will not only yield fair return but would be least disruptive for industry’s harmony. Under highly competitive conditions in homogeneous product market (such as food, raw materials and textiles) the company has no pricing decision to make.

(ii) Sealed bid pricing:

Competitive pricing is adopted in situations where firms compete for jobs on the basis of bids. The bid is the firms offer price, and it is a prime example of pricing based on the expectations of how competitors will price rather than on a rigid relation based on the concerns own costs or demand. The objective of the firm in bidding situation is to get the contract and therefore it tries to set its prices lower than the other bidding firms.


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Q.11. What are some goals of a ‘transfer-pricing’ system in an organisation?

Ans. It should:

1. provide information that motivates divisional managers to take good economic decisions which will improve the divisional profits and ultimately the profits of the company as a whole.

2. provide information which will be useful for evaluating the divisional performance.

3. seek to achieve goal congruence.

4. ensure that divisional autonomy is not undermined.

Q.12. State the general guidelines to be used in adopting a pricing policy in a manufacturing organisation.

Ans. The general guidelines to be used in adopting a pricing policy are as under:

(i) The pricing policy should encourage optimum utilization of resources.

(ii) The pricing policy should work towards a better balance between demand and supply.

(iii) The pricing policy should promote exports.

(iv) The pricing policy should serve as an incentive to the manufactures to maximize production by adopting improved technology.

(v) The pricing policy should avoid adverse effects on the rest of the economy.

Q.13. Discuss pricing under different market structures.

Ans. The determination of optimal price can be considered under the following market structures:

Perfect Competition

Under perfect competitive market, there are large numbers of sellers selling a homogeneous product using identical production process and all of them have perfect information about the market and price. Perfect market allows free entry and exit of firms into and out of the industry.

Under this type of market, firm has no pricing policy of its own as the sellers are price takers (i.e. it has to accept the price determined by the market) and sell as much as they are capable of selling at the prevailing market price. Since each firm produces and sells a homogeneous product, it cannot increase its price beyond the market price. If it does so then it has to lose all of its market demand to the competitors.

There is no control over market price which will equate the quantities available with the quantities which the buyers are willing to buy. The firm has to take a decision in favour of the quantity to sell. The firm can continue to produce so long as its marginal cost is less than or equal to its selling price, upto the point at which the marginal cost is equal to price, increase in output


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will add to revenue and thereafter the increase will add to cost.

Monopoly

Monopoly is a market condition where there is only one supplier or producer of a homogeneous product for which there is no close substitute but has many buyers. Under the monopoly, a firm is a price setter i.e. it can fix any price but here also the pricing is done taking elasticity of demand for the product into consideration. That means though the seller/ producer can fix any price but it will go for the price where demand for the product and consequent profit will be maximum.

Monopolistic Competition

The monopolistically competitive market is one in which there are large number of firms producing similar but not identical products. Since there is limit to the growth of competitors the excess profits earned by monopolistic situation attracts new competition. This will have a long-run effect on the excess profits which will tend to diminish because of the price competition with close substitutes. The company will, however, have to compare marginal cost and marginal revenue in maximising its profits.

Under monopolistic condition, consumers may buy more at a lower price than at higher price. The profit can be maximised by equating marginal revenue with marginal cost.

Oligopoly

A market structure where there are few firms producing or selling homogenous or identical product. In this type of market structure the firms are aware of the mutual interdependence of investment, production process, advertising and sales plan of its rival firm. Hence, any change in any variable by a firm is likely to have an equal reaction on the part of other competing firms. It is therefore, clear that the oligopolistic firm, while determining the price for its product, consider not only the demand for the product but also the reactions of the other firms in the industry to any action or decision it may take.

If a firm does not follow or adapt its pricing policy in consonance with its competitor, the shift in the sales will be sensitive. That means demand will shift towards the lower price. Thus, each firm will study the potential reaction before increasing or decreasing the selling price. The firms in oligopolistic market maintain the price of the product either by close analysis of each other’s behavior or by means of cooperation and collusion.

Skimming Pricing

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

(i) The demand is likely to be inelastic in the earlier stages till the product is established in the market.


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(ii) The change of high price in the initial periods serves to skim the cream of the market that is relatively insensitive to price. The gradual reduction in price in the later year will tend to increase the sales.

(iii) This method is preferred in the beginning because in the initial periods when the demand for the product is not known the price covers the initial cost of production.

(iv) High initial capital outlays, needed for manufacture, results in high cost of production. Added to this, the manufacturer has to incur huge promotional activities resulting in increased costs. High initial prices will be able to finance the cost of production particularly when uncertainties block the usual sources of capital.

Penetration Pricing

This policy is in favour of using a low price as the principal instrument for penetrating mass markets early. It is opposite to skimming price. The low price policy is introduced for the sake of long-term survival and profitability and hence it has to receive careful consideration before implementation. It needs an analysis of the scope for market expansion and hence considerable amount of research and forecasting are necessary before determining the price.

Penetrating pricing, means a pricing suitable for penetrating mass market as quickly as possible through lower price offers. This method is also used for pricing a new product. In order to popularise a new product penetrating pricing policy is used initially. The company may not earn profit by resorting to this policy during the initial stage. Later on, the price may be increased as and when the demand picks up.

Penetrating pricing policy can also be adopted at any stage of the product life cycle for products whose market is approached with low initial price. The use of this policy by the existing concerns will discourage the new concerns to enter the market.

We must distinguish penetration pricing from Predatory Pricing. Predatory Pricing (loss leading) is the practice of selling a product or service at a very low price, intending to drive competitors out of the market or create barriers to entry for potential new competitors.

The three circumstances in which penetrating pricing policy can be adopted are as under:

(i) When demand of the product is elastic to price. In other words, the demand of the product increases when price is low.

(ii) When there are substantial savings on large scale production. Here increase in demand is sustained by the adoption of low pricing policy.

(iii) When there is threat of competition. The prices fixed at a low level act as an entry barrier to the prospective competitors.


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Chapter 5 MARGINAL COSTING AND DECISION MAKING – DEVELOPMENTS IN BUSINESS ENVIRONMENT

UNIT – I: TOTAL QUALITY MANAGEMENT (TQM)

Q.1. Define Total Quality Management? What are the six Cs for successful implementation of TQM?

OR What are the essential requirements for successful implementation of TQM? Ans. The total quality management is a set of concepts and tools for getting all

employees focused on continuous improvement in the eyes of the customer. Quality is an important aspect of world-class manufacturing. The success of Japanese companies is grass rooted in their long-term commitment to improvement of quality. A world class manufacturing approach demands that the quality must be designed into product and the production process, rather than an attempt to remove poor quality by inspection. This means that the objectives of quality assurance in a world-class-manufacturing environment, is not just reject defective product, but to systematically investigate the cause of defects so that they can be gradually eliminated. Though the goal is zero defect, the methodology is one of continuous improvement.

Six Cs of TQM (i) Commitment: If a TQM culture is to be developed, so that quality improvement becomes

normal part of everyone’s job, a clear commitment, from the top must be provided. Without this all else fails.

(ii) Culture: Training lies at the centre of effecting a change in culture and attitudes.

Negative perceptions must be changed to encourage individual contributions. (iii) Continuous improvement: TQM is a process, not a program, necessitating that we are committed in

the long term to the never ending search for ways to do the job better. (iv) Co-operation: The on-the-job experience of all employees must be fully utilized and their

involvement and co-operation sought in the development of improvement strategies and associated performance measures.

(v) Customer focus: Perfect service with zero defects in all that is acceptable at either internal

or external levels. (vi) Control: Documentation, procedures and awareness of current best practice are

essential if TQM implementations are to function appropriately. The need for control mechanisms is frequently overlooked, in practice.


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Q.2. Discuss the benefits accruing from the implementation of a Total Quality Management programme in an organisation.

Ans. The benefits accruing from the implementation of a Total Quality Management programme in an organisation are:

(i) There will be increased awareness of quality culture in the organisation. (ii) It will lead to commitment to continuous improvement. (iii) It will focus on customer satisfaction. (iv) A greater emphasis on team work will be achieved.

Q.3. Discuss the various Quality Cost.

Prevention Costs

The costs incurred for preventing the poor quality of products and services may be termed as Prevention Cost. These costs are incurred to avoid quality problems. They are planned and incurred before actual operation and are associated with the design, implementation, and maintenance of the quality management system. Prevention costs try to keep failure and appraisal cost to a minimum.

Examples include the costs for:

Quality planning (creation of plans for quality, reliability, operations, production, and inspection)

Quality assurance (creation and maintenance of the quality system)

Supplier evaluation

New product review

Error proofing

Capability evaluations

Quality improvement team meetings

Quality improvement projects

Quality education and training (development, preparation, and maintenance of programs)

Cost incurred due to product specification arising may be from incoming materials or intermediate processes.

Appraisal Costs

The need of control in product and services to ensure high quality level in all stages, conformance to quality standards and performance requirements is Appraisal Costs. These are costs associated with measuring and monitoring activities related to quality. Appraisal Cost incurred to determine the degree of conformance to quality requirements (measuring, evaluating or auditing). They are associated with the supplier’s and customer’s evaluation of purchased materials, processes, products and services to ensure that they are as per the specifications. They could include:


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Verification (checking of incoming material, process setup, and products against agreed specifications)

Quality audits(confirmation that the quality system is functioning correctly)

Supplier rating (assessment and approval of suppliers of products and services)

Checking and testing purchased goods and services

In-process and final inspection/test

Field testing

Product, process or service audits

Calibration of measuring and test equipment

Internal Failure Costs

Internal Failure Cost associated with defects found before the customer receives the product or service. Internal failure costs are incurred to remedy defects discovered before the product or service is delivered to the customer. These costs occur when the product is not as per design quality standards and they are detected before they are transferred to the customer. These are costs that are caused by products or services not conforming to requirements or customer/user needs and are found before delivery of products and services to external customers. Deficiencies are caused both by errors in products and inefficiencies in processes. They could include:


• Waste- waste occurs when unnecessary work is done or holding of stock as a result of errors, poor organization, or communication

• Scrap—defective product or material that cannot be repaired, used, sold

• Rework or rectification—when the work needs to be rectified for defective material or errors

• Failure analysis—activity required to establish the causes of internal product or service failure

• Delays

• Re-designing

• Shortages

• Failure analysis

• Re-testing

• Downgrading

• Downtime

• Lack of flexibility and adaptability


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External Failure Costs

External failure costs are incurred to medicate defects discovered by customers. These costs occur when products or services that fail to reach design quality standards are not detected until after transfer to the customer. After the product or service is delivered and then the defects is found then it is an external failure. Further external failure costs are costs that are caused by deficiencies found after delivery of products and services to external customers, which lead to customer dissatisfaction. They could include:


• Repairs and servicing (of both products that have been returned by the customer and which are serviced at the customer’s place)

• Warranty claims (failed products that are replaced or services that are re-performed under a guarantee)

• Complaints (all work and costs associated with handling and servicing customer’s complaints)

• Returns (handling and investigation of rejected or recalled products, including transport costs)

• Complaints

• Repairing goods and redoing services

• Warranties

• Losses due to sales reductions

• Environmental cost

UNIT – II: ACTIVITY BASED COSTING

Q.1. What are the areas in which activity based information is used for decision making?

Ans. The areas in which activity based information is used for decision making are as under:

(i) Pricing

(ii) Market segmentation and distribution channels

(iii) Make-or-buy decisions and outsourcing

(iv) Transfer pricing

(v) Plant closed down decisions

(vi) Evaluation of offshore production

(vii) Capital investment decisions

(viii) Product line profitability


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Q.2. Explain briefly four different categories of activities that drive the expenses at the product level.

OR Give two examples for each of the following categories in activity based costing: (i) Unit level activities (ii) Batch level activities (iii) Product level activities

(iv) Facility level activities.

Ans. Four different categories of activities that drive the expenses at product cost level are:

1. Unit level activities

2. Batch level activities

3. Product level activities

4. Facility level activities

A brief explanation of the above activities is given as under:

1. Unit Level Activities:

These are the activities whose costs are strongly correlated to the number of units produced. Examples:

(a) Use of indirect materials

(b) Inspection or testing of every item produced or say every 100th item produced

(c) Indirect consumables

2. Batch Level Activities: These are the activities whose cost are driven by the number of batches of

units produced. Such activities are known as batch level activities. Examples: (a) Material ordering (b) Machine set up costs (c) Inspection of products – like first item of every batch 3. Product Level Activities: In this case the cost of some of the activities are driven by the creation of a new

product line and its maintenance, for example Advertisement costs fall into this category of individual products are advertised rather than the company’s name.

Examples: (a) Designing the product (b) Producing parts to a certain specification (c) Advertising costs, if advertisement is for individual products 4. Facility level Activities: In these activities some costs are related to maintaining the building and

other facilities required by a concern. The activities which drive these costs are known as facility level activities.

Examples: (a) Maintenance of buildings (b) Plant security (c) Production manager’s salaries (d) Advertising campaigns promoting the company


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Q.3. State the need for emergence of activity based costing.

Ans. Need for emergence of activity based costing:

1. Traditional product costing systems were designed when most companies manufactured a narrow range of products.

2. Direct materials and direct labour were the dominant factors of production then.

3. Companies were in seller’s market. 4. Overheads were relatively small and distortions due to inappropriate

treatment were not significant.

5. Cost processing information was high.

6. Today companies produce a wide range of products. Overheads are of considerable importance.

7. Simple methods of apportioning overheads on direct labour or machine hour basis are not justified.

8. Intense global competition calls for correct costing of products to avoid errors in decision making.

9. Traditional systems can measure volume related costs.

10. No volume related activities like material handling, set up etc. are important and their costs cannot be apportioned on volume basis.

Q.4. Explain which features of the service organizations may create problems for the application of activity based costing

Ans. The following may create problem for adoption of ABC system in service organisation:

(i) Facility sustaining costs (such as property rents etc.) represent a significant portion of total costs and may only be avoidable if the organisation ceases business. It may be impossible to establish appropriate cost drivers.

(ii) It is often difficult to define products where they are of intangible nature. Cost objects can therefore be difficult to specify.

(iii) Many service organisations have not previously had a costing system and much of the information required to set up a ABC system will be non-existent. Therefore introduction of ABC system may be expensive.

Q.5. Explain the concept of activity based costing. How ABC system support corporate strategy?

Ans. Activity based costing: It focuses on activities as the fundamental cost objects and uses the costs of these activities as building blocks for compiling the costs for other objects. According to CIMA, it is defined as “Cost attribution to cost units on the basis of benefits received from indirect activities i.e. ordering, setting-up, assuring quality etc.” Under activity based costing costs are accumulated for each activity as a separate cost object. The collected costs are applied to products based on the benefits received from various activities. The final product cost are built up from the costs of the specific activities undergone.


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In the first stage the activity driven overhead cost is charged to activity based cost pools and in the second stage cost driver based rates are derived to charge cost to product lines. The cost driver based rates are based on activities.

Activity based costing can be used for: (a) Pricing of products; (b) Design and development of new products ABC supports corporate strategy in many ways such as: 1. ABC system can effectively support the management by furnishing data,

at the operational level and strategic level. Accurate product costing will help the management to compare the profit of various customers, product lines and to decide on price strategy etc.

2. Information generated by ABC system can also encourage management to redesign the products.

3. ABC system can change the method of evaluation of new process technologies, to reduce setup times, rationalization of plant layout in order to reduce or lower material handling cost, improve quality etc.

4. ABC system will report on the resource spending. 5. ABC analysis helps managers’ focus their attention and energy on

improving activities and the actions allow the insights from ABC to be translated into increased profits.

6. Performance base accurate feedback can be provided to cost centre managers. 7. Accurate information on product costs enables better decisions to be made

on pricing, marketing, product design and product mix.

Q.6. Why are conventional product costing systems more likely to distort product costs in highly automated plants? How do activity based costing systems deal with such a situation?

Ans. The conventional product cost system was in vogue when companies manufactured narrow range of products, overhead costs were relatively small and distortions arising from inappropriate overhead allocations wee not significant. It used volume measures like direct labour hours or machine hours for charging overhead costs to products. In the case of a company using highly automated plant, direct labour is a small fraction of cost when compared with overheads (because of higher amount of depreciation). In case where such a company is multi product, overheads which are large in proportion to direct labour are influenced by number of set up, inspection, number of purchases etc. In these circumstances, the volume based method of recovery of overheads is no longer appropriate and such a measure will report inaccurate product costs. Hence, the traditional system of costing was found to over cost high volume products and under cost low volume products. Activity Based Costing (ABC) system aims at refining the costing system used in automated plants in the following manner:

1. ABC systems trace more costs as direct costs. 2. ABC systems create homogeneous cost pools linked to different activities. 3. For each activity cost pool, ABC systems seek a cost allocation base that has

a cause-and-effect relationship with costs in the cost pool.


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Q.7. Differentiate between ‘Value-added’ and ‘Non-value-added’ activities in the context of activity based costing.

Give examples of Value added and Non-value-added activities.

Ans. A value added activity is an activity that customers perceive as adding usefulness to the product or service they purchase. In other words, it is an activity that, if eliminated, will reduce the actual utility or usefulness which customers obtain from using the product or service. For example, painting a car in a company manufacturing cars or a computer manufacturing company making computers with preloaded software. A non-value added activity is an activity where there is an opportunity of cost reduction without reducing the product’s service potential to the customer. In other words, it is an activity that, if eliminated, will not reduce the actual or perceived value that customer obtain by using the product or service. For example, storage and moving of raw materials, reworking or repairing of products etc. Value-added activities enhance the value of products and services in the eyes of the organisation’s customers while meeting its own goals. Non-value added activities on the other hand do not contribute to customer perceived value.

Q.8. How has the composition of manufacturing costs changed during recent years? How has this change affected the design of cost accounting system?

Ans. Traditionally, manufacturing companies classified the manufacturing costs to be allocated to the products into (a) direct materials (b) direct labour and (c) indirect manufacturing costs. In the present day context, characterised by intensive global competition, large scale automation of manufacturing process, computerization and product diversification to cater to the changing consumer tastes and preferences has forced companies to refine their costing systems to provide better measurement of the overhead costs used by different cost objects. Accordingly, manufacturing costs are classified into three broad categories as under:

1. Direct Cost: As many total costs relating to cost objects as feasible are classified into direct cost. The objective is to trace as many costs as possible into direct and to reduce the amount of costs classified into indirect because the greater the proportion of direct costs the greater the accuracy of the cost system.

2. Indirect cost pools: Increase the number of indirect cost pools so that each of these pools is more homogeneous. In a homogeneous cost pool, all the costs will have the same cause-and-effect relationship with the cost allocation base.

3. Use of cost-and-effect criterion for identifying the cost allocation base for each indirect cost pool.


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The change in the classification of manufacturing costs as above has lead to the development of Activity Based Costing (ABC). Activity Based Costing refines a costing system by focusing on individual activities as the fundamental cost objects. An activity is an event, tasks or unit of work with a specified purpose as for example, designing, set up, etc. ABC system calculates the costs of individual activities and assigns costs to cost objects such as products or services on the basis of the activities consumed to produce the product or provide the service.

Q.9. What is the fundamental difference between Activity Based Costing System (ABC) and Traditional Costing System? Why more and more organisations in both the manufacturing and non-manufacturing industries are adopting ABC?

Ans. In the traditional system of assigning manufacturing overheads, overheads are first allocated and apportioned to cost centres (e.g. products). Under ABC, overheads are first assigned to activities or activity pools (group of activities) and then they are assigned to cost objects. Thus, ABC is a refinement over the traditional costing system. Usually cost centres include a series of different activities. If different products create different demands on those activities, the traditional costing system fails to determine the product cost accurately. In that situation, it becomes necessary to use different rates for different activities or activity pools.

The following are the reasons for adoption of ABC by manufacturing and non-manufacturing industries:

(i) Fierce competitive pressure has resulted in shrinking profit margin. ABC helps to estimate cost of individual product or service more accurately. This helps to formulate appropriate marketing/corporate strategy.

(ii) There is product and customer proliferation. Demand on resources by products/customers differ among product/customers. Therefore, product/customer profitability can be measured reasonably accurately, only if consumption of resources can be traced to each individual product/customer.

(iii) New production techniques have resulted in the increase of the proportion of support service costs in the total cost of delivering value to customers. ABC improves the accuracy of accounting for support service costs.

(iv) The costs associated with bad decisions have increased substantially. (v) Reduction in the cost of data processing has reduced the cost of tracking

resources consumption to large number of activities.

The ABC identifies the activities that cause cost to be incurred, and searches for the fundamental cost drivers of these activities. Once the activities and their drivers have been identified, this information can be used to attach overhead to those cost objects (e.g. products) that have actually caused the cost to be incurred.


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In comparing the ABC approach with the traditional approach, the obvious staring point is a comparison of the costs of individual products as determined under a traditional costing system with those same costs under an ABC system. However, this would be a pointless exercise if it simply stopped there: for a given sales revenue and a given level of total costs, the overall company profit will be precisely the same whatever method of allocation is used to allocate the total cost between individual product lines.

Traditional Production Costing System

Sum of production departments’ allocated costs = total production overhead

Activity-based costing system

Sum of activity cost pools = total production overhead

Production overhead

Activity cost pool

A

Activity cost pool

B

Activity cost pool

C

Activity cost pool

D

Product

Production overhead

Production departments

Service departments


A


B


C

Products

Reallocate to individual production departments

Allocate to products


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10 Discuss Value Added (VA) Activities / Non-Value Added (NVA) Activities

Activity Based Management views the business as a set of linked activities that ultimately add value to the customer. ABM is based on the premise that activities consume costs. Therefore, by managing activities costs will be managed in long term. Activities may be grouped in such a way as to describe the total process. For Example, serving a particular customer involves a number of discrete activities, but the sum total of these activities represents the process by which the client is serviced. ABM classifies each activity within a process as value-added activities or non-value added activities.

Value-Added Activities

The VA activities are those activities which are indispensable in order to complete the process. The customers are usually willing to pay (in some way) for these services. For Example, polishing furniture by a manufacturer dealing in furniture is a value- added activity.

Non-Value-Added Activities

The NVA activity represents work that is not valued by the external or internal customer. NVA activities do not improve the quality or function of a product or service, but they can adversely affect costs and prices. Non-Value Added activities create waste, result in delay of some sort, add costs to the products or services & for which the customer is not willing to pay. Moving materials and machine set up for a production run are examples of NVA activities. By measuring activities rather than traditional departmental costs, business can focus on cross functional processes in order to identify NVA activities and pinpoint the time drives of cost at each stage.

NVA Costs should be reported in activity center cost reports.

UNIT – III: TARGET COSTING

Q.1. What is Target Costing and what are the stages to the methodology? OR

Explain the steps involved in target costing approach to pricing. OR

Trace the stages involved in target costing. OR

What is Target Costing? It is said that implementation of the target costing technique requires intensive marketing research. Explain why intensive marketing research is required to implement target costing technique.

Ans. Meaning & the concept It is a management tool used for reducing a product costs over its entire life

cycle. It is drive by external market factors. A target market price is determined by marketing management prior to designing and introducing a new product. This target price is set at a level that will permit the company to achieve a desired market share and sales volume. A desired profit margin is then deducted to determine the target maximum allowable product cost. Target costing also


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develop methods for achieving those targets and means to test the cost effectiveness of different cost-cutting scenarios.

Stages to the methodology (i) Conception (planning) phase: Under this stage of life cycle, competitors products are to be analysed, with

regard to price, quality, service and support, delivery and technology. The features which consumers would like to have like consumer value etc. established. After preliminary testing, the company may be asked to pin-point a market niche, it believes, is under supplied and which might have some competitive advantage.

(ii) Development phase: The design department should select the most competitive product in the

market and study in detail the requirement of materials, manufacturing process alongwith competitors cost structure. The firm should also develop estimates of internal cost structure based on internal costs of similar products being produced by the company. If possible the company should develop both the cost structure (competitors and own) in terms of cost drivers for better analysis and cost reduction.

(iii) Production phase: This phase concentrates its search for better and less expensive products,

cost benefit analysis in different features of a product priority wise, more towards less expensive means of production, as well as production techniques etc.

Steps involved in target costing approach to pricing (i) Setting of target selling price: The setting of target selling price of a product which the customers are

prepared to pay, depends on many factors like: design specification of the product, competitive conditions, customer’s demand for increased functionality and higher quality projected production volume, sales forecasts etc. A concern can set its target selling price after taking into account all of the aforesaid factors.

(ii) Determination of target cost: Target profit margin may be established after taking into account

long-term profit objectives and projected volumes of sales. On deducting target profit margin from target selling price, target cost is determined.

(iii) Estimate the actual cost of the product: Actual cost of the product may be determined after taking into account the design

specifications, material cost and other costs required to produce the product. (iv) Comparison of estimated actual cost with target: In case the estimated cost of the product is higher than that of the target

cost of the product then the concern should resort to cost reduction methods involving the use of value engineering/value analysis tools.


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Q.2. List the steps involved in target costing process with the help of a block diagram.

Ans.

Target Costing Process

Q.3. Discuss, how target costing may assist a company in controlling costs and pricing of products.

Ans. Target costing may assist control of costs and pricing of products as under:

(i) Target costing considers the price that ought to be charged by a company to achieve a given market share.

(ii) Target costing should take life cycle costs into consideration.

(iii) If there is a gap between the target cost and expected cost, ways and means of reducing or eliminating it can be explored.

(iv) The target cost may be used for controlling costs by comparison.

Set target selling price based on customer expectations and sales forecast

Establish profit margin based on long-term profit objectives and projected volume

Determine target (or allowable cost per unit (target selling price less required profit margin)

Compare with Estimate the current cost of new product

Establish cost reduction targets for each component and production activity, using value engineering and value analysis


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UNIT – IV: LIFE CYCLE COSTING

Q.1. What is life cycle costing? Explain the stages in product life cycle.

Ans. Meaning:

Life cycle costing estimates, tracks and accumulates the costs over a product’s entire life cycle from its inception to abandonment or from the initial R & D stage till the final customer servicing and support of the product. It aims at tracing of costs and revenues on product by product basis over several calendar period throughout their life cycle. Costs are incurred along the product’s life cycle starting from product’s design, development, manufacture, marketing, servicing and final disposal. The objective is to accumulate all the costs over a product life cycle to determine whether the profits earned during the manufacturing phase will cover the costs incurred during the pre and post manufacturing stages of product life cycle.

Stages of product life cycle

(i) Market research:

It identifies the products which customers wants, how much they are prepared to pay for it and how much quantity they intend to buy.

(ii) Specification:

It provides details such as required life, maximum permissible maintenance costs, manufacturing costs, units required, delivery date, expected performance of the product.

(iii) Design:

Proper drawings and process schedules are defined.

(iv) Prototype manufacture:

Prototype may be used to develop the product and eventually to demonstrate that it meets the requirements of the specifications.

(v) Development:

Testing and changing to meet the requirements after the initial run as a product when first made rarely meets the specifications.

(vi) Tooling:

Tooling up for production means building a production line, building expensive jigs, buying the necessary tool and equipments.

(vii) Manufacture:

It involves the purchase of raw material and components, use of labour to make and assemble the product.


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(viii) Selling:

Stimulating and creating demand for the product when the product is available for sale.

(ix) Distribution:

The product should be distributed to the sales outlets and to the customers.

(x) Product support:

The manufacturer or supplier should make sure that spares and expert servicing facilities are available for the entire life of the product.

(xi) Decommissioning:

When a manufacturing product comes to an end, the plant used to build the product must be sold or scrapped.

Q.2. What is Product Life Cycle Costing? Describe its characteristics and benefits.

Ans. Meaning:


Characteristics of product life cycle costing

(i) Product life cycle costing involves tracing of costs and revenues of each product over the several calendar periods throughout their entire life cycle.

(ii) Product life cycle costing traces research and design and development costs and total magnitude of these costs for each individual product and compared with product revenue.

(iii) Report generation for costs and revenues.

Benefits of product life cycle costing

(i) The product life cycle costing results in earlier actions to generate revenue or to lower cost than otherwise might be considered.

(ii) Better decision should follow from a more accurate and realistic assessment of revenues and costs, at least within a particular life cycle stage.

(iii) Product life cycle thinking can promote long-term rewarding in contrast to short term profitability rewarding.

(iv) It provides an overall framework for considering total incremental costs over the life span of a product.


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Q.3. What is total life cycle costing approach? Why is it important?

Ans. Product life cycle costing is important for the following reasons:

(i) When non-production costs like costs associated with R & D, design, marketing, distribution and customer service are significant, it is essential to identity them for target pricing, value engineering and cost management. For example, a poorly designed software package may invoice higher costs on marketing, distribution and after sales service.

(ii) There may be instances where the pre-manufacturing costs like R & D and design are expected to constitute a sizeable portion of life cycle costs. When a high percentage of total life cycle costs are likely to be so incurred before the commencement of production, the firm needs an accurate prediction of costs and revenues during the manufacturing stage to decide whether the costly R & D and design activities should be undertaken.

(iii) Many costs are locked in at R & D and design stages. Locked in or committed costs are those costs that have not been incurred at the initial stages or R & D and design but that will be incurred in the future on the basis of the decisions that have already been taken. For example, the adoption of a certain design will determine the product’s material and labour inputs to be incurred during the manufacturing stage. A complicated design may lead to greater expenditure on material and labour costs every time the product is produced. Life cycle budgeting highlights costs throughout the product life cycle and facilitates value engineering at the design stage before costs are locked in.

Total life cycle costing approach accumulates product costs over the value chain. It is a process of managing all costs along the value chain starting from product’s design, development, manufacturing, marketing, service and finally disposal.

Q.4. What is product life cycle costing? What are the costs that you would include in product life cycle cost?

Ans. Meaning:



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Objective: Life cycle costing estimates and accumulates costs over a products entire life cycle. The objective is to determine whether costs incurred at different stages of development, manufacturing and marketing of the product will be recovered by revenue to be generated by the product over its life cycle. Life cycle costing provides an insight, useful for understanding and managing costs over the life cycle of the product. In particular it helps to evaluate the viability of the product, decides on pricing of the product at different stages of product life cycle and often helps to estimate the value of the product to its users. When used in conjunction with ‘target costing’, life cycle costing becomes a potent tool for cost management.

Cost in different stages of the product life cycle Product life cycle costing traces costs and revenues of each product over several calendar periods throughout their entire life cycle. The costs are included in different stages of the product life cycle, as detailed below:

Development phase : R & D cost, Design cost. Introduction phase : Promotional cost, Capacity cost. Growth phase/Maturity : Manufacturing cost, Distribution costs /

Product support cost. Decline/Replacement phase : Plants reused, sold, scrapped & related costs. Q.5. Discuss the Characteristics & Strategies for the various stages of a product

under life cycle costing. Life Cycle Costing involves identifying the costs and revenue over a product’s life i.e. from inception to decline. Life cycle costing aims to maximize the profit generated from a product over its total life cycle. Understanding this can be a useful analysis tool and can help to suggest which strategies the organisation needs to adopt in order to compete successfully. Product Life Cycle Each product has a life cycle. The life cycle of a product varies from a few months to several years. Product life cycle is thus a pattern of expenditure, sales level, revenue and profit over the period from new idea generation to the deletion of product from product range. The life cycle of a product consists of four phases/ stages viz., Introduction; Growth; Maturity and Decline.


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Stage I: Introduction Stage

Stage one is where the new product is launched in the market. As the product is novel, there is minimal awareness and acceptance of it. Competition is almost negligible and profits are non- existent. The length of the introduction stage differs from product to product depending on various factors

Characteristics

Decisions about the product branding, packaging and labelling

High distribution and promotional expenses

Profits are low or negative due to low initial volume

Pricing may be low- penetration or high- skimming pricing

Huge efforts to attract various marketing channels

Aggressive promotional efforts to increase awareness

Product refinements are not possible

Few competitors produce basic version of products

Focus on those buyers who are the most ready to buy

Strategies

Attracting customers by raising awareness of the product through promotion activities.

Inducing customers to try and buy the product.

Strengthening or expanding channel and supply chain relationships.

Building on the availability and visibility of the product that boost channel intermediaries to support the product.

Setting price in alignment with the competitive realities of the market.

Stage II: Growth Stage

The next stage in the product life cycle is growth stage. Sales begin to expand rapidly because of greater customer awareness. Competitors enter the market often in large numbers. As a result of competition, profit starts declining near the end of the growth stage.

Characteristics

High volume of business and increase in competition

Sales increase at an increased rate in early growth stage

New channels to handle additional volumes and new markets

Shift of emphasis from product awareness to product conviction

Overall strategy for trade-off between high profits and high market share

Improving and/or adding features or strategic lowering of prices to attract more buyers

Same promotional spending or slightly higher

Educating market is main goal


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The length of the growth stage varies according to the nature of the product and competitive reactions

Strategies

Establish a clear brand identity through promotional campaigns.

Maintain control over product quality to assure customer satisfaction.

Maximize availability of the product through strong distribution channel.

Find the ideal balance between price and demand as per price elasticity.

Overall strategy shifts from acquisition to retention of customers, from motivating product trial to generating repeat purchases and building brand loyalty.

Development of long-term relationships with customers and partners for the maturity stage.

Value-based pricing strategies may be considered.

Leverage the product’s perceived differential advantages to secure a strong market position.

Stage III: Maturity Stage

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

Characteristics

Overcapacity in the industry

Intensified competition

Population growth and replacement demand govern future sales

Some laggard buyers still enter the market

Profits start to decline

No new distribution channels to fill

Customers start moving towards other products and substitutes

Strong marketing challenges

High R & D budgets

Strategies

Strong marketing efforts are needed to win over the competitor’s customers.

Product features may be improved or enhanced to differentiate product from that of the competitors.

Prices may have to be reduced to attract the price-sensitive consume₹

Various sales promotion incentives are necessary for the consumers as well as dealers to maintain their interest in the product.


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Distribution becomes more intensive and incentives may be offered to encourage product over competing products.

Stage IV: Decline Stage

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

Sales of most product forms drop to zero or may remain at a low level

Sales decline for a number of reasons, including technological advances, consumer's shift in taste, etc.

Profits start declining and at times become negative

No of organisations producing the products drops Strategies

The product can be maintained in the market by differentiation, keeping low cost for some more time by adding certain new features and finding new uses.

The firm can continue to offer the product to its loyal customers (niche segment) at a reduced price.

Firm can even discontinue the product.

Use the product as replacement product for launching another new product successfully in the market.

The various marketing decisions in the decline stage will depend on the fact that, whether it is being revived, or given a new lease of file, or left unchanged if it is being liquidated.

The price may be maintained or reduced drastically if liquidated.

Summary

Life Cycle Characteristics

Introduction Growth Maturity Decline

Objectives Create product awareness & trial

Maximise market share

Maximise profits while defending market share

Reduce expenditures & milk the brand

Sales Low sales Rapidly rising

Peak sales Declining sales

Costs per Customer

High cost per customer

Average cost per customer

Low cost per customer

Low cost per customer


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Profits Negative Rising profits

High profits Declining profits

Customers Innovators Early adopters

Middle majority

Laggards

Competitors Few Growing number

Steady number beginning to decline

Declining number

Strategies

Introduction Growth Maturity Decline

Product Offer basic product

Offer product extensions,

service & warranty

Diversify brands and models

Phase out weak items

Price Cost plus profit

Price to penetrate market

Price to match or beat competitors

Price cutting

Advertising Build product awareness amongst early adopters & dealers

Build awareness

& interest in mass market

Stress on brand differences and benefits

Reduce level to keep

hard core loyalty

Distribution Build selective distribution

Build Intensive distribution

Build more intensive distribution

Go selective: Phase out unprofitable outlets

Sales Promotion

Use heavy sales promotion to entice trial

Reduce to take advantage of heavy consumer demand

Increase to encourage brand switching

Reduce to minimal level


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Q.5. Explain the essential features of life cycle costing.

Ans. (i) Product life cycle costing involves tracing of costs and revenues of each product over the several calendar periods throughout their entire life cycle.

(ii) Product life cycle costing traces research and design and development costs and total magnitude of these costs for each individual product and compared with product revenue.

(iii) Report generation for costs and revenues.

UNIT – V: VALUE CHAIN ANALYSIS Q.1. Explain, how does value chain approach help an organisation to assess its

competitive advantage. OR

What steps are involved in ‘value chain’ analysis approach for assessing competitive advantages?

Ans. Most corporations define their mission as one of creating products and services. In contrast, the other companies are acutely aware to the strategic importance of individual activities within their value chain. They are concentrating on those activities that allow them to capture maximum value of their customers and themselves.

These firms use the value chain analysis approach to better understand which segments, distribution channels, price points, product differentiation, selling prepositions & value chain configuration will yield them the greatest competitive advantage.

The way the value chain approach helps these organizations to assess competitive advantage includes the use of following steps of analysis:

(i) Internal cost analysis: to determine the sources of profitability and the relative cost positions of

internal value creating processes; (ii) Internal differentiation analysis: to understand the sources of differentiation with internal value creating process; and (iii) Vertical linkage analysis: to understand the relationships and associated costs among external

suppliers and customers in order to maximize the value delivered to customers and to minimize the cost.

The value chain approach used for assessing competitive advantages is an integral part of the strategic planning process. Like strategic planning, value chain analysis is a continuous process of gathering, evaluating and communicating information for business decision making.

Q.2. Compare value chain analysis from Traditional Management Accounting.

OR Differentiate between ‘Traditional Management Accounting’ and ‘Value Chain Analysis in the strategic framework’.

Ans. A comparison between Value Chain Analysis (VCA) and Traditional Management Accounting (TMA) is given as under:


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Value Chain Analysis

Traditional Management Accounting

1. Focus External Internal 2. Perspective Entire set of linked activities

from suppliers to end users Value added

3. Cost driver concept

Multiple cost drivers - Structural drivers - Executional drivers

Single cost driver

4. Cost containment philosophy

A set of unique cost drivers for each activity

Application at the overall firm level

5. Insights for strategic decisions

Views cost containment as a function of the cost drivers regulating reductions each value activity.

Across the board cost

Identify cost drivers at the individual activity level, develops cost differentiation advantage either by controlling those drivers better than competitors by configuring the value chain

Q.3. Define the term ‘value-chain’. Mention three ‘useful strategic frameworks of the value chain analysis.

Ans. Value chain is the linked set of value-creating activities all the way from basic raw material sources for component suppliers through to the ultimate end-use product or service delivered to the customer. Proter’s described the value chain as the internal processes or activities a company performs “to design, produce, market, deliver and support its product”. He further states that “a firm’s value chain and the way it performs individual activities are a reflection of its history, its strategy, its approach of implementing its strategy, and the underlying economics of the activities themselves”. The business activities are classified into primary activities and support activities.

Primary activities are those activities which are involved in transforming the inputs in to outputs, delivery and after sales service. Support activities are intended to support the primary activities like for example procurement, human resources management, etc.

Three useful strategic frameworks for value chain analysis are:

Industry structure analysis;

Core competencies; and

Segmentation analysis.


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UNIT – VI: COST CONTROL AND COST REDUCTION

Q.1. Briefly explain the concept of Value Analysis as a cost reduction technique.

Ans. Value analysis as a cost reduction technique:

Value analysis or value engineering is one of the most widely used cost reduction techniques. It can be defined as a technique that yields value improvement. It is the process of systematic analysis and evaluation of various techniques and functions with a view to improve organisational performance. It aims at reducing and controlling costs of a product from the point of view of its value by analysing the value currently received. It investigates into the economic attributes of value. It attempts to reduce cost through design change, modification of material specification, change in the source of supply and so on. It emphasises on finding new ways of getting equal or better performance from a product at a lesser cost without affecting its quality, function, utility and reliability. For example, the function of fastener is to join two or more parts. Value analysis examines the value of this function in terms of alternative methods such as welding, taping, stapling, etc. in view of the stress and vibrations involved in a specific application.

In value analysis each and every product or component of a product is subjected to a critical examination so as to ascertain its utility in the product, its cost, cost benefit ratio, and better substitutes etc. When the benefits are lower than the cost, advantage may be gained by giving up the activity concerned or replacing it for betterment. The best product is one that will perform satisfactory at the lowest cost.

The various steps involved in value analysis are:

(1) identification of the problem;

(2) collecting information about function, design, material, labour, overhead costs, etc. of the product and finding out the availability of the competitive products in the market; and

(3) exploring and evaluating alternatives and developing them.

Q.2. Cost reduction efforts frequently focus on two key areas? What are they?

Ans. Cost reduction may be defined as the achievement of real and permanent reduction in the unit cost of goods manufactured or services rendered without impairing their suitability for the use intended or diminution of the quality of the product.

The cost reduction efforts frequently focus their attention on the following two areas:

(i) Reduction in unit cost resulting from reduction in expenditure in respect of a given volume of output.

(ii) Reduction in unit cost by an increase in productivity that is, an increase in yield or rate of output for a given expenditure.


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In practice, however, cost reduction will ultimately be achieved by a combination of these influences and it will hardly be possible to pin-point the extent of contribution which each factor will make to the overall savings.

Q.3. What disadvantages the measurement of work has in terms of work done?

Ans. The disadvantages which the measurement of work has in terms of work done are as below:

1. The quantity produced is very much a function of the method employed and therefore, variations in method render the measurement unreliable, without any adjustment which, if made at all, is arbitrary.

2. There is no means of comparing the work done on difficult jobs as the measure itself peculiar to each job and therefore, varies from job to job.

3. Even on any specific job, while the quantity of output gives a measure of the work actually done, it does not give any indication of how this compares with the potential standard to be expected. This gives rise to the situation where past output determines the apparent standard, which itself becomes distorted with every change method of product.


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UNIT – VII: JIT PURCHASING AND BACK FLUSHING IN A JIT SYSTEM

Q.1. What is JIT? Explain how it eliminates wastage of resources.

Ans. Just-in-time concept

The CIMA Official Terminology defines JIT as:

JIT: A system whose objective is to produce or procure products or components as they are required by a customer or for use, rather than for stock. A just-in-time system is a ‘pull’ system, which responds to demand, in contrast to a ‘push’ system, in which stocks act as buffers between the different elements of the system, such as purchasing, production and sales.

JIT production is defined as:

JIT production: a production system which is driven by demand for finished products whereby each component on a production line is produced only when needed for the next stage.

And JIT purchasing as:

JIT purchasing: a purchasing system in which material purchases are contracted so that the receipt and usage of material, to the maximum extent possible, coincide.

These Official Terminology definition give JIT the appearance of being merely an alternative production management system, with similar characteristics and objectives to techniques such as MRP. However, JIT is better described as a philosophy, or approach to management, as it encompasses a commitment to continuous improvement and the pursuit of excellence in the design and operation of the production management system.

JIT eliminates wastage of resources.

A just-in-time (JIT) approach is a collection of ideas or philosophy that streamline a company’s production process activities to such an extent that waste of all kinds viz., material and labour is systematically driven out of the process. JIT has a decisive, positive impact on product costs. In other words it enables a company to ensure that it receives products l spare parts l materials from its suppliers on the specified date and time of their requirement.

Elimination of wastage of resources:

JIT helps in reducing waste of time, thereby the entire production process is concentrated on the time spent in actually producing products. For example, all inspection time is eliminated from the system as operators conduct their own quality checks. Secondly, all movement, which involves shifting inventory and work-in-process throughout various parts of the plant, can be eliminated by clustering machines together in logical groupings. Third, queue time is eliminated by not allowing inventory to build up in front of machine. Finally, one can eliminate storage time by clearing out excessive stocks of inventory and having suppliers deliver parts only as and when needed.

Another way in which waste may be eliminated in a JIT system is to charge cost drivers to wasteful activities that accumulate costs. By shrinking the amount of wastage of time out of the manufacturing process, a company effectively eliminates activities that do not contribute to the value of a product, which in turn reduces the costs associated with them.


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Q.2. What do you mean by ‘Back flushing’ in JIT system? Explain briefly the problems with back flushing that must be corrected before it will work properly.

OR

What do you mean by back-flushing in JIT system? What are the problems that must be corrected before it will work properly?

Ans. Traditional accounting systems record the flow of inventory through elaborate accounting procedures. Such systems are required in those manufacturing environment where inventory/WIP values are large. However, since JIT systems operate in modern manufacturing environment characterized by low inventory and WIP values, usually also associated with low cost variances, the requirements of such elaborate accounting procedures does not exist.

Back flushing requires no data entry of any kind until a finished product is completed. At that time the total amount finished is entered into the computer system which is multiplied by all components as per the Bill of Materials (BOM) for each item produced. This yields a lengthy list of components that should have been used in the production process and this is subtracted from the opening stock to arrive at the closing stock to arrive at the closing stock/inventory.

The problems with back flushing that must be corrected before it works properly are:

(i) Production Reporting:

The total production quantity entered into the system must be absolutely correct, if not, then wrong components and quantities will be subtracted from the stock.

(ii) Scrap Reporting:

All abnormal scrap must be diligently tracked and recorded. Otherwise materials will fall outside the black flushing system and will not be charged to inventory.

(iii) Lot Tracing:

Lot tracing is impossible under the back flushing system. This is required when a manufacturer needs to keep records of which production lots were used to create a product in case all the items in a lot need be recalled.

(iv) Inventory Accuracy:

The inventory balance may be too high at all times because the back flushing transactions that relieves inventory usually does so only once a day, during which time other inventory is sent to the production process. This makes it difficult to maintain an accurate set of inventory records in the warehouse.


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Q.3. Critically examine “It is prudent to hold large inventories in an inflationary economy”.

Ans. In an inflationary economy, prices rise rapidly. Holding large inventories will affect the inventory carrying cost including interest on funds blocked. However, there are other risks like obsolescence, deterioration in quality, limited shelf-life in case of certain materials etc. In addition to these risks, cheaper substitutes may be available at a later date. New sources of supply may be available at competitive rate or else price may fall. Hence speculation should be avoided.

Alternative use of funds:

The funds so blocked may be invested for expansion or diversification, which may result into higher profitability than the benefit arising from holding large inventory. Hence normal level of inventory may be held to avoid stock-out leading to loss of production. In view of above points all inventory control techniques may be applied for deciding the amount to be invested in inventory. Inflationary economy is one factor. There are several other considerations for deciding the quantum of inventory.

Q.4. Explain, how the implementation of JIT approach to manufacturing can be a major source of competitive advantage.

Ans. JIT provides competitive advantage in the following ways:

(i) Stocks of raw materials and finished goods are eliminated, stock holding costs are avoided.

(ii) JIT aims at elimination of non-value added activities and elimination of cost in this direction will improve competitive advantage.

(iii) It affords flexibility to customer requirements where the company can manufacture customized products and the competitive advantage is thereby improved.

(iv) It focuses the direction of performance based production of high quality product.

(v) It minimize waiting times and transportation costs.

UNIT – VIII: THROUGHPUT ACCOUNTING

Q.1. Explain the concept and aim of theory of constraints. What are the key measures of theory of constraints?

Ans. Meaning:

The theory focuses attention on constraints or bottlenecks within the organisation which hinder speedy production. The main concept is to maximise the rate of manufacturing output, i.e. the throughput of the organisation. The idea behind TOC is that raw materials should be turned into products that are immediately shipped to customers at the greatest possible speed, in a similar way to the JIT system.


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What is a bottleneck

A bottleneck is an activity within the organisation where the demand for that resource is more than its capacity to supply. A constraint is a situation factor which makes the achievement of objectives throughput more difficult then it would otherwise be. A bottleneck is always a constraint but a constraint need not be a bottleneck. Throughput is thus related directly to the ability to cope with the constraint and to manage the bottleneck.

The important concept behind TOC is that the production rate of the entire factory is set at the pace of the bottleneck – the constraining resource. Hence, in order to achieve the best results TOC emphasizes the importance of removing bottlenecks or, as they are called in the USA, binding constraints from the production process. If they cannot be removed they must be coped with in the best possible way so that they do not hinder production unduly. In order to do this, network diagrams need to be drawn to identify the bottlenecks or binding constraints. Figure below illustrates a simple network chart where the assembly and test process is the bottleneck.

Network chart of a manufacturing process

It can be seen that the assembly and test process is the bottleneck and that in order to maximise throughput, a buffer stock is needed prior to the assembly and test process so that its employees never have to wait for components from prior processes.

Key measures of theory of constraints: (i) Throughput contribution: It is the rate at which the system generates profits through sales.

It is defined as, sales less completely variable cost, sales – direct are excluded. Labour costs tend to be partially fixed and conferred are excluded normally.

(ii) Investments: This is the sum of material costs of direct materials, inventory, WIP, finished

goods inventory, R & D costs and costs of equipment and buildings. (iii) Other operating costs: This equals all operating costs (other than direct materials) incurred to

earn throughput contribution. Other operating costs include salaries and wages, rent, utilities and depreciation.

Process 1 2 hrs

Fabrication 1 hr

Process 2 1½ hrs

Assembly & test 1½ hr

Packing ½ hr


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UNIT – IX: SHUT DOWN & DISINVESTMENT

Q.1. “Cost not the only criterion for deciding in favour of shut down” – Briefly explain.

Ans. Very often it becomes necessary for a firm to temporarily close down the factory due to trade recession with a view to reopening it in the future. In such cases, the decision should be based on the marginal cost analysis. If the product are making a contribution towards fixed expenses or in other words if selling price is above the marginal cost, it is preferable to continue because the losses are minimized. By suspending the manufacture, certain fixed expenses can be avoided and certain extra fixed expenses may be incurred in protecting the machinery. So the decision is based on as to whether the contribution is more than the difference between the fixed expenses incurred in normal operation and the fixed expenses incurred when the plant is shut down. In other words, the shut down point is calculated by using the formula:

Decision Making in Relation to Shut Down

1. Shut down point = {(Total fixed cost – Shut down costs) Contribution per unit}

Decision Making in Relation to Shut Down Vs. Continue

Q.2. What is disinvestments strategy? Highlight the main reasons for disinvestment.

Ans. Disinvestment Strategy:

Disinvestment involves a strategy of selling off or shedding business operations to divert the resources, so released, for other purposes. Selling off a business segment or product division is one of the frequent forms of divestment strategy. It may also include selling off or giving up the control over subsidiary where by the wholly owned subsidiaries may be floated as independently quoted companies.

Reason for Disinvestment Strategy

1. In case of a firm having an opportunity to get more profitable product or segment but have resource constraint, it may selling off it’s unprofitable or less profitable division and utilized the recourse so released. Cost benefit analysis and Capital Budgeting Method are the useful tool for analyzing this type of situation.

2. In case of purchase of new business, it may be found that some of the part of the acquired business is not upto the mark. In such type of situation disposal of the unwanted part of the business is more desirable than hold it.

3. In case where any business segment or product or subsidiary is pull down the profit of the whole organisation, it is better to cut down of that operation of the product or business segment.


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UNIT – X: OTHER IMPORTANT CONCEPTS

Q.1. What is Bench Marking technique so far as product and operations are concerned? Can you describe the Bench Marking process?

OR

What do you mean by Bench Marking? What are perquisites of Bench Marking?

Ans. Role of bench marking in continuous improvement in an organisation

Bench marking is a technique which is being adopted as a mechanism for achieving continuous improvement. It is a continuous process of measuring a company’s products, services or activities against the other best performing organizations either internal or external to the company. the objective is to ascertain how the processes and activities can be improved. The latest developments, best practices and model examples can be incorporated within various operations of the business of the company. It represents an ideal way of achieving high competitive standards.

Pre-requisites of Bench Marking

(i) The objectives of bench marking should be clearly defined.

(ii) Senior Managers should support bench marking and commit themselves for continuous improvement.

(iii) The scope of the work should be appropriate in the right of the objectives, resources, time and experience of those involved.

(iv) Sufficient resources should be made available to complete projects within the required time.

(v) Bench marking teams should have the right skill and competencies.

(vi) Stake holders, staff and others should be kept informed of the reason of bench marking.

Bench marking process

Bench marking process consists of following three sub-processes:

(i) Planning the variable to be bench marked, selecting the firms and methods to be used for collecting data for comparison in these firms.

(ii) Establishing the current and projected gap in performance between the target company operations and internal firm’s operations.

(iii) Communicating bench mark findings to operating personnel and establishing internal costs for achievement. The gap may be reduced by two type of actions viz., strategic actions and continuous operating actions.


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Bench marking code of conduct

Bench marking is the process of identifying and learning from the best practices anywhere in the world. It is a powerful tool for continuous improvement. To contribute to efficient, effective and ethical bench marking, individuals agree for themselves and their organisation to be abided by the following principles for the benchmarking with other organisations.

Suggested bench marking code of conduct

(i) Principle of legality

(ii) Principle of exchange

(iii) Principle of confidentiality

(iv) Principle of use

(v) Principle of first party contact

(vi) Principle of third party contact

(vii) Principle of preparation

Q.2. Write short notes on the following:

Material Requirement Planning.

Ans. Material Requirement Planning

It is eye opening to note that a major cause of production inefficiency is a lack of integrated production planning, production scheduling and production control information system. One approach to improve production efficiency is material requirement planning. MRP integrates several production related information systems so that MRP system can access and extract data from these systems to accomplish production scheduling in a proper way. MRP’s purpose to greatly improve both inventory management and production scheduling. The benefits of a successful MRP system include:

Significantly decreased inventory levels and corresponding decreases in inventory carrying costs.

Fewer stock shortage which cause production interruption and time consuming schedules juggling by managers.

Better customer service

Greater responsiveness to changes in product demand

Closer coordination of the marketing, engineering and finance activities with the manufacturing activities.


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Q.3. State the requirements for operation of a Materials Requirement Planning (MRP) system.

Ans. Materials Requirement Planning (MRP) originated in the early 1960s as a computerised approach for co-ordinating the planning, acquisition and production of materials. Important requirements for the operation of a MRP system are as follows:

(i) Master production schedule:

It specifies the quantity of each finished unit of products to be purchased along with the time at which each unit will be required.

(ii) Bill of material file:

This file specifies the sub-assemblies, components and materials requirement for each item of finished goods.

(iii) Inventory file:

It maintains details of items in hand for each sub-assemblies, components and materials required.

(iv) Routing file: This file specifies the sequence of operations required to manufacture

components sub-assemblies and finished goods. (v) Master parts file:

It contains information about the production time of sub-assemblies and components produced internally and lead time for externally procured items.

Q.4. State the major features of Enterprise Resource Planning (ERP). OR

Explain briefly the main features of ERP. OR

What do you mean by ERP? OR

Explain the main features of ‘Enterprise Resource Planning’. Ans. 1. It facilitates company wide integrated information systems covering all

functional areas like manufacturing, purchase, payables, inventory etc.

2. It performs core activities and increases customer services thereby projecting and enhancing the corporate image.

3. It bridges the information gap across organisations.

4. It offers a solution to better project management.

5. It allows automatic introduction of the latest technologies like Electronic Fund Transfer, Internet, Video Conferencing etc.

6. It eliminates business problems like shortage of material, inventory problems etc.

7. It provides for improving and refining the business process.

8. It provides complete integration of systems, not only across departments, but also across the companies under same management.


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Q.5. State the main types of information which will be required by a manager to implement the balanced score card approach to performance measurement.

Ans. (i) Customer perspective – How do customers see us?

(ii) Internal business process perspective – Where we must excel at?

(iii) Learning and growth perspective – Can we continue to improve and create value?

(iv) Financial perspective – How do we look to the shareholders?

Q.6. What are bench marking code of conduct?

Ans. Bench marking is the process of identifying and learning from the best practices anywhere in the world. It is a powerful tool for continuous improvement. To contribute to efficient, effective and ethical bench marking, individuals agree for themselves and their organisation to be abided by the following principles for the bench marking with other organisations.

Suggested bench marking code of conduct

(i) Principle of legality

(ii) Principle of exchange

(iii) Principle of confidentiality

(iv) Principle of use

(v) Principle of first party contact

(vi) Principle of third party contact

(vii) Principle of preparation

Q.7. “Balanced score card and performance measurement system endeavours to create a blend of strategic measures, outcomes and drive measures and internal and external measures”. Discuss the statement and explain the major components of a balanced score card.

Ans. The balanced score card translates an organisation’s mission and strategy into a comprehensive set of performance measures that provides the framework for implementing its strategy. The balanced score card does not focus solely on achieving financial objectives. It is an approach, which provides information to management to assist in strategic policy formulation and achievement. It emphasizes the need to provide the user with a set of information, which addresses all relevant areas of performance in an objective and unbiased manner. As a management tool it helps companies to assess overall performance, improve operational processes and enables management to develop better plans for improvements.


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Major components of a balanced score card

The components of balanced score cards varies from business to business. A well designed balanced score card combines financial measures of post performance with measures of firm’s drivers of future performance. The specific objectives and measures of an organisation balanced score card can be derived from the firm’s vision and strategy. Generally, balanced score card has the following four perspectives from which a company’s activity can be evaluated.

(i) Financial perspective: Financial perspective measures the results that the organisation delivers

to its stakeholders. The measures are: operating income, revenue growth, revenues from new products, gross margin percentage, cost reduction in key areas, economic value added, return on investment.

(ii) Customer perspective: The customer perspective considers the business through the eyes of

customers, measuring and rejecting upon customer satisfaction. (iii) Internal business perspective: The internal perspective focuses attention on the performance of the key

internal processes, which drive the business such as innovative process, operation process and post-sales services.

(iv) Learning & growth perspective: The measures are: employee education & skills levels, employee turnover

ratio, information system availability, percentage of employee suggestion implemented etc.

Q.8. What are the elements of a Balanced Score Card? Also explain, how it can be used as a Financial Planning Model.

Ans. The elements of a balanced score card are:

(i) Financial perspective

(ii) Customer perspective

(iii) Internal business process perspective

(iv) Learning and growth perspective

The objective of the balanced score card is to provide a comprehensive framework for translating the company’s strategic objectives into a coherent set of performance measures. It emphasizes the use of financial and non-financial measures as part of the programme to achieve future financial performance. It helps in planning, setting targets and aligning strategic initiatives.

To evaluate the success of the implementation of the strategy, the company can assess the change in the operating income by comparing the targeted operating income with the actual operating income. The change in the operating income may arise due to growth factor, change in price of inputs and outputs and productivity factor. The company is said to be successful in implementation of strategy only if the change in the operating income closely aligns with that strategy.


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Q.9. “In many organisations, initiative to introduce balanced score card failed because efforts were made to negotiate targets rather than to build consensus.”

Required: Elucidate the above statement

Ans. Balanced score card is a set of financial and non-financial measures relating to a company’s critical success factors. It is an approach which provides information to management to assist in strategy implementation. Therefore, the components to be included in the balanced score card must flow from strategy. The targets should be measurable and must flow from strategy and corporate plan of the company. It is necessary that managers should agree to the components and targets because in absence of a consensus, managers may not commit to the targets established by the top management/the board of directors. Moreover, the functions are interdependent and results in one functional area/perspective (e.g. innovation and learning) have direct bearing on the results in other functional area/perspective (e.g. customer perspective). Therefore, it is not sufficient that individual managers agree to their targets. Successful implementation requires that the top management builds an overall consensus on the components and targets of the balanced score card. Negotiation undermines the fundamental principle that the components and targets should flow from strategy. As a result, an approach to establish targets through negotiation defeats the very purpose of balanced score card.

Q.10. Describe the four types of bench marking of critical success factors.

Ans. The bench marking is of following types:

(i) Competitive Bench Marking:

It involves the comparison of competitors products, processes and business results with own.

(ii) Strategic Bench Marking:

It is similar to the process bench marking in nature but differs in its scope and depth.

(iii) Global Bench Marking:

It is a bench marking through which distinction in international culture, business processes and trade practices across companies are bridged and their ramification for business process improvement are understood and utilized.

(iv) Process Bench Marking:

It involves the comparison of an organisation critical business processes and operations against best practice organization that performs similar work or deliver similar services.


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(v) Functional Bench Marking:

This type of bench marking is used when organisations look to bench mark with partners drawn from different business sectors or areas of activity to find ways of improving similar functions or work processes.

(vi) Internal Bench Marking:

It involves seeking partners from within the same organisation, for example, from business units located in different areas.

(vii) External Bench Marking:

It involves seeking help of outside organisations that are known to be best in class. External bench marking provides opportunities of learning from those who are at the leading edge, although it must be remembered that not every best practice solution can be transferred to others.

Q.11. State the characteristic features of a database created for operational control and decision making.

Ans. The characteristic features of a data-base created for operational control and decision making are as under:

(i) There should be a file structure that facilitates the association of one internal record with other internal records.

(ii) There should be cross functional integration of files.

(iii) Independence of program/data file for ease of updating and maintenance of data base.

(iv) There must be common standards throughout with respect to data definitions, record formats and other data descriptions.

(v) A data dictionary should be available.


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Chapter 6 STANDARD COSTING

Q.1. What are the basic differences between Standard Costing and Budgetary Control?

Ans. Basic differences between Standard Costing and Budgetary Control

Basic differences between Standard Costing and Budgetary Control are as follows:

(i) Standard costs are ascertained for material labour and overheads. Here the control of each element of cost is effected by comparing actual costs with standard costs of actual output whereas budgets are prepared for different functions like sales, production, capital assets, etc. of business. Budgetary control here is concerned with the overall profitability and financial position of the business.

(ii) Range of standard costing is narrow as it is mainly confined to the control of production costs. But the range of budgeting is wider than that of standard costing. It in fact covers sales, capital and financial expenses as well.

(iii) Standard costing is confined to the projection of cost accounts only whereas budgetary control includes projection of financial accounts as well.

(iv) For exercising control, variances are computed in standard costing as well as budgetary control. But these variances are normally recorded in different cost accounts under standard costing whereas they are not revealed under budgets.

(v) Under standard costing various causes of variances in respect of each cost element can be analysed in minute detail and corrective action taken accordingly, Whereas budgetary control system deals with total expenses and revenues based on estimates.

Q.2. How are cost variances dispose off in a standard costing system? Explain.

Ans. There is no unanimity of opinion among Cost Accountants regarding the disposition variances. The following are commonly used methods for their disposition.

1. Transfer all variances to Profit and Loss Account. Under this method, stock of work-in-progress, finished stock and cost of sales are maintained at standard cost and variances arising are transferred to Profit & Loss A/c.

2. Distribution variances on pro-rate basis over the cost of sales, work-in-progress a finished goods stocks by using suitable basis.

3. Write off quantity variance to Profit and Loss A/c and spread price variance over cost of sales, work in progress and finished goods. The reason behind apportioning price variance to inventories and cost of sales is that they represent costs although they are derived as variances.


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Q.3. “Calculation of variances in standard costing is not an end in itself, but a means to an end.” Discuss.

Ans. The crux of standard costing lies in variance analysis. Standard costing is the technique whereby standard costs are predetermined and subsequently compared with the recorded actual costs. It is a technique of cost ascertainment and cost control. It establishes predetermined estimates of the cost of products and services based on management’s standards of efficient operation. It thus lays emphasis on “what the cost should be”. These should be costs are then compared with the actual costs. The difference between standard cost and actual cost of actual output is defined as the variance. The variance in other words is the difference between the actual performance and the standard performance. The calculations of variances are simple. A variance may be favourable or unfavourable. If the actual cost is less than the standard cost, the variance is favourable but if the actual cost is more than the standard cost, the variance will be unfavourable. They are easily expressible and do not provide detailed analysis to enable management to exercise control over them. It is not enough to know the figures to these variances from month to month. We in fact are required to trace their origin and causes of occurrence for taking necessary remedial steps to reduce/eliminate them. A detailed probe into the variance particularly the controllable variances helps the management to ascertain:

(i) the amount of a variance (ii) the factors or causes of their occurrence (iii) the responsibility to be laid on executive and departments and (iv) corrective actions which should be taken to obviate or reduce the variances.

Mere calculation and analysis of variances is of no use. The success of variance analysis depends upon how quickly and effectively the corrective actions can be taken on the analysed variances. In fact variances gives information. The manager needs to act on the information provided for taking corrective action. Information is the means and action taken on it is the end. In other words, the calculation of variances in standard costing is not an end in itself, but a means to all end.

Q.4. What are the various formulae used in calculating budget ratios? Ans. (i) Efficiency ratio represents the standard hours equivalent to work

produced expressed as a percentage of actual hours spent in producing the work.

(ii) Activity ratio is the number of standard hours equivalents to work produced, expressed as a percentage of the budgeted standard hours.

(iii) Standard capacity usage ratio is the relationship between the budgeted number of working hours and the maximum possible working hours in a budget period.

(iv) Actual capacity utilisation ratio is the relationship between the actual number of working hours and the budgeted number of working hours in a period.

(v) Calendar ratio is the relationship between the actual number of working days in a period and the number of working days in a relative budget period.


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Q.5. Mention the causes that give rise to labour rate variance.

Ans. Causes for the occurrence of labour rate variance. This variance arises due to the difference between standard labour hour rate specified and the actual labour hour rate paid. It is computed by multiplying the actual hours taken by workers on a job by the difference between the standard and actual wage rate per hour. Main causes which contribute for the occurrence of labour rate variance are as below:

(i) Increase in actual wage rate per hour paid to workers.

(ii) Use of wrong type of labour i.e. for a job requiring the use of non-skilled labour uses skilled labour. Since the wages of skilled labour are more than that of non-skilled labour therefore this increased wage rate per hour of skilled labour force accounts for the occurrence of labour rate variance.

(iii) Payment of special increments or allowances to workers.

(iv) Non-anticipated wage increase at the time of setting standards.

(v) Using a gang or mix different from that used for setting labour standard.

(vi) Resorting to excessive overtime.

Q.6. Describe three distinct group of variances that arise in standard costing?

Ans. The three distinct groups of variances, that arise in standard costing are:

(i) Variances of efficiency:

These are the variances, which arise due to efficiency or inefficiency in use of material, labour etc.

(ii) Variances of prices and rates:

These are the variances, which arise due to changes in procurement price and standard price.

(iii) Variances due to volume:

These represent the effect of difference between actual activity and standard level of activity.

These can be summarized as under:

Element of cost Variance of efficiency

Variance of price

Variance of volume

Materials Usage, mixture, yield Price Revision

Labour Efficiency, Idle time Rate of pay -

Overheads

- Variable Efficiency Expenditure Revision

- Fixed Efficiency Expenditure Revision

Capacity

Calendar


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Q.7. State the features of Partial Plan of Standard Cost Accounting procedure. Ans. Features of Partial Plan of Standard Cost Accounting procedure:

Standard cost operations can be recorded in the books of account by using partial plan. Features of partial plan of standard costing procedures are as follows:

(i) Partial plan system uses current standards in which the inventory will be valued at current standard cost figure.

(ii) Under this method WIP account is charged at the actual cost of production for the month and is credited with the standard cot of the month’s production of finished product.

(iii) The closing balance of WIP is also shown at standard cost. The balance after making the credit entries represent the variance from standard for the month.

(iv) The analysis of variance is done after the end of the month. Q.8. “Standard costing system is not compatible with Activity Based Costing

System.” Do you agree with this statement? Explain your answer.

Ans. Standard costing system is a tool for cost control. Traditionally, standards are established for each cost element based on engineering specifications. Variances between standard costs and actual costs are reported periodically to managers. Managers use the information for remedial measures or for revision of standards. In ‘Activity Based Costing System’ costs are collected around activity pools and are assigned to products and services using appropriate cost drivers. Standards can be established for costs for carrying out each type of activity. Therefore, it is not correct to say that the standard costing system is not compatible with Activity Based Costing System.

Q.9. How the opportunity cost for inefficient use of scarce resources be presented in variance reports under standard costing system?

Ans. Opportunity cost arises from failure to use scarce resources efficiently. For example, inefficient use of scarce material results in lower production and loss of contribution. Similarly inefficient capacity utilisation results in loss of production and consequently loss of contribution. Therefore, it is appropriate to include contribution loss in reporting material usage variance or labour efficiency variance, in case the material is scarce or labour hours is scarce. As a general rule loss of contribution should be included in the variance report and should be assigned to the manager, whose below standard performance has caused the loss.

Q.10. Overhead variances should be viewed as interdependent rather than independent.” Explain.

Ans. The operations of a firm are so inter linked that the level of performance in one area of operation will affect the performance in other areas. Improvements in one area may lead to improvements in other areas. A sub-standard performance in one area may be compensated by a favourable performance in another area. Because of such interdependency among activities in the firm, the managers should not jump to conclusions merely based on the label of variances namely favourable or unfavourable. They should remember that there is a room for trade off amongst variances. Hence, variances need to be viewed as ‘attention directors’ rather than problem solvers. Thus, a better picture will be captured when overhead variance are not viewed in isolation but in an integrated manner.


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Chapter 7 BUDGETARY CONTROL

Q.1. State, how is Zero Base Budgeting superior to Traditional Budgeting.

OR

Write short note on ‘Zero Base Budgeting as an approach towards productivity improvement.’

Ans. Zero base budgeting is superior to traditional budgeting in the following manner:

1. It provides a systematic approach for evaluation of different activities.

2. It ensures that the functions undertaken are critical for the achievement of the objectives. It provides an opportunity for management to allocate resources to various activities after a thorough cost-benefit analysis.

3. It helps in the identification of wasteful expenditure and then their elimination.

4. It facilitates the close linkage of departmental budgets with corporate objectives.

5. It helps in the introduction of a system of Management by Objectives.

Q.2. What are the advantages and limitations of Zero Base Budgeting?

Ans. Advantages of Zero Based Budgeting

(i) It provides a systematic approach for evaluation of different activities and ranks them in order to preference for allocation of scarce resources.

(ii) It ensures that the various functions undertaken by the organisation are critical for the achievement of its objectives and area being performed in the best way.

(iii) It provides an opportunity to the management to allocate resources for various activities only after having a thorough cost-benefit analysis.

(iv) The area of wasteful expenditure can be easily identified and eliminated.

(v) Departmental budgets are closely linked with corporate objectives.

(vi) The technique can also be used for the introduction and implementation of the system of ‘management by objective’.

Limitations of Zero Based Budgeting

(i) The success of zero based budgeting depends on the top management support.

(ii) It is a time consuming and costly exercise.


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Q.3. “Because a single budget system is normally used to serve several purposes, there is a danger that they may conflict with each other”. Do you agree? Discuss.

Ans. A single budget system may be conflicting in planning and motivation, and planning and performance evaluation roles as below:

(i) Planning and motivation roles:

Demanding budgets that may not be achieved may be appropriate to motivate maximum performance but they are unsuitable for planning purposes. For these, a budget should be a set based on easier targets that are expected to be met.

(ii) Planning and performance evaluation roles:

For planning purposes budgets are set in advance of the budget period based on an anticipated set of circumstances or environment. Performance evaluation should be based on a comparison of active performance with an adjusted budget to reflect the circumstance under which managers actually operated.

Q.4. Describe the process of Zero Base Budgeting.

Ans. The Zero Base Budgeting involves the following steps:

(i) Corporate objectives should be established and laid down in details.

(ii) Decide about the techniques of Zero Base Budgeting to be applied.

(iii) Identify those areas where decisions are required to be taken.

(iv) Develop decision programmes and rank them in order of preferences.

(v) Preparation of budget, that is translating decision packages into practicable units/items and allocating financial resources.

Q.5. What do you mean by a flexible budget? Give an example of an industry where this type of budget is typically needed?

Ans. Flexible budgets are those which can be flexible or changed to suit different levels of performance or activities. In this exercise only the variable and semi-variable costs undergo change while fixed costs remain unaltered. These kinds of budgets are used largely in seasonal industries where changes in levels of performance are common. These are also used by management to build profit forecasters under varying levels of performance. In flexible budgeting a series of budgets are prepared one for each of a number of alternative production levels or volumes. Flexible budgets represent the amount of expenses that is reasonably necessary to achieve each level of output specified.


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Zero Base Budgeting (ZBB) makes a significant departure from the traditional budgeting mainly in approach rather than in basic planning and control philosophy. The approach to budgeting has traditionally been incremental in nature in the sense that the amount spent by a manager in the previous year on various programmes and activities is accepted with little examination and only request for increase over the last year’s appropriation is required to be justified. ZBB, on the contrary, requires each manager to re-evaluate all the programmes and activities of his department and justify his entire budget request. Thus every year the manager has to build up his budget from the gross root. ZBB starts with the assumption that zero (i.e. nothing) will be sent on each activity. Hence, the term zero base. ZBB has generally been applied to the service or support areas (e.g. personnel, research and development etc.) rather than to production area. The principal advantage of ZBB is that it forces the managers to constantly evaluate the costs and benefits of all the programmes under their control.

Q.6. Discuss the limitations, benefits & suitability of Beyond Budgeting (BB)

Limitations of Traditional Budgets

Time-consuming and costly to put together

Constrain responsiveness and flexibility

Often a barrier to change

Rarely strategically focused and are often contradictory

Add little value, especially given the time required to prepare

Concentrate on cost reduction and not on value creation

Developed and updated too infrequently, usually annually

Are based on unsupported assumptions and guesswork

Reinforce departmental barriers rather than encourage knowledge sharing

Make people feel undervalued.

To overcome these limitations a tool came into force known as Beyond Budgeting. Beyond Budgeting is a leadership philosophy that relates to an alternative approach to budgeting which should be used instead of traditional annual budgeting.

BB identifies its two main advantages.

It is a more adaptive process than traditional budgeting.

It is a decentralised process, unlike traditional budgeting where leaders plan and control organisations centrally.

Characteristics of Beyond Budgeting

The rolling budgets may incorporate KPIs.

Benchmarking can be incorporated in budgets.

Here the focus of the managers shift to improving future results.


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Allow operational managers to react to the environment.

Encourage a culture of innovation.

More timely allocation of resources.

Suitability

Industries where there is rapid change in the business environment

- Flexible targets will be responsive to change.

Industries using management methods such as TQM

-Continuous improvement will be the key.

Industries undergoing radical change, e.g. using BPR

- Budgets may be hard to achieve in such circumstances.

Benefits of the 'Beyond Budgeting' Model

Beyond budgeting helps managers to work in coordination to beat the competition. Internal rivalry between managers is reduced as target shifts to competitors.

Helps in motivating individuals by defining clear responsibilities and challenges.

It eliminates some behavioural issues by making rewards team-based.

Proper delegation of authority to operational managers who are close to the concerned action and can react quickly.

Operational managers do not restrict themselves to budget limits and focus on achieving key ratios.

It establishes customer-orientated teams.

It creates information systems which provide fast and open information throughout the organisation.

Beyond Budgeting – Principles for Adaptive Performance Management

Goals Set aspirational goals aimed at continuous improvement, not fixed annual targets.

Rewards Reward shared success based on relative performance, not on meeting fixed annual targets.

Planning Make planning a continuous & inclusive process, not an annual event.

Controls Base controls on relative key performance indicators (KPIs) and performance trends, not variances against a plan.

Resources Make resources available as needed, not through annual budget allocations.

Co-ordination

Co-ordinate cross-company interactions dynamically, not through annual planning cycles.


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Chapter 8 COSTING OF SERVICE SECTOR

Q.1. Explain Pricing by Service Sector.

Ans. The service provided by service sector has no physical existence, a value is to be fixed and billed for its clients. Most of the service organisations use a form consisting of time and material pricing to arrive at the price of a service. Service companies such as appliance repair shops, automobile repair business, calculate their prices by two computations, one for labour and other for materials and parts. A mark-up percentage may also added to the cost of labour, materials and parts to arrive at the price to be billed. For professionals, direct labour costs and apportioned overhead and indirect costs are considered for pricing.

Q.2. How will you apply customer costing in service sector? Explain with the help of a suitable example.

Ans. Customer costing analyses the costs incurred to earn the revenues from customers. A customer cost hierarchy, categorizing the costs relating to the customers into different cost pools on the basis of different types of cost drivers or different degrees of difficulty in determining cause and effect relationship, is used. The details of activities involved in customer costing, for example, are sales order processing, sales visits, normal delivery costs, special orders, and credit collection charges. The central theme of this approach is customer satisfaction. The profitability of different customers or groups of customers will differ.

Customer costing can be introduced in a company engaged in courier service where the costs to serve the customers vary with the type of service selected by customers (how fast the package is to be delivered), the destination, weight, size of package and whether the package is to be collected from customers’ location or will be dropped at the office of the courier firm. The firm could use an efficient system of internet strategy to accomplish the tasks like preparing labels at the customers’ site, arranging for pick up, dropping at the destination and tracking and tracing packages. The system calculates the freight charges, invoices customers daily and produces customized reports. These parameters can be used with the objective of determining customer profitability and based on the costs involved in handling each customer, the firm can even offer volume discounts to customers who use the services heavily.


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Q.4. Explain the main characteristics of Service Sector Costing.

Ans. (i) Activities are labour intensive:

The activities of service sector generally are labour intensive. The direct material cost is either small or non-existent. For example, cost of stationery used by a professional consultant for expressing an opinion in black and white, for a client will be small or even non existent in case he gives verbal opinion. In the preceding example direct labour cost content of a service is significant.

(ii) Cost-unit is usually difficult to define: The selection of cost unit usually, for service sector is difficult to ascertain

as compared to the selection of cost unit for manufacturing sector. The following table provides some examples of the cost units for service sector.

(A) To External Customers Cost Unit

(i) Hotel Bed nights available, Bed night occupied

(ii) School Student hours, Full time students (iii) Hospital Patient per day, Room per day

(iv) Accounting firm Charged out client hours

(v) Transport Passenger km., quintal km. (B) Internal Services Cost Unit

(i) Staff canteen Meals provided, No. of staff

(ii) Machine maintenance Maintenance hours provided to user dept. (iii) Computer department Computer time provided to user dept.

(iii) Product costs in service sector:

Costs are classified as product or period costs in manufacturing sector for various reasons. These are:

(i) To determine the unit manufacturing costs so that inventories can be valued and selling prices created and verified.

(ii) To report production costs on income statement.

(iii) To analyse costs for control purposes.

The only difference between manufacturing and service sector is that in service sector there is no physical product that can be stored, assembled and valued. Services are rendered and cannot be stored up or placed in a vault. In service sector the cost of material is insignificant. Rendering a loan service, representing someone in court of law or selling an insurance policy are typical services performed by professionals. For computing unit cost of these services the most important cost would be professional’s labour cost. The direct labour cost is traceable to service rendered. In addition to labour cost the service sector like manufacturing sector incurs various overhead cost. In service sector those overhead costs which are incurred for offering a service are classified as service overhead (like factory overhead in manufacturing sector).


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Chapter 9 UNIFORM COSTING AND INTER FIRM COMPARISON

Q.1. What are the requisites for the installation of a uniform costing system?

Ans. Requisites for the installation of uniform costing:

Essential requisites for the installation of uniform costing are as under:

(i) The firm’s in the industry should be willing to share/furnish relevant data or information.

(ii) A spirit of cooperation and mutual trust should prevail among the participating firms.

(iii) Mutual exchange of ideas, methods used, special achievement made, research and know how etc. should be frequent.

(iv) Bigger firms should take the lead towards sharing their experience and know how with the smaller firm to enable the latter to improve their performance.

(v) In case of accounting methods, principles, procedure and production method uniformity must be established.

Q.2. What is Uniform Costing? Why is it recommended?

Ans. Meaning:

It has been defined by the Institute of Cost and Works Accountants of England as “The use by several undertaking of the same costing principles and/or practices”. Thus when a number of undertakings, whether under the same management or not, decide to adhere to one set of accepted costing principles especially in matters where there can be two opinions – they are said to be following uniform costing. It makes inter firm comparison easy and, of course, one of the aims of uniform costing is to introduce inter-firm comparison. Use of uniform costing is comparatively easy among concerns manufacturing the same type of products.

A great deal of spade work is required to be done before the introduction of uniform costing is an industry. Its introduction helps the firms to submit reliable cost data to price fixing bodies to determine the average cost and fixing the fair selling prices of various products. It serves as a pre-requisite to cost audit.

Uniform cost manual

It is a written document, which may be in the form of a booklet or bulletin, containing the principles, methods and procedures, for the ascertainment and control of cost in uniform costing. It is necessary for the successful operation of uniform costing system. Such a manual provide guidelines to the participating firms to organise their accounting system on a uniform basis.


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The following are the salient features of a uniform cost manual:

1. It includes statement of objectives and purpose of the system, scope of the system, advantages and extent of co-operation necessary.

2. It contains the general principles of accounting, nature of coding, terminology to be followed, classification and description of accounts. This section also includes details of stock control, labour and overhead cost collection and control.

3. Essential cost data and various ratios to be computed for comparison of performance and efficiency in the operation of the participating units.

4. Mode, format and time for presenting cost data and reports to the management.

5. It provides necessary guidelines about the treatment of description, interest on capital wastage, scrap, by-product, etc.

Limitation of uniform costing

It is not quite easy to implement uniform costing system. Certain problems and difficulties do arise resulting into its limitations as under:

(i) High initial installation cost:

Small firms feel that the system of uniform costing is meant only for large size and medium size firms as its installation involves high initial cost. They do not deny the benefits accruing from it but fail to implement it due to its high cost.

(ii) Costing inflexibility:

Sometime it is impossible to have uniform standards, methods and procedures of costing in various firms due to varied circumstances under which they operate. In other words the requirements for uniform costing are not flexible. This inflexibility may render the adoption of uniform costing a difficult task.

(iii) Non-disclosure of data:

Adoption of uniform costing system requires the disclosure of cost data and other data by various concerns. Many concerns may not like to disclose the secret data/information due to the fear, that the same, might be misused by their competitors. Thus non-disclosure of data also weakens the use of uniform costing.


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Advantages of uniform costing

Uniform costing refers to use of the same costing principles and practices by several undertakings. These undertakings may or not be under the same management. Adherence to the same costing methods and procedures specially when there can be two or more options is the characteristic feature of a uniform system of costing.

The following are the advantages of uniform costing:

(i) The management of an individual firm/unit will be saved of the botheration of developing and introducing a costing system of their own.

(ii) A uniform costing system for the firms in the same industry is provided for the adoption of such undertakings. Since, the system is divided by mutual consultation and after considering the difficulties and circumstances prevailing in the various undertakings, therefore it is readily adopted and successfully implemented.

(iii) If facilitates comparison of cost figures of various firms. Such a comparison enables the firms to identify their weak and strong points and control costs effectively and efficiently.

(iv) The availability of cost data other firms in the industry enables each firm to know its standing in the industry.

(v) The benefits of research and development of bigger firms are made available to smaller firms at no cost.

(vi) This system of costing requires the introduction of a uniform wage system in all the firms at no cost.

(vii) It helps trade associations in negotiating with the government in trade matters, particularly, when an industry seeks any assistance or concession from the government in matters of subsidies, exports, taxation, duties and price determination, etc.

(viii) Uniform costing is of great help in price fixation. Unhealthy competition is avoided between the firms in the same industry in framing policies and submitting tenders.

(ix) It helps the government also in regulating the prices of essential and important items such as bread, flour, sugar, cement and steel etc.


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‘Points on which uniformity is essential before introducing uniform costing’.

The points in respect of which uniformity is required to be established before the introduction of uniform costing in an industry are as below:

(i) Uniformity in the size of various units where uniform costing is to be introduced:

The size of units should be more or less the same which are to be brought under uniform costing. Units differing in size should be classified in a number of categories according to their size. Since the cost structure in an organisation is influenced by its size, the classification of units based on their size would make the cost statements of these units more comparable.

(ii) Uniformity in the production method:

All units in an industry should use uniform methods of production.

(iii) Uniformity in the accounting method, principles and procedures:

In fact, the uniformity should be achieved in respect of following:

1. Identifying stages of production where costs are to the measured

2. Same methods of valuing inventory should be used

3. Cost unit

4. Classification of costs and its components

5. Identifying methods of pricing material issues

6. Methods of remunering and providing incentive to labour

7. Basic of allocation and apportionment of overheads

8. Basic of distribution and redistribution of overheads

9. Methods of depreciation

10. Treatment of notional expenses

11. Treatment of material losses

12. Allocation/apportionment of joint costs

13. Preparation of cost statements, reports and their submission schedule

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