Ca Final - Ama (Costing) Theory Notes: Amogh Ashtaputre @amoghashtaputre Amogh Ashtaputre Amogh Ashtaputre
Ca Final - Ama (Costing) Theory Notes: Amogh Ashtaputre @amoghashtaputre Amogh Ashtaputre Amogh Ashtaputre
Ca Final - Ama (Costing) Theory Notes: Amogh Ashtaputre @amoghashtaputre Amogh Ashtaputre Amogh Ashtaputre
THEORY NOTES
[APPLICABLE FOR MAY 2016 & ONWARDS]
BY CA AMOGH
Amogh Ashtaputre
Amogh Ashtaputre
@amoghashtaputre
Amogh Ashtaputre
THEORY NOTES
INDEX
Chapter
Topic
No.
1
Marginal Costing
Relevant Costing
Standard Costing
Pricing Policy
Transfer Pricing
Target Costing
10
11
Just in Time
12
13
14
15
16
17
Budgetary Control
All the chapters carry questions from past examinations (theory) at the end along
with suggested answers.
Question I:
State the objectives of Cost Accounting.
Objectives of Cost Accounting:
The primary objective of study of cost is to contribute to profitability through Cost Reduction
and Cost Control. The following objective of Cost Accounting can be identified.
1. Ascertainment of Cost: This involves collection of cost information, by recording them
under suitable heads of account and reporting such information on a periodical basis.
2. Determination of selling price: Selling price is influenced by a number of factors.
However prices cannot be fixed below cost save in exceptional circumstances. Hence
cost accounting is required for determination of proper selling price.
3. Cost Control and Cost Reduction: In the long run, higher profits can be achieved only
through Cost Reduction and Cost Control.
4. Ascertaining the profit of each activity: Profit of each department / activity / product
can be determined by comparing its revenue with appropriate cost. Hence Cost
Accounting ensures profit measurement on an objective basis.
5. Assisting management in decision-making: Business decisions are taken after
conducting Cost-Benefit Analysis. Hence Cost and benefits of various options are
analysed and the Manager chooses the least cost option. Thus Cost Accounting and
reporting system assists managers in their decision making process.
Question II:
Classification of costs:
a. On the basis of Time period:
1. Historical Costs: Costs relating to the past period, which has already been incurred.
2. Current Costs: Costs relating to the present period.
3. Pre-determined Costs: Costs relating to the future period; Cost, which is computed in
advance, on the basis of specification of all factors affecting it.
b. On the basis of Behaviour / Nature / Variability:
1. Variable Costs: These are costs which tend to vary or change in relation to volume of
production or level of activity. These costs increase as production increases and viceversa e.g. cost of raw material, direct wages etc. However, variable costs per unit are
generally constant for every unit of the additional output.
Costs
Output
2. Fixed Costs: The cost which remain fixed irrespective of the change in the level of
activity / output. These costs are not affected by volume of production e.g. Factory Rent,
Insurance etc. Fixed Costs per unit vary inversely with volume of production i.e. if
production increases, fixed costs per unit decreases and vice-versa. Sometimes, these
are also known as Capacity Costs or Period Cost.
Cost
Output
For decision-making purpose Fixed Costs are further sub-classified into (a) Committed
Fixed Costs and (b) Discretionary Fixed Costs.
Committed Fixed Costs
Discretionary Fixed Costs
These are costs that arise from the These are costs incurred as a result of
possession of
managements discretion.
Plant, building and equipment It arises from periodic (usually yearly)
decisions regarding the maximum outlay
(e.g. depreciation rent, taxes
to be incurred, and
insurance premium etc.) or
It
is
not tied to a clear cause and effect
A basic organization (e.g.
relationship between inputs and outputs
salaries of staff)
These costs remain unaffected by any
short-term changes in the volume of
production.
Any reduction in committed fixed costs
under normal activities of the concern
would have adverse repercussions on
the concerns long term objectives.
Such costs cannot be controlled.
3. Semi-variable Costs: These are those costs which are party fixed and partly variable.
These are fixed upto a particular volume of production and become variable thereafter
for the next level of production. Hence, they are also called Step Costs. Some examples
are Repairs and Maintenance, Electricity, Telephone etc.
Cost
Output
c. On the basis of Elements:
1. Materials Cost of tangible, physical input used in relation to output/production, for
example, cost of materials, consumable stores, maintenance items etc.
2. Labour Cost incurred in relation to human resources of the enterprise, for example,
wages to workers, Salary to Office Staff, Training Expenses etc.
3. Expenses Cost of operating and running the enterprise, other than materials and
labour, it is the residual category of cost. For example, Factory Rent, Office
Maintenance, Salesmen Salary etc.
d. On the basis of Relationship:
1. Direct Costs: Costs which are directly related to / identified with / attributable to a Cost
Centre or a Cost unit.
Example: Cost of basic raw material used in the finished product, wages paid to site
labour in a contract etc.
2. Indirect Costs: Costs that are not directly identified with a cost centre or a cost unit.
Such costs are apportioned over different cost centers using appropriate basis.
Examples: Factory Rent incurred over various departments; Salary of supervisor
engaged in overseeing various construction contracts etc. Note: All indirect costs are
collectively called as Overheads, since they are generally incurred over various products
(cost units), various departments (cost centers) and over various heads of expenditure
accounts.
e. On the basis of Controllability
1. Controllable Costs Costs, which can be influenced and controlled by managerial
action. However, Controllability is a relative term and is subject to the following
restrictions.
(a) Time Certain costs are controllable in the long run and not in the short run.
(b) Location Certain costs are not influenced and decided at a particular location / cost
centre. If lease agreements of factory premises are executed centrally at the Head
Office, factory managers cannot control the incurrence of cost.
(c) Product / Output Certain cost are controllable by reference to one product or market
segment and not by reference to the other, for example, cost of common raw material
input for exports is lower than that of domestically sold goods since excise duty
concessions / duty drawback is available for export sales.
2. Uncontrollable Costs These are the costs that cannot be influenced and controlled by
a specific member of the organization. The line of difference between controllable and
non-controllable costs is thin.
Note: No cost is uncontrollable. Controllability is subject to the restrictions laid down
above.
f. On the basis of Normality:
1. Normal Cost: Cost, which can be reasonably expected to be incurred under normal,
routine and regular operating conditions.
2. Abnormal Cost: Costs over and above normal costs; Costs which is not incurred under
normal operating conditions e.g. fines and penalties.
4. Discretionary costs These are escapable or avoidable costs. In other words these
are costs, which are not essential for the accomplishment of a managerial objective.
5. Replacement Cost It is the cost at which there could be purchase of an asset or
material identical to that which is being replaced or devalued. It is the cost of
replacement at current market price and is relevant for decision-making.
6. Imputed Costs These are notional costs appearing in the cost accounts only e.g.
notional rent charges, interest on capital for which no interest has been paid. These are
relevant costs for decision-making. Where alternative capital investment projects are
being evaluated, it is necessary to consider the Imputed interest on capital before a
decision is arrived at as to which is the most profitable project.
7. Out-of pocket cost These are the costs, which entail current or near future cash
outlays for the decision at hand as opposed to cost, which do not require any cash outlay
(e.g. depreciation). Such costs are relevant for decision-making, as these will occur in
near future. This cost concept is a short-run concept and is used in decisions relating to
fixation of selling price in recession, make or buy, etc. Out-of-pocket costs can be
avoided or saved if a particular proposal under consideration is not accepted.
B. Irrelevant Costs: The costs, which are not relevant or useful for decision-making.
1. Sunk Cost It is the cost, which has already been incurred or sunk in the past. It is not
relevant for decision-making and is caused by complete abandonment as against
temporary shutdown. Thus if a firm has obsolete stock of materials amounting to
Rs.50,000 which can be sold as scrap for Rs.5,000 or can be utilised in a special job, the
value of opening stock of Rs.50,000 is a sunk cost and is not relevant for decisionmaking.
2. Committed Cost A cost, which has been committed by the management, is not
relevant for decision making. This should be contrasted with discretionary costs, which
are avoidable costs.
3. Absorbed Fixed Cost Fixed costs which do not change due to increase or decrease in
activity is irrelevant for decision-making. Although such fixed costs are absorbed in cost
of production on a normal rate, such costs are irrelevant for managerial decision-making.
However if fixed costs are specific, they become relevant for decision-making.
Explicit and Implicit Costs:
Explicit Costs These are also known as out of pocket costs. They refer to costs
involving immediate payment of cash. Salaries, wages, postage & telegram, printing &
stationery, interest on loan etc. are some examples of explicit costs involving immediate
cash payment.
Implicit Costs These costs do not involve any immediate cash payment. They are not
recorded in the books of account. They are also known as economic costs.
Estimated cost:
the expected cost of manufacture or acquisition, often in terms of a unit of product computed
on the basis of information available in advance of actual production or purchase. Estimated
costs are prospective costs since they refer to prediction of costs.
Cost Reduction
It aims at achieving a reduction in cost
by using any suitable technique like
value engineering, Work Study,
Standardisation and Simplification,
Variety reduction, Quality measurement
and research
Operations research,
Market research,
Job Evaluation and Merit Rating
Improvement in design,
Mechanisation and automation.
Data Base
A data base is a computer file system that uses a particular file organization to facilitate rapid
updating of individual records, simultaneous updating of related records, easy access to all
records by all applications programs, and rapid access to all stored data which must be
brought together for a particular routine report or inquiry or for special purpose report or inquiry.
Features:
A file structure that facilitates the association of one internal record with other internal
records.
Cross-functional integration of files of that records which previously would have been in
entirely independent files can now be associated and processed together automatically.
Program/data file independence, which eases the updating and maintenance of the database
and enhances special-report capabilities.
Common standards throughout in respect of data definitions, record formats, and other types
of data descriptions.
A data base management system (DBMS) to manage the data files.
A data dictionary that contains information about the data and the database.
Large-scale direct access memory to contain the data and the data base management
system.
Sophisticated communications equipment and programs that permit multiple users to
access the database simultaneously.
Sophisticated backup, recovery, and restart techniques to permit reconstruction of the data
base files if data is lost or destroyed.
A query language that permits each on-line query as well as records update on a
transaction-by transaction basis.
Key attributes of Operational Databases:
Operational Databases: Operational activities require full details about the transactions
involved. Operational databases satisfy the requirements of day-to-day operations (as opposed
to decision making). The attributes of operational databases of operational activities are :
1. Consistency of related information elements: Operating personnel (as well as
managers) are alert for information that is inconsistent with information they already
possess. If information from different sources about the same transactions is consistent
(one source tends to confirm and support the other), this information, as well as the
information system, has greater validity. In case of inconsistencies, operations personnel
may develop time-consuming supplemental information systems of their own.
2. Timeliness of transactions, information and managerial reports: Information is more
useful when they are provided on a real time basis to operations as well as for
managers. Operational databases are always timely due to:
(a) Simultaneous updating of all records affected by a transaction;
(b) Frequent use of on-line transactions entry; and
(c) Multiple files need not be processed sequentially for report generation.
3. Backup detail provided by inquiry capability: Operations personnel must refer to back
details, such as transactions with a vendor in a preceding period, that are needed to
answer customer questions about account status. If the detailed backup data is retained
with an on-line database that has a query language, the details needed can usually be
accessed rapidly through the window provided by the data base query language.
4. Data sharing: The sharing of a large pool of operations data among multiple user
departments is possible with database. For example, production engineering and
inventory personnel may need information related to one anothers current activities that
can be made available as needed. Such data is made available through all operational
database.
Attributes of Managerial Databases
Managerial databases are used for managerial decision-making (as opposed to operations).
Apart from the routine features found in Operational Database, the following additional features
are found in Managerial Databases:
1. Intelligence systems: Intelligence information needed from outside the organization for
strategic planning purposes is both substantial in quality and critical to top management
activities. The combination of intelligence systems and database constitutes one of the
most important ingredients in a MIS.
2. Special management problems: Database improve managers ability to respond
rapidly to special management problems, thus providing an enhanced adhoc reporting
capability. However data for special problem usage cannot be anticipated, it may be
possible to provide the information needed for these problems more rapidly with a
database because of progam/file independence, common standards, and other data
base characteristics.
3. Management models: Database can serve managers by enhancing the ability to
develop computer models for management use. Data can be extracted from an
operations database for inclusion in the Decision Support Systems database. This data
need not be reformatted and placed in a separate file for accessing by the model, which
is the common practice for modeling with non-data base systems. The ability of relational
data base systems to quickly generate entire new files (which could become the DSS
data base) appears to recommend them for companies that expect to develop decision
support systems.
4. Key task information systems: Databases can serve managers by helping them to
organize the information system around key management tasks. Databases should be
structured around key tasks at each level, usually with one database for each key task.
Successful accomplishment of key tasks often requires co-ordinating information from
multiple functional areas, which argues in favour of cross-functional data base systems
for key tasks.
Principles relevant for creating Databases for Management purposes
1. Wholistic Principle Consider a global perspective: whenever a new application is
contemplated, it should be viewed in the light of the entire scheme of the information
system. An effective data base system cannot be established on application at a time
when an entirely new orientation and a coherent data base master plan are required.
The cost of unplanned development is high.
2. Decision making Principle Use a top-down design: A database project begun by
first focusing on information needs at the bottom of the organization-a bottom-up
approach will never receive adequate attention. The top-down approach to designing
databases explicitly recognizes management needs. This approach focuses first on
senior and middle-management information needs and then on operations needs.
3. Exception Principle Provide for selective information reporting: The database should
generate primary reports for each major management activity, with backup detail
available on request. This primary report should contain all the relevant information
required for the managerial tasks and should not contain extraneous information.
Managers should not be forced to go through several data base reports simultaneously
to sort the relevant information from the available information.
4. Differentiation Principles Provide for different and multiple data bases for different
levels of management: Databases should be designed by the type of managerial activity
(such as key tasks) for a particular level of management, due to difference in information
requirements and distinction between planning and control activities. In many situations
at least two types of databases at each level will be most useful; one or more databases
may be needed for management control, and one or more may also be needed for
planning activities.
5. Non-conversion Principle Do no convert existing files: Conversion of existing
conventional files has many disadvantages. It means that the database design
personnel, (1) are not aware of information resource management concepts (or at least
do not practice them), (2) are not practicing the first two principles of global perspective
and top-down design, (3) are intending to develop data bases that are not cross
functional, and (4) will end up with a more expenses and probably no effective file
system, in terms of managerial utility; than that existed before conversion.
Q. 4
Costs may be classified in a variety of ways according to their nature and information needs of
the management Discuss. (November 1997) (4 marks)
Answer:
Costs can be classified according to their nature and information needs of the management in
the following manner.
1. By element: Under this classification costs are classified into (a) Direct costs and (b)
Indirect costs according to elements viz. materials, labour and expenses.
2. By function: Here costs are classifieds as: Production cost, administration cost, selling
cost, distribution cost, research cost, distribution cost etc.
3. By behaviour: According to this classification costs are classified as fixed, variable and
semi-variable costs. Fixed costs can be further classified as committed and
discretionary costs.
4. By Controllability: Costs are classified as controllable and non-controllable costs.
5. By normality: Costs are segregated as normal and abnormal costs.
Management of a business house requires cost information for decision making under different
circumstances. For e.g. they require such information for fixing selling price, controlling and
reducing costs. To perform all these functions a classification of cost according to their nature
and information needs is an essential pre-requisite of the management.
Q. 5
What are incremental costs and sunk costs? (November 1998) (4 marks)
Answer:
Refer above
Q. 6
Briefly explain the term Products cost and period cost. (May 1999) (4 marks)
Answer:
Refer above
Q. 7
Give any three examples of opportunity cost. (May 1999) (3 marks)
Answer:
Refer above
Q. 8
Outline the key attributes of an operational database? (May 2003) (4 marks)
Answer:
Refer above
Q. 9
Explain the concept of relevancy of cost in the context of decision making. (May 2004) (4
Marks)
Answer:
Relevant costs are those costs which are affected by a decision. Relevance means pertinent to
the decision in hand. The expected future costs which are essential and which differ by taking
an alternative course of action are relevant costs. Examples of relevant costs re:
Past costs are not relevant costs
Historical or sunk costs are not relevant
Variable costs are relevant costs
Fixed costs are not relevant
Book value of equipment is not relevant
Disposal value of equipment is relevant
Fixed costs which differ by decision becomes relevant
Variable costs which do not differ by a decision are not relevant
(a) Producing or distributing a few more or few less number of the products;
(b) A change in the method of production or of distribution;
(c) An addition or deletion of a product or a territory and
(d) Selection of an additional sales channel.
Differential cost, thus includes fixed and semi-fixed expenses. It is the difference between the
total costs of two alternatives, it is all adhoc cost determined for the purpose of choosing
between competing alternatives, each with its own combination of income and costs.
Differential cost may be incremental or decremental.
Marginal Cost:
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.
Distinguish between Differential Cost and Marginal Cost:
The main point which distinguishes marginal cost and differential cost 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.
Variable Cost
Variable cost is that portion of cost, which changes or varies in relation to output or
volume of production.
Generally, Variable Cost = Direct Materials + Direct Labour + Direct Expenses +
Variable Overheads
Variable cost per unit remains constant.
Fixed Cost
Fixed Costs are costs, which remain constant, for a given period of time, irrespective of level of
output.
Generally, Fixed Cost consist of Fixed Production Overheads Plus Administrative Overheads
Plus Fixed Selling and Distribution Overheads.
Fixed cost per unit of output will however fluctuate with changes in the level of production. As
output increases, fixed cost per unit decreases, and vice-versa.
Fixed costs are treated as period costs and are therefore charged to profit and loss account.
Semi-variable Cost
Some expenses exhibit characteristics of Fixed and Variable Costs, Such costs are semi
variable costs.
Increase or decrease in expenses is not in proportion to output. Example: Delivery van
expenses, Telephone, Electricity etc.
These expenses can be segregated into fixed and variable. Example: Depreciation of plant and
machinery depends partly on efflux of time and partly on wear and tear. The former is fixed and
the latter is variable.
Methods of segregating Semi-variable costs into fixed and variable costs
The following methods can be applied for segregation of semi variable costs into fixed and
variable portions;
(a)
(b)
(c)
(d)
(e)
Control over Expenses: Fixed costs are based on policy and relate to the period in
which they are incurred. Hence it may be difficult to control them. On the other hand,
Variable Costs relate to the level of activity and can be controlled properly.
(b)
Budgeting and Estimates: Overhead classification into fixed and variable helps as
a budgeting tool to forecast future movement in expenses. Estimates and Quotations
can be prepared on the basis of such useful analysis.
(c)
Decision-making: Since all costs are not fully fixed or fully variable, proper
segregation is a must to know the behaviour of total cost at different levels of output.
Such classification helps in understanding the pattern of total costs and take
appropriate decisions.
and carried forward and charged to the next period. Likewise the opening stock valuation also
includes the fixed overheads of previous period.
Unlike that, under marginal costing, the fixed overheads are all treated as period cost items
and are charged to the period rather than the output. Accordingly, the stock valuation
includes only the variable factory or production cost and not the fixed charge.
4. PROFIT MANIPULATION:
Profit figure can be manipulated by showing higher stocks under absorption costing.
No such manipulation is possible under marginal costing.
5. VARIANCE CALCULATION:
In variance reporting, Fixed Overheads expenditure variance only can be computed under
marginal costing. There is no volume variance since fixed overheads are non absorbed.
In variance reporting Fixed Overheads Expenditure and Volume variance, variance can be
computed under absorption costing. Volume variance can also be sub-classified into
Capacity, Efficiency and Calendar variances.
6. OVER /UNDER ABSORPTION:
If the spent amount is different from absorbed amount then, there will be over/under
absorption under absorption costing.
Since all fixed costs are written off in the period in which they are incurred there is no
possibility of over/under absorption.
7. APPLICATION:
Absorption costing technique is used for external reporting purposes. It distorts decisionmaking.
Marginal costing technique is used for internal reporting purposes. It aids in decisionmaking.
Contribution:
Contribution is the excess of sales revenue over the variable cost, i.e. Contribution =
Sales Less Variable cost.
It is called so, since it initially contributes towards recovery of fixed costs and thereafter
towards profit of the business. The contribution forms a fund for fixed expenses and
profit.
The contribution concept is based on the theory that the profit and fixed expenses of a
business is a joint cost which cannot be equitably apportioned to different segments of
the business. Hence contribution serves as a measure of efficiency of operations of
various segments of the business.
Fixed Cost
Profit
Cost-Volume-Profit Analysis:
Cost-Volume-Profit analysis is analysis of three variables i.e, cost, volume and profit which
explores the relationship existing amongst costs, revenue, activity levels and the resulting
profit.
It aims at measuring variations of profits and costs with volume, which is significant for
business profit planning.
CVP analysis makes use of principles of marginal costing. It is an important tool of planning for
making short term decisions.
The following are the basic decision making indicators in Marginal Costing:
(a)
(b)
(c)
(d)
(e)
3. Control Breakeven Chart: Both budgeted and actual cost data are depicted in this
chart. This chart is useful in comparing the actual performance of the firm with the
budgeted performance for exercising control.
4. Analytical break even chart: This chart shows the break-up of variable expenses into
important elements of cost. Viz. direct materials, direct labour, variable overheads, etc.
Also the appropriations of profit such as ordinary dividends, preference dividend ,
reserves, etc. are depicted in this chart.
5. Product wise break even chart: Separate break-even charts for different products can
also be prepared to compare the profitability of the products or their contribution.
6. Profit graph: Profit graph is a special type of break-even chart, which shows the profits
or loss at different levels of output.
Impact of non-linear sales and cost functions, on the Break-even point
In break-even analysis, it is presumed that the total sales line and variable cost lines will have
a linear relationship. i.e. these lines will be straight lines. However, in actual practice it is
unlikely to have a linear relationship for two reasons, namely:
(a) After the saturation point of existing demand, the sales value may show a downward
trend.
(b) The law of increasing cost may operate and the variable cost per unit may increase after
reaching particular level of output.
In such cases the contribution will not increase in a linear proportion. When such a situation
arises, the company should find the level of output where the profitability is optimum and any
manufacture beyond this level will not be profitable. The optimum profit is earned at the point
where the distance between sales and total cost is the greatest.
Limitations of break-even chart
1. The variable cost line need not necessarily be a straight line because of the possibility of
operation of law of increasing returns or decreasing returns.
2. Similarly the selling price will not be a constant factor. Any increase or decrease in output
is likely to have all influence on the selling price.
3. When a number of products are produced separate break-even charts will have to be
calculated. This poses a problem of apportionment of fixed expenses to each product.
4. Break-even charts ignore the capital employed in business, which is one of the important
guiding factors the determination of profitability.
Margin of Safety
Margin of Safety (MOS) represents the difference between the actual total sales and sales at
break-even point. It can be expressed as a percentage of total sales, or in value, or in terms of
quantity.
Significance
Upto Break even point the contribution earned is sufficient only to recover fixed costs.
However beyond the Break even point. The contribution is called profit (since fixed costs
are fully recovered by then)
Profit is nothing but contribution carried out of Margin of Safety Sales.
The size of the margin of safety shows the strength of the business.
If the margin of safety is small, it may indicate that the firm has large fixed expenses and is
more vulnerable to changes in sales.
If the margin of safety is large, a slight fall in sales may not affect the business very much
but if it is small even a slight fall in sales may adversely affect the business.
Indifference Point
Meaning:
It is the level of sales at which total costs (and hence total profits) of two options are equal. The
decision maker is indifferent as to option chosen, since both options will result in the same
amount of profit.
Significance:
Indifference point represents a cut-off indicator for deciding on the most profitable option. At
that level of sales (i.e indifference point).Costs and profits of two options are equal. The
profitability of different options are:
Level of Sales
Below Indifference
Point
Reason
Lower the Fixed Costs, lower
will be the BEP. Hence more
profits beyond the BEP
Indifference Point
The higher the PV ratio, the
better it is.
expenses incurred in normal operation and the fixed expenses incurred when plant is shut
down.
Key Factor:
Key factor or Limiting factor represents a resource whose availability is less than its
requirement.
It is a factor, which at a particular time or over a period limits the activities of a firm.
It is also called Critical Factor (Since it is vital or critical to the firms success) and Budget
Factor (since budgets are formulated by reference to such limitations or restraints).
Some examples of key Factor are (a) Shortage of raw material; (b) Labour shortage; (c)
Plant capacity; (d) Sales Expectancy; (e) Cash availability etc.
In case of key factor situation the procedure for decision-making is as under:
Step
1
2
3
4
5
Description
Identify the key factor
Compute total contribution or contribution per unit of the product.
Compute contribution per unit of the key factor, i.e. Contribution per hour,
contribution per kg of raw material etc.
Rank the products based on contribution per unit of the key factor
Allocate the key resources based on ranks given above
Answer:
Refer to above.
Q. 7
What is margin of safety? How can margin of safety be improved? (May 1999) (4 marks)
Answer:
Refer to above.
Q. 8
What are the limitations of break even chart? (May 1999) (4 marks)
Answer:
Refer to above.
Q. 9
Discuss the relationship between Angle of incidence, Break even level and margin of safety.
(November 1999) (8 marks)
Answer:
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 of incidence, the higher the rate of profit and vice versa. (Refer module page 2.23 for
graphical representation)
Break Even Level:
The Break Even level is the level or a business situation at which there is neither a profit nor
a loss to the firm. In other words, at this level, the total contribution equals fixed costs.
Margin of Safety
Margin of Safety (MOS) represents the difference between the actual total scales and sales at
break-even point. It can be expressed as a percentage of total sales, or in value, or in terms of
quantity.
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 will be
large and business enjoys financial stability. A low break even point indicates that the
business could be run profitable 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 as high as in 1.
3. If the break even point is high and angle of incidence is small, the margin of safety will be
low. This implies that 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, the margin of safety will be
low. The business is likely to incur losses through a small reduction in activity. However,
after a break even point, the business makes the profit at a high rate.
Q. 10
Briefly explain the methods of separating semi-variable costs into fixed and variable elements.
(May 2000) (6 marks)
Answer:
Refer above.
Q. 11
Briefly explain the methods of separating semi-variable costs into fixed and variable elements.
(May 2000) (6 marks)
Answer:
Refer above.
Q. 12
State three applications of direct costing. (May 2001) (3 marks)
Answer:
Refer to above.
Q. 13
State three applications of direct costing. (May 2001) (3 marks)
Answer:
Refer to above.
The above areas involve the use of marginal costs, relevant cost and different cost
approaches.
I. Inventory Decisions
Need
If the stock level is less, it disrupts production and affects sales
If the stock level is more, it involves locking up money, increases expenditure by way of
carrying costs and risk of obsolescence. Hence the optimum inventory levels, which lies
somewhere between the maximum and minimum levels, should be determined.
Different departments within an organization can have varying interest concerning stock:
(a) Sales department would like to have maximum stock of all varieties of finished goods
so as to meet all its customer demand immediately.
(b) Production department may wish to produce large batches of a new products so that
production runs are long and costs are low.
(c) Financial control department would prefer low stock in order to reduce the capital
tied up in stock.
So decisions regarding stock levels are usually concerned with seeking the best economic
compromise between conflicting objectives.
II. Plant Location Decisions:
The following are the basic aspects of plant location decisions:
(a) Selection of territory the state or territory in which the factory is to be located and
(b) Selection of site the exact site where the factory is to be put up.
Selection of territory. This aspect is influenced by:
(a) Entrepreneurs choice;
(b) Tax benefit available; and
(c) Laws of the State, which may be suitable for setting up of the industrial units.
Selection of site: The advantages associated with each probable site may be analysed into
the following categories:
Natural Advantages
Availability of water and power
Availability of raw material
Proximity to markets
Climatic conditions
Availability of labour-in certain areas
cheap and unskilled labour is
available in plenty, in certain areas
skilled labour will be available.
Derived Advantages
Specialized facilities like railways,
warehouses, harbour, etc.
Links with other industries, like
proximity to an industry from which
raw materials are purchased.
Availability of ancillary services, like
repairs.
Factors of distribution such as
transport
facilities,
freight
rate
concessions, etc.
Analysis of alternatives: If a number of alternative sites are available, decisions can be taken
by reference to the following aspects:
1. Relative advantages of one site over others
2. Capital expenditure of alternative site locations
3. Break-even analysis of the project at various site locations
4. Incremental rate of return
5. Intangible factors
III. Cost factors and non-cost-factors in an asset replacement decision
Cost Factors:
Comparison of operating costs of the existing plant with that of alternative plant. Figures of
comparative profitability, return on capital employed and interest on capital. Assessment of
opportunity costs to determine whether the funds proposed to be invested in
purchase of the new asset in replacement could be more gainfully deployed elsewhere.
Effect of disposal of the existing plant.
Additional capital expenditure of an obligatory nature to be incurred, if any, on related or
allied projects such as those for welfare.
Effect on tax liability due to profit or loss on the sale of plant/machinery to be replaced.
Non Cost Factors:
1. Market standing of the product: If the product is likely to become obsolete or go out of
fashion in the near future, it will not be worthwhile to go in for plant replacement.
2. Nature of the market capability of absorbing the product manufactured by the new plant
in its entirety at the anticipated price.
3. Constraints on the resources required for the new plant.
4. Possibility of any bottleneck or imbalances in subsequent operations or process, in the
new plant and if so, whether these can be removed.
5. Possibility of any substitute product coming up which make the replaced plant redundant.
6. Likely effects of any change in the policy of the Government with regard to import of raw
materials, export of products, levy of duties etc.
Areas of Decision Making
IV. Further Processing Decisions
The following steps are involved in decision making on further processing of joint products:
(a) Compute Additional Revenue = Sale Value after Further Processing Sales Value at
split off
(b) Compute Additional Costs = Further Processing costs + S & D OH if any
(c) Compute Additional Profit = Additional Revenue Additional Costs
(d) If Additional Profit is positive, process further, else sell at split off point.
Quality Improvement: This is undertaken where the sales are declining due to poor
quality of product or to compete successfully with the other manufacturers who supply
product of good quality.
Style Improvement: This strategy aims at improving the aesthetic appeal of the product
in contrast to its functional appeal. Changes in style of motor vehicles are examples of this
strategy.
The elimination of a weak product is done by: Piece-meal basis: Where the loss becomes
conspicuous and hence necessary to eliminate the product.
Crisis basis: The need to eliminate the product arises because of persistent decline in total
sales, piling inventories, or rising costs.
The system can be considered efficient if it maintains a particular level of service at minimum
cost. This means freight charges, warehousing cost, inventory carrying cost etc. should be
minimum.
Decision-making tools used for this purpose are (a) Linear programming (Transportation
Model); and (b) Inventory models.
Answer:
Important factors to be considered in marginal costing decisions are as follows:
Whether a product or production makes a contribution.
In the selection of alternatives, additional fixed costs if any should be considered.
The continuity of demand after expansion and its impact on selling price are to be
considered.
Non-cost factors such as the need to keep labour force intact and governmental attitude are
also to be taken into account.
Q. 2
In what circumstances it may be justifiable to sell at a price below marginal cost? (May 2000)
(4 marks)
Answer:
It may be justifiable to sell at a price below marginal cost for a limited period under the
following circumstances:
1. Where materials are of perishable nature
2. Where stocks have been accumulated in large quantities and the market prices have
fallen.
3. To popularise the new product
4. Where such reduction enables the firm to boost the sale of other products having larger
profit margins.
5. To capture foreign markets
6. To obviate shut down costs
7. To retain future market
Q. 3
Cost is not the only criteria for deciding in favour of shut down briefly explain. (May 2000) (3
marks)
Answer:
Cost is not the only criteria for deciding in favour of shut down. Non-cost factors worthy of
consideration in this regard are as follows:
1. Interest of workers, if the workers are discharged. It may become difficult to get skilled
workers later, on reopening of the factory. Also shut-down may create problems.
2. In the face of competition it may be difficult to re-establish the market for the product.
3. Plant may become obsolete or depreciate at a faster rate or get rusted. Thus heavy
capital expenditure may have to be incurred on re-opening.
Q. 4
State the non-cost factors to be considered in make/buy decisions. (May 2001) (4 marks)
Answer:
Non-cost factors in make/buy decisions:
Possible use of released production capacity and facility as a result of buying instead of
making.
Source of supply should be reliable and they are capable of meeting un-interruptedly the
requirement of the concern.
Assurance about the quality of goods supplied by outside supplier.
Reasonable certainty, from the side of suppliers about, meeting the delivery dates.
The decision of buying the product / component from outside suppliers should be
discouraged, if the technical know how used is highly secretive.
The decision of buying the component from outside suppliers should not result in the laying
off of workers and create industrial relations problems. In fact, on buyinf from outside,
the resources freed, should be better utilised elsewhere in the concern.
The decision of manufacturing the product / component should not adversely affect the
concerns relationship with outside suppliers.
Ensure that more than one supplier of product / component is available to reduce the risk of
outside buying.
In case the necessary technical expertise is not available internally then it is better to buy
the requirements from outside.
Q. 5
Enumerate the factors involved in decisions relating to expansion of capacity. (May 2001) (3
marks)
Answer:
The factors involved in decisions relating to expansion of capacity are enumerated as below:
1. Additional fixed overheads involved should be considered.
2. Possible decrease in selling price due to increased production capacity.
3. Whether the demand is sufficient to absorb the increased production.
By Sales
By Closing Stock
To Other Variable
Manufacturing expenses
(Direct Expenses DE)
To Administrative Overheads
To Selling & Distribution Overheads
To Other Expenses
To Net Profit
Since all the fixed overheads are written under profit and loss account, they are entirely written
off in the period in which they are incurred. (As nothing is charged to the closing stock)
Trading and Profit and Loss Account (Under Absorption Costing)
(Under Financial Accounting)
Trading Account
To Opening Stock
By Sales
By Closing Stock
To Other Variable
Manufacturing expenses
(Direct Expenses DE)
To Net Profit
By Sales
By Closing Stock
To Administrative Overheads
To Other Expenses
To Net Profit
As can be seen that under Absorption Costing, fixed production / manufacturing overheads are
charged to trading account. In such a case to the extent any production remains unsold, the
fixed overheads will be carried forward to the next year. (This is because closing stock
valuation will include part of the fixed overheads).
Following are the differences between Absorption costing & Marginal Costing:
1. COST CLASSIFICATION:
Under adsorption costing, costs are classified on functional basis i.e. Production,
Administration, Selling & Distribution, Research, Development etc.
Under marginal costing, fixed costs are treated as period costs. They are written off in the
period in which they are incurred.
3. STOCK VALUATION:
Under absorption costing, the fixed overheads (fixed production overheads under financial
accounting system and fixed production and administration overheads under cost accounting
system) are charged to the output. To the extent, the output remains unsold i.e. closing stock;
its valuation would include not only the variable production cost but also the fixed overheads.
This implies that part of the current period's fixed cost is effectively converted into an asset
and carried forward and charged to the next period. Likewise the opening stock valuation also
includes the fixed overheads of previous period.
Unlike that, under marginal costing, the fixed overheads are all treated as period cost items
and are charged to the period rather than the output. Accordingly, the stock valuation
includes only the variable factory or production cost and not the fixed charge.
For the normal accounting purposes, absorption costing is very widely accepted but for
management accounting purpose, it is only the marginal costing technique that is to be used.
The profit and loss statement based on two different methods would give us two different
profit figures and the difference would be only because of stock valuation, (difference in
respect of opening and closing stock), and under cost accounting, under/over absorption, if it
is carried forward.
When production is more than sales, profit under absorption costing system will be higher
as compared to marginal costing. This is because closing stock valuation will be higher under
absorption costing system.
When production is less than sales, profit under marginal costing system will be higher as
compared to absorption costing. This is because opening stock valuation will be lower under
absorption costing system.
Both the systems will give same profits when there are no stocks or when the opening and
closing stocks are same.
Incidentally it may also be noted that usual analysis of fixed overheads variance, based on
recovery, into expenditure variance, volume variance etc.
follows absorption costing. If at all it is specifically given that the company follows marginal
costing then, the usual analysis is irrelevant and we need to calculate only one variance i.e.
fixed overheads expenditure variance.
Since all fixed costs are written off in the period in which they are incurred there is no
possibility of over/under absorption.
5. APPLICATION:
Absorption costing technique is used for external reporting purposes. It distorts decisionmaking.
Marginal costing technique is used for internal reporting purposes. It aids in decisionmaking.
ii.
iii.
iv.
v.
ii.
iii.
iv.
v.
ii.
iii.
This means that the contribution would always be some fixed percentage of sates. Also the
contribution-minus fixed cost is net profit just as contribution minus net profit is fixed cost or
fixed cost plus net profit is equal to contribution.
To get the break even point, we need to know the amount of fixed cost and the relationship
between sales and contribution (known as profit/volume ratio). Amount of fixed cost is the
amount of contribution required and the P/v ratio is the rate at which contribution will be
earned. By using these two, we can easily calculate break-even point. The break-even point
can be expressed in terms of value or volume.
ii)
Cash Break-even point where only the cash fixed cost is considered.
iii)
Shut down point where only the additional fixed charge is considered.
iv)
v)
Profit Break-even-point.
If there are two or more constraints on production side, then the most profitable mix can be
developed either by graphical method (if there are only two products) or by simplex method (if
we have three or more products).
B. Relevant cost
- Money to be spent
- Inflow to be lost
C. Net gain / (loss) [A B]
2) The outflow to be avoided is that outflow which would take place if the proposal is
rejected & would be avoided if the proposal is accepted. Thus it is not the outflow, which
has already been avoided, & also not the outflow, which anyway is not going to take
place.
(B)
1) The money is vet to be spent, which means relevant cost is future cost & not sunk cost.
Further it would be spent if & only if the proposal is accepted, not otherwise.
2) Likewise the inflow to be lost is the inflow that would take place but for the decision &
would not take place because of the decision.
To conclude the events that is to be written in parts (A) & (B) are such that they have
direct link with the way we take the decision. Unless there is one to one relationship
between the way we take the decision & relevant revenue or relevant cost taking place,
the transaction given in the problem would not be relevant.
(C)
Usually we take the decision only based on the net gain or net loss. However
sometimes
we are specifically asked to take the decision after taking into account the qualitative
factors. In such cases, we will make the recommendation only after carefully
considering the qualitative or subjective / intangible considerations. [Ref. Q.9 (b)]
However if it is clearly given that additional utilisation would not increase the variable cost then
the same should be ignored.
Likewise if the company if operating at full capacity then acceptance of offer would result into
diversion of some capacity to the given offer & in such cases, like the treatment given to labour
in such cases, either variable charge may be taken as money to be spent or it may be
completely ignored & contribution to be lost should be calculated after treating variable charge
as irrelevant charge.
In most of the problems, the variable charge is given as % of labour cost. In such cases it
should be remembered that for special offer the workers may be paid nothing or may be paid
the wages but irrelevant or may be paid at a rate other than normal. The variable charge as
such depends on utilisation of capacity & not on whether workers are paid anything and, if yes,
whether relevant or not. Accordingly, we calculate variable overheads as if the labour cost is
normal.
The points written above pertain to variable production overheads & not to administration and
S&D overheads. The administration & S & D charges may or may not be relevant. The
instruction would always be given in the problem in this regard but it not given then variable
charges like sales commission should be ignored because the comm. is unlikely to be paid on
the sales value of special proposal.
It is therefore, desirable that the level of production and capacity utilization, which are likely
to apply in the near future, should be arrived at with utmost care on realistic basis
keeping in view both the past performance and the future demand.
5. Depreciation:
If a firm wants to survive and stay in business, it has to maintain its fixed capital intact so that
its fixed assets may be replaced at the end of their useful working life out of the funds
generated from profits retained in the business.
In a period of relatively stable price levels, depreciation based on historical cost of fixed
assets would be adequate for achieving this object.
In periods when the price level is continuously changing, the firm may not be left with
adequate funds generated out of accumulated depreciation at the end of the life of the
plant to replace it at a higher price.
Hence depreciation should be properly included as part of cost so as to leave sufficient
profits for asset replacement.
Advantages of Cost Plus pricing
Guaranteed Contribution: When full costs plus basis is used for pricing, the firm earns a
guaranteed contribution equivalent to fixed costs plus profit margin. Even, profit margin is
taken as nil, fixed costs included in prices will guarantee minimum contribution.
Assured Profit: Cost plus is a fair method of price fixation. The business executives are
convinced that the price fixed will cover the cost.
Reduced risks and uncertainties: If price is greater than cost, the risk is covered. This is
true when normal expected capacity basis of cost estimation is used. The decisionmaker may accept a pricing formula that seems reasonable for reducing uncertainty.
Most suitable in long run: Cost plus pricing is ideal in the long run since there are no
permanent opportunity cost. The effect of seasonal fluctuations is ironed out and prices
are established based on normal long run costs.
Considers market factors: Cost plus pricing does not mean that market forces are ignored.
The mark up added to the cost to make a price reflect the well-established customs of
trade, which guide the price fixer towards a competitive price.
Full Recovery of all costs of the product: For long-run pricing decisions, full costs of the
product informs managers of the minimum costs to be recovered so as to continue in
business rather than shut down.
Price Stability: Price fixation based on full costs of the product promotes price stability,
because it limits the ability of sales person to cut prices. Price stability facilitates
planning.
Simplicity: A full cost formula for pricing does not require a detailed analysis of costbehaviour patterns to separate costs into fixed and variable components for each
product. It is simple to operate.
Disadvantages of Cost plus pricing
Ignores demand: Cost plus pricing ignores demand and fails to take into account the
buyers needs and willingness to pay, which govern the sales volume obtainable at each
series of prices.
Ignores competition: It fails to reflect competition adequately.
Arbitrary Cost allocation: It assumes that the costs have been estimated with exact
accuracy. This assumption is not true particularly in multi-product firms where the
common costs are allocated arbitrarily.
Ignores opportunity costs: For many decisions incremental cost play a vital role in pricing,
rather than full costs. This aspect is ignored. Also opportunity costs, most relevant for
decision-making are summarily ignored.
Price-Volume relationships: Since the fixed overheads are apportioned on the basis of
volume of production, the cost will be more if sales volume is less and vice-versa. The
increase or decrease in sales volume is dependent on price. Thus it is a vicious circlecost plus mark up is based on sales volume & sales volume is based on price.
II. Rate of Return Pricing
Rate of return pricing is used when each division is treated as an Investment Centre.
Determination of return on capital employed is one of the most crucial aspects in price
fixation and performance evaluation of Investment Centres.
The firm should determine an average mark-up on cost, which is necessary to produce a
desired rate of return on its investment.
The issues to be considered are:
Basis on which the capital employed is computed
Components to be covered in the return on capital
Fairness of the rate or return.
The fairness of the rate of return varies from industry to industry and from time to time and is
primarily dependent on the risks involved. In following fair rate of return, the desirability of
earning adequate profits to plough back into business should be kept in mind.
It would be correct to assume that allowing the industry to earn adequate return on the
capital employed would attract additional capital and increase the number of factories
and production of all commodity which must ultimately lead to competition and reduction
in costs and prices.
III. Variable Costs Pricing:
Selling prices are fixed above variable costs in order to generate contribution. However, in the
short run, selling prices may be equal to variable cost or sometimes even below variable cost.
Some illustrative situations are:
Products / Materials are perishable in nature.
Launch of new product at competitive prices.
Sales of old and defective stocks, seconds sales, etc.
Disposal of accumulated stocks, where market prices have fallen (to save carrying costs)
Sale of one product with reduced margin, to boost sales of other products having higher
profit margin.
IV. Pricing above marginal cost, but below total cost.
In periods of recession, a firm may sell its articles at a price less than the total cost but above
the marginal cost for a limited period. The advantages of this policy arise due to avoidance of
shut-down. Thus the benefits are:
The firm can continue to produce and use the services of skilled employees who are
well trained and will be difficult to re-employ later if discharged.
Plant and machinery can be prevented from deterioration through idleness.
The firm would be ready to take advantage of improved business conditions later.
The firm can continue in the market and reduce loss of market share to Competitors.
Such pricing policy is necessarily restricted to the short run. When business conditions
improve in the long run, such pricing below total cost but above marginal costs is not advisable.
can be set as the matter of primary consideration and then the decision can be adjusted to
bring it in consonance with the other decision of the business.
Incremental pricing analyses all aspects of decision-making as listed below:
Relevant Cost Analysis: This technique considers changes in costs rather than in average
cost. Overhead allocations are irrelevant. Incremental revenue inflows and cost outflows
are included for decision-making.
Product-Line Relationship Analysis: This technique necessitates consideration being
given to possible complementary relations in demand. Sale of one product may lead to
the sale of a complementary product. This overall effect on profitability has to be
evaluated.
Opportunity Cost Analysis: the incremental revenue should cover the opportunity cost and
also generate surplus. A price which results in an incremental revenue which in turn
merely covers the incremental costs is not sufficient. If the opportunity foregone is
greater than incremental revenue, the decision is not sound.
Time Factor Analysis: The decision should take into account the short run and long run
effects. A high price may increase its immediate profits but may lead to loss of revenue in
the long run owing to competitors snatching the business
CVP Analysis: In fixing prices, consideration should be given to price volume relationship.
The responsiveness of the market to the price should be such that the volume is
increased to achieve full utilization of plant capacity.
Risk Analysis: Consideration should also be given to the evaluation of uncertainty and risk
factor. The decision taken should be able to maximize the expected value based on
probability theory.
PRICING STRATEGIES
Pricing strategy is defined as a broad plan of action by which an organization intends to reach
its goal. Some illustrative strategies are:
Expanding product lines that enjoy substantial brand equity.
Offer Quantity discounts to achieve increase in sales volume.
Some types of pricing strategies, which a firm can adopt are:
Market entry Strategies New Product Pricing Skimming or penetration Pricing
Discount Strategies Differentials and discounts to Dealers, Distributors and Customers
etc.
Price Discrimination Strategies based on customers, time, product version etc.
Geographic Pricing Strategies
a) Skimming Pricing Strategy:
It is a policy of high prices during the early period of a products existence and in the later
years the prices are gradually reduced. It is an attempt to exploit those segments of the market
that are relatively insensitive to price changes. For example, high initial price may be charged
to take advantage of the novelty appeal of a new product when the demand is initially inelastic.
It offers a safeguard against unexpected future increase in costs, or a large fall in demand after
the novelty appeal has declined. This policy should not be adopted when the substitutes
are already available in the market.
The reasons for following such a policy are:
1. Inelastic Demand: The demand is likely to be inelastic in the earlier stages till the
product is established in the market. The firm can take advantage of high prices.
2. Sales Boost: 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
years will tend to increase the sales.
3. Assured Profit: 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. Contribution is guaranteed.
4. Cost Revenue Matching: High initial capital outlays, needed for manufactures, results in
high cost of production. Also, the manufacturer has to incur huge promotional activities
resulting in increased costs. High initial prices will be able to finance the cost of
production. Gradually, the economies of scale and savings in costs are passed on to
customers.
b) Penetration Pricing Strategy
It is a policy of using a low price as the principal instrument for penetrating mass markets
early.
This method is used for pricing a new product and to popularize it initially.
Profits may not be earned in the initial stages. However, prices may be increased as and
when the product is established and its demand picks up.
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 is necessary before determining the price.
The circumstances in which penetrating Pricing can be adopted are:
Elastic demand: The demand of the product is high, when price is low. Hence lower prices
mean large volumes and hence more profits.
Mass Production: When there are substantial savings in large-scale production, increase
in demand is sustained by the adoption of low pricing policy.
Frighten off competition: The prices fixed at a low level act as an entry barrier to the
prospective competitors. The use of this policy by existing concerns will discourage the
new concerns to enter the market. This pricing policy is also know as stay-out-pricing
PARETO ANALYSIS
Meaning:
PARETO ANALYSIS is a rule that recommends focus on the most important aspects of the
decision making, in order to simplify the process of decision making.
It is based on the 80:20 phenomenon, first observed by Vilfredo Pareto, an Italian economist.
He noticed that 80% of the wealth of Milan was owned by 20% of its citizen. This pattern
of 80:20 or approximations like 70:30 can be observed in many different business
situations.
The management can use it in a number of different circumstances to direct management
attention to the key control mechanism or planning aspect. It helps to clearly establish
top priorities and to identify both profitable and unprofitable targets.
Usefulness of Pareto Analysis: Pareto analysis is useful to
Prioritize problems, goals and objectives.
Identify root causes
Select and define key quality improvement programs.
Select key customer relations and service programs.
Select key employee relations improvement programs.
Select and define key performance improvement programs.
Maximize research and product development time.
Verify operating procedures and manufacturing processes
Sales/distribution of Products or services.
Allocate physical, financial and human resources.
Situations where Pareto Analysis can be applied:
Pareto analysis is applicable in the presentation of Performance Indicators data through
selection of representative process characteristics that truly determine or directly or indirectly
influence or conform the desired quality or performance result or outcome. It is generally
applicable to the following business situations:
1. Product Pricing
Where a company sells a number of products, it may not be possible to analyse costvolume-price- profit relationships for all products.
Pareto Analysis is used for analyzing the firms estimated sales revenues from various
products and it might indicate that approximately 80% of its total sales revenue is earned
from about 20% of its products.
This helps top management to delegate the pricing decision for approximately 80% of its
products to the lower managerial levels. Top management can concentrate on pricing
decisions for the important 20% products, which are essential for the companys survival.
Sophisticated pricing methods can be adopted for the important products while for other
products cost based pricing methods may be used.
To External Customer
(i) Hotel
(ii) School
(iii) Hospital
(iv) Accounting firm
(v) Transport
Cost Unit
Bed nights available, Bed night occupied
Student hours, Full time students
Patient per day, Room per day
Charged out client hours
Passenger km., quintal km.
(B)
Internal Services
(i) Staff canteen
(ii) Machine maintenance
(iii) Computer department
Cost Unit
Meals provided, No. of staff
Maintenance hours provided to user department
Computer time provided to user department
3. Product costs in service sector: Cost are classified as product or period costs in
manufacturing sector for various reasons. These are:
To determine the unit manufacturing costs so that inventories can be valued and
selling prices created and verified.
To report production costs on income statement
To analyse costs for control purposes.
Question II:
What are the differences between manufacturing and service sector.
1. The 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.
2. In service sector the cost of material is insignificant.
3. For computing unit cost of services the most important cost would be professionals
labour cost.
4. The direct labour cost is traceable to service rendered.
5. 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 overheads (like factory overhead in manufacturing
sector).
6. Examples: Rendering a loan service, representing someone in court of law or selling an
insurance policy are typical services performed by professionals.
Question III:
How is cost data collected in service sector?
COLLECTION OF COSTING DATA IN SERVICE SECTOR
1. Classification: Costs are accumulated under various heads for control purpose and for
decision making.
2. Grouping: Costs are then grouped under fixed costs and variable costs.
3. Put in a particular format: They are then put in a format, which depends upon the
nature of industry and the need of the management.
4. Period: For preparing a cost sheet under operating costing, costs are usually
accumulated for a specified period viz. a month, a quarter or year etc.
5. Composite cost units: Often composite cost units such as passenger km, bed, nights
etc. are used by these organizations for ascertaining the cost of these services
respectively. Since there is no
Question IV:
Discuss the different costing methods that are used in service sector.
Different costing methods used in service sector:
Job Costing method: In job costing method the cost of a particular service is obtained by
assigning costs to a distinct identifiable service. In service sector like Accounting firm,
Advertising campaigns etc. job costing method is used.
Process Costing method: In process costing system the cost of a service is obtained by
assigning costs to masses of similar unit and then computing unit cost on an average
basis. Retail banking, Postal delivery, Credit card etc. uses process costing method.
Hybrid costing method: Many companies uses a method of costing which is neither job
costing nor process costing method. They in fact uses a hybrid costing method which
combines elements of both job costing and process costing methods.
Question V:
Write a note on Job costing method in service sector.
Job costing method in service sector: The two costs, which are incurred in service sectors,
are:
Direct labour
Service overheads
For ascertaining the price of a service provided by service sector if job-costing method is
followed, the costs for each job are to be monitored continuously. There are two main uses of
this job costs information:
1.
2.
The five steps, which are generally adopted for assigning costs to individual jobs, are as
follows:
1. Identify the job that is chosen as cost object : For instance, litigation work for
Motorola India Ltd. By Dua & Associates by assuming that work requires 100 budgeted
hours of professional labour.
2. Identify the direct cost categories for the job : In the above example the professional
hours required for doing litigation work is a direct cost.
3. Identify indirect costs (overheads) associated with the job: This step requires
identifications of indirect costs incurred for providing services. These costs may include
the costs of support labour, computer time, travel, telephone/fax machine, photocopying
etc.
4. Select the cost allocation base to be used in assigning each indirect cost to the
job : This step requires the selection of cost allocation base that has a cause and effect
relationship between changes in it and changes in the level of indirect costs. The
allocation base suitable for allocating indirect cost of law firm is professional labour
hours.
5. Identify the rate per unit of the cost allocation base used to allocate cost to the
job: The budgeted indirect cost allocation rate is computed by using following formula.
Question VI:
Write a note on Customer Costing in service sector.
Customer Costing in service sector: The customer costing is a new approach to
management. The theme of this approach is customer satisfaction. In some service industries
such as public relations, the specific output of industry may be difficult to identify and even
more difficult to quantify. Further where there are multiple customers, identifying support
activities i.e. common costs with particular customer may be more problematic. In such cases,
it is important to cost customers. An ABC analysis of customers profitability provides valuable
information to help management in pricing customer. Consider a banking sector A banks
activities for customer will include the following types of activities. These are :
(i)
(ii)
(iii)
(iv)
(v)
(vi)
Stopping a cheque
Withdrawal of cash
Updation of pass book
Issue of duplicate pass book
Returning a cheque because of insufficient funds
Clearing of a customer cheque.
Different customers or categories of customers use different amount of these activities and so
customer profiles can be build up and customer can be charged according to the cost to serve
them.
For example:
1. In Computer Institute the cost of providing a course for enrolled students may be
determined by a variety of factors, such as type of course (Oracle or Java) and the level
of course (introduction or advanced).
2. A hotel may have activities that are provided for specific types of customers such as well
laid gardens, swimming pool and a bar. Older guest may appreciate and use the
garden, families the swimming pool and business guests the bar. If the activities are
allocated to relevant guest a correct cost per bed occupied can be calculated for each
type of category.
For customer costing purpose, the costs are divided into following categories. These are
1. Customer Specific costs: These are direct and indirect cost of providing service to
customer plus customer related cost assigned to each customer. For example cost of
express courier service to a client/customer who requests overnight delivery of some
agreement.
2. Customer-line categories: These are the cost which are broken into the broad
categories of customers and not individual customer.
3. Company costs: These are those costs which are not allocated to either customer line
or individual customers but charge to company. The example is the cost of
advertisement to promote sale of service.
Question VII:
Write a note on pricing by service sector.
PRICING BY SERVICE SECTOR
1. The service sector follows a different approach for pricing their service. Although a
service has no physical existence it must be priced and billed to customers.
2. Most service organizations use a form consisting of time and material pricing to arrive at
the price of a service.
3. Service companies such as appliance repair shops, automobile repair business
calculate their prices by using two computations, one for labour and other for materials
and parts.
4. A mark up percentage is used to add the cost of overhead to the direct cost of labour,
materials and parts. If materials and parts are not part of service being performed, then
only direct labour costs are used as basis for determining price.
5. For professionals such as accountants and consultants direct labour costs and
apportioned overhead and indirect costs are considered for pricing.
Merits
Simple to understand.
Easy to operate
No negative contribution to
Transferring division
Demerits
Costs and prices fluctuate from time
to time. Hence, transfer prices also
vary.
No contribution for transferring
Merits
Simple to understand.
Easy to operate
Guaranteed contribution to
transferring division, to the extent of
Fixed Manufacturing Costs.
Ideal if transferring division has
sufficient spare capacity, and
intermediate product is not
marketable.
Demerits
Costs and prices fluctuate from time
to time. Hence, transfer prices also
vary.
Not suitable for performance
evaluation of transferring division.
Does not consider opportunity costs
and losses.
Not suitable for transferring divisions
which operate at full capacity.
Merits
Simple to understand.
Easy to operate
Guaranteed contribution to
transferring division, to the extent of
Fixed Costs. Usable if transferring
division has sufficient spare capacity,
and intermediate product is not
marketable.
Demerits
Actual Costs fluctuate from time to
time.
No suitable for performance
evaluation of transferring division.
Does not consider opportunity costs
and losses.
Not suitable for transferring divisions
which operate at full capacity.
Cost efficiency of transferring division
may mean lower prices, hence no
incentive for cost reduction.
d) Standard Costs:
Merits
Simple and easy to operate when
compared to actual cost based
methods.
Inventories are carried at standard
costs in transferring and receiving
divisions.
Demerits
The transferring division usually
absorbs variances and hence
segment-wise performance evaluation
is not possible.
Does not consider opportunity costs
and losses.
Cost Plus mark-up: Under this method, the transfers are made at Cost + Mark-up basis. Cost
may be any variant i.e. Variable Manufacturing Costs or Full Manufacturing Costs or Total Cost
(Actual) or Standard Costs.
Mark-up added to cost may be expressed either (1) as a percentage of full cost or (2) as a
percentage of capital employed.
Motivates
management effort
Yes
Preserves sub-unit
autonomy
Other factors
Yes, if based on
budgeted costs; less
incentive to control
costs if transfers are
based on actual
costs.
No, since it is rulebased
Negotiated
Yes
Yes, but transfer
prices are affected
by bargaining
strengths.
Yes
Yes, because it is
based on
negotiations
between sub-units.
Bargaining and
negotiations take
item and may, need
to be reviewed
repeatedly as
conditions change.
Recipient Divisions ability to pay, for example, if the recipient division sells the final product
at Rs.100 after incurring incremental costs of Rs.15 in its own division it will be prepared
to pay maximum of Rs.85 for the intermediate product.
The transfer price may be determined by negotiations between divisional managers, subject to
the range of minimum to maximum prices. The range of transfer prices as given above must be
adhered to since:
Transferring Division has no incentive to transfer at any price below the minimum, as its
incremental costs and opportunity costs may not be fully recovered.
Recipient Division has no incentive for internal purchase, at any price above the
maximum, as outsourcing may be beneficial to such division.
The Transferring Division is provided with sufficient incentive for internal transfer, since
marginal costs are fully recovered and the lump-sum fee received will reduce its losses by
recovering fixed costs.
The Recipient Division is also interested in the internal procurement since the transfer
price will be less than market price or cost of alternative option like outsourcing etc.
Moreover, the lump-sum fixed fee constitutes a commitment if the divisions to utilize a
portion of the capacity of the transferring divisions, for an agreed compensation.
Q. 5
Outline the limitations of negotiated method of transfer price. (May 2003) (4 marks)
Question II:
Define Value Engineering and its scope. What are the issues that needs to be dealt with
during a value engineering review.
VALUE ENGINEERING (VE)
Meaning
Value Engineering or Value Analysis involves searching for opportunities to modify the
design of each component or part of a product to reduce cost, but without reducing the
functionality or quality of the product. It entails studying the activities that are involved in
producing the product to detect non-value adding activities that may be eliminated or
minimized to save costs, but without reducing the functionality or quality of the product.
Scope
Value Engineering and Value Analysis help identify costs into (a) Value-Added Cost and (b)
Non Value-Added Cost. The objective is to retain (if possible, reduce) value-added cost, while
totally avoiding or eliminating non-value added costs.
Value-added cost: A value-added cost is a cost that, if eliminated, would reduce the value
or utility (usefulness) customers obtain from using the product or service.
Non value-added cost: A non value-added cost is a cost that, if eliminated would not
reduce the value or utility customers obtain from using the product or service. It is a cost
that the customer is unwilling to pay to the company.
Some issues analysed during VE review are:
1. Elimination of unnecessary functions from the production process:
This involves a detailed review of the entire manufacturing process to see if there are
any steps that add no value to the product, e.g. interim quality review before further
processing and final quality check.
By eliminating unnecessary or duplicate functions, the firm can reduce their associated
direct or overhead costs from the total product cost.
The possible repercussions of elimination of any intermediate production function should
be carefully analysed. The engineering team must be careful to develop work-around
steps that eliminate the need for the original functions.
This involves the creation of a design that uses fewer parts or has fewer features.
This approach is based on the assumption that a minimal design is easier to
manufacture and assemble Also, with fewer parts to purchase, less procurement
expenses is associated with the product.
However, sometimes it would be less expensive to settle for a few extra standard parts
that are more easily and cheaply obtained, rather than customised pre-fabricated parts,
which complicate the assembly process.
This is also known as Design For Manufacture and Assembly (DFMA) and involves the
creation of a product design that can be created in only a specific manner. For example,
a toner cartridge for a laser printer is designed so that it can be successfully inserted
into the printer only when the sides of the cartridge are correctly aligned with the printer
opening; all other attempts to insert the cartridge will fail.
When used for the assembly of an entire product, this approach ensures that a product
is not incorrectly manufactured or assembled, which would call for a costly disassembly
or product recalls from customers who have received defective goods.
5. Substitution of Parts:
This is also called as Component Parts Analysis. This approach encourages the search
for less expensive components or materials that can replace more expensive parts
currently used in a product design.
Substitution of new parts is encouraged since new materials are being developed every
year.
However parts substitution must be accompanied by a review of related changes
elsewhere in the design and the consequent impact on total costs.
This also involves allied analysis on tracking the intentions of suppliers to continue
production of parts in the future. If parts are not available, they must be eliminated from
the product design.
6. Combination of Steps:
Sometimes, a careful review of all processes associated with a product reveals that
some steps can be eliminated, other steps can be consolidated, or that several can be
accomplished by one person, rather than having people in widely disparate parts of the
production process to perform them. This is also known as Process Centering.
By combining steps, transfer and queue time can be eliminated from the production
process, which in turn reduces the chances of damage during transfers.
7. Search for better way of doing things:
This seeks to answer a basic question is there a better way?
It strikes at the core of the cost reduction issue. It is a more general attempt to start from
scratch and build a new product or process that is not based in any way on pre-existing
ideas.
Improvements resulting from this technique tend to have the largest favorable impact on
cost reductions but can also be the most difficult for the organization to adopt, especially
if it has used other designs or systems for production.
Question III:
Briefly describe the role of a firms Suppliers in its Value Engineering or Cost Reduction
drive.
Role of a firms Suppliers in its Value Engineering or Cost Reduction drive
Value Engineering also involves calling on the services of a companys suppliers to assist in
the cost reduction effort. Suppliers of materials can have significant role in value engineering
due to the following reason:
Suppliers can contribute information on enhanced types of technology of materials.
Suppliers specialize in areas that a company has no information about and can share
product expertise.
They may have also conducted extensive value engineering for the components
they manufacture, resulting in advanced designs that a Company may be able to
incorporate into its new products.
Suppliers may have also redesigned their production processes, or can be
assisted by a companys engineers in doing so, producing cost reductions or
decreased production waste that can be translated into lower components costs
for the company.
Question IV:
Briefly explain Kaizen costing.
KAIZEN COSTING
Kaizen Costing refers to the ongoing continuous improvement program that focuses on the
reduction of waste in the production process, thereby further lowering costs below the initial
targets specified during the design phase. It is a Japanese term for a number of cost reduction
steps that can be used subsequent to issuing a new product design to the factory floor.
The initial VE review may not be complete and perfect in all costs aspects. There may be
further chances of waste reduction, cost and time reduction and product improvement. Such
continuous cost reduction technique is call as kaizen Costing.
The review of product costs under the target costing methodology is not reserved just for the
period up to the completion of design work on a new product. On the contrary, there are always
opportunities to control costs after the design phase is completed, though these opportunities
are fewer than during the design phase.
Kaizen Costing Process: Activities in kaizen costing include elimination of waste in
production, assembly and distribution processes, as well as the elimination of work steps in
any of these areas. Thus kaizen costing is really designed to repeat many of the value
engineering steps for as long as a product is produced, constantly refining the process and
thereby stripping out extra costs at each stage.
Savings from Kaizen Costing: The cost reductions resulting from kaizen costing are much
smaller than those achieved with value engineering. But these are still significant since
competitive pressures are likely to force down the price of a product over time, and any
possible cost savings allow a company to still attain its targeted profit margins Mille continuing
to reduce cost.
Multiple Versions of Products - Continuous Kaizen Costing: Multiple improved versions of
products can be introduced to meet the challenge of gradually reducing costs and prices. The
market price of products continues to drop over time, which forces a company to use both
target and kaizen costing to reduce costs and retain its profit margin.
However, prices eventually drop to the point where margins are reduced, which forces the
company to develop a new product with lower initial cost and for which kaizen costing can
again be used to further reduce costs. This pattern may be repeated many times as a company
forces its costs down through successive generations of products.
The exact timing to switch to a new product is easy to determine well in advance since the
returns from kaizen costing follow a trend line of gradually shrinking savings. Since prices also
follow a predictable downward track, plotting these two trend lines into the future reveals when
a new product version must be ready for production.
Question V:
What are the advantages of target costing?
Advantages of Target Costing:
Innovation: It reinforces top-to-bottom commitment to process and product innovation and
is aimed at identifying issues to be resolved.
Non-Traditional: The traditional sources of cost data is a central accounting data base
consisting of accounts payable, billings, bills of material, and inventory records. These
do not provide information required for Target Costing.
Futuristic: Target Costing Data is essentially futuristic, as it is associated with new and
improved products, new designs and manufacturing processes.
Poorly defined: The data for Target Costing project is more poorly defined information.
The Cost Accountant has to start from scratch in order to estimate costs. In earlier
stages of product designs, best possible guesses may have to be used.
6. Engineering Data: This information extends to (a) upcoming technological changes that
can be used to enhance the features of existing products (b) interaction of various
components of a product, so that one can predict what cost changes are likely to arise in
the subsystem of a product if a part is reconfigured in a different subsystem (c) changes
in costs that will arise from the use of a smaller or larger number of fasteners, different
materials , different product sizes or weights or a host of other factors.
7. Supplier Data: Information on suppliers coves (a) previous quality, cost and on time
delivery performance of all key suppliers. (b) production capacities of each supplier (c)
assumed profitability levels for each supplier etc. The cost accountant can use this
information to determine which standard parts are no longer acceptable for future
product designs, based on a history of high cost, poor quality or inadequate on-time
delivery. Also, if suppliers show inadequate profits, it may signal their inability to obtain
further cost reductions through capital asset purchases, which may necessitate
switching to a different supplier.
Question X:
What are the steps involved in implementing target costing system?
Steps involved in implementing a Target Costing System:
1. Create a Project Charter: Project Charter is a document, approved by top management
that describes its goals and what it is authorized to do. This Charter is based on the
corporate mission statement and related goals. Written approval of Project Charter by
the top management provides the target costing effort with a strong basis of support and
direction in all subsequent efforts.
2. Obtain a Management Sponsor: Management Sponsor is an individual belonging to
top management. His role will be to support the initiative in all respects, to obtain
funding, to co-ordinate with other members of top management, to eliminate problems in
a timely manner.
3. Obtain a Budget: The funding should be based on a formal allocation of money through
the corporate budget. The fund should be given unreservedly to the target costing effort.
4. Assign a Strong Team Manager: The Target Costing Team involves the active
participation of many members with diverse backgrounds. A strong Team Manager is
required to bring the group together as a smooth functioning team focused on key
objectives. He should be skilled in dealing with management, the use of project tools
and working with a diverse group of people. This manager should be a full-time
employee, so that his or her complete attention can be directed towards the welfare of
the project.
5. Enroll Full-time Participants: It is essential that the members of the team be devoted
to it full-time rather than trying to fulfill other commitment elsewhere in the company at
the same time. They should have a single focus on ensuring the success of the targetcosting program.
6. Use Project Management Tools: Target costing can be a highly complex effort
especially for high-cost products with many features and components. The team should
use all available project management tools, such as Microsoft Project (for tracking the
Particulars
Phase
Sales Volume
Introduction
I
Initial stages,
hence low
Growth
II
Rise in sales levels
at increasing rates.
Prices of
Products
High levels to
cover initial
costs and
promotional
expenses.
Highest, due to
effort needed to
inform potential
customers,
launch products,
distribute to
customers etc.
Negligible and
insignificant
Retention of high
level prices except
in certain cases*
NIL due to
heavy initial
costs.
Increase at a rapid
pace.
Ratio of
promotion
expenses to
Sales
Completion
Profits
Total expenses
remain the same,
while ratio is
reduced due to
increase in sales.
Entry of a large
number of
competitors
Maturity
III
Rise in sales
levels at
decreasing rates.
Prices fall closer
to cost, due to
effect of
competition
Decline
IV
Sales level off
and then start
decreasing.
Gap between
price and cost is
further reduced.
Ratio reaches a
normal % of
sales. Such
normal %
becomes the
industry
standard.
Fierce
Competition
Reduced sales
promotional
efforts as the
product is no
longer in
demand.
Normal rate of
profits since
costs and prices
are normalized.
Starts
disappearing due
to withdrawal of
products
Declining profits
due to price
competition,
entry of new
products etc.
* In the growth stage, the firm will maintain the prices at the high levels, in order to realise
maximum profits. Price reduction will not be undertaken unless (a) the low prices will lead
Question II:
Briefly explain the Characteristics of product life cycle.
Manufacture: Manufacture of a product involves the purchase of the raw materials the
purchase of bought out components, the use of labour to make and assemble the
product is considered under this stage.
Selling: When the product is fit and available for sale, it may be necessary to spend money
on a campaign to sell the product. Stimulating and creating demand for the product is
considered under this stage.
Distribution: In the process of selling the product, it must be distributed to the sales outlets
and to the customers. Demand at various locations and markets, must be met through
appropriate distribution channels.
Product support: The manufacturer or supplier will have to make sure that spares and
expert servicing are available for the life of the product. The manufacturer or the supplier
may even have to offer free servicing and parts replacement during the early life of the
product.
Decommissioning or Replacement: When a manufacturing product comes to an end, the
plant used to build the product must be reused, sold, scrapped, or decommissioned in a
way that is acceptable to society.
time periods, but the emphasis is on costs and revenue accumulation over the entire life
cycle for each product.
Product life cycle costing traces research and design and development costs, incurred to
individual products over their entire life cycles, so that the total magnitude of these costs
for each individual product can be reported and compared with product revenues
generated in later periods.
Life cycle costing therefore ensures that costs for each individual product can be reported and
compared with product revenues generated in later periods. Hence the costs are made more
visible.
BENEFITS OF PRODUCT LIFE CYCLE COSTING
The benefits of product life cycle costing are summarized as follows:
1.
The product life cycle costing results in earlier actions to generate revenue or to lower
costs than otherwise might be considered. There are a number of factors that need to the
managed in order to maximize return on a product.
2.
Better decisions should follow from a more accurate and realistic assessment of
revenues and costs, at least within a particular life cycle stage.
3.
Product life cycle thinking can promote long-term rewarding in contract to short-term
profitability rewarding.
Question V:
What is the Importance of Product Life Cycle Costing?
Importance of Product Life Cycle Costing:
Product Life Cycle Costing is considered important due to the following reasons:
1. Time based analysis: Life cycle costing involves tracing of costs and revenues of each
product over several calendar periods throughout their life cycle. Costs and revenues
can be analysed by time periods. The total magnitude of costs for each individual product
can be reported and compared with product revenues generated in later periods.
2. Overall Cost Analysis: Production costs are accounted and recognized by the routine
accounting system. However non-production costs like R&D, design, marketing,
distribution, customer service etc. are less visible on a product-by-product basis. Product
Life Cycle Costing focuses on recognizing both production and non-production cost.
3. Pre-production Costs analysis: The development period for R&D and design is long
and costly. A high percentage of total product costs may be incurred before commercial
production begins. Hence, the company needs accurate information on such costs for
deciding whether to continue with the R&D or not.
4. Effective Pricing Decisions: Pricing Decisions, in order to be effective, should include
market consideration on the one hand and cost considerations on the other. Product Life
Cycle Costing and Target Costing help analyse both these considerations and arrive at
optimal price decisions.
5. Better Decision Making: Better decisions should follow from a more accurate and
realistic assessment of revenues and costs, at least within a particular life cycle stage.
6. Long Run Wholistic view: Product life cycle thinking can promote long-term rewarding
in contrast to short-term profitability rewarding. It provides an overall framework for
considering total incremental costs over the entire life span of a product, which in turn
facilitates analysis of parts of the whole where cost effectiveness might be improved.
7. Life Cycle Budgeting: Life Cycle Budgeting. i.e. Life Cycle Costing with Target Costing
principles, facilitates scope for cost reduction at the design stage itself. The Company
stands to benefit since costs are avoided before they are committed or locked in.
8. Review: Life cycle Costing provides scope for analysis of long term picture of product
line profitability, feedback on the effectiveness of life cycle planning and cost data to
clarify the economic impact of alternatives chosen in the design, engineering phase etc.
Question III:
Explain in brief the JIT approach for reducing WIP inventory.
JIT approach for reducing WIP inventory:
At times, there may be huge differences between the operating speeds of different machines.
This affects cost in following manner:
In JIT philosophy, there are two ways to resolve the above problems.
1. Kanban Card: It is a notification card that a down stream machine sends to each upstream
machine that feeds it with parts, authorizing the production of just enough components to
fulfill the production requirements. This is also know as pull system, since these cards are
initiated at the end of the production process pulling work authorizations through the
production system. WIP cannot pile up since it can be created only with kanban
authorization.
2. Working Cells: A Working cell is a small cluster of machines, which can be run by a single
machine operator. The establishment of working cells has the following advantages:
The individual machine operator takes each output part from machine to machine within
the cell; and thus there is no way for WIP to build up between machines.
The operator can immediately identify defective output which otherwise is difficult for each
machine of the cell. The smaller machines used in a machine cell are generally much
simpler than the large automated machinery they replace. Hence maintenance costs are
reduced.
Question IV:
Employee Training and Development is a pre-requisite for JIT implementation
Explain.
Employee Training and Development is a pre-requisite for JIT implementation:
JIT focuses on waste reduction, inventory management and product quality. The focus of
attention shifts away from performance based to high production volumes and quality. In order
to make JIT effective, employee participation and co-operation is a must. For this purpose, the
HR department must prepare and organise training classes to teach to employees:
How to operate a multitude of different machines?
How to perform limited maintenance on the machines without having to call in the
maintenance staff?
How to spot product errors?
How to relate ones role in the entire system flows? and
When to halt the production process to fix problems?
Question VII:
Explain in brief the effect of JIT on Overhead Costs.
JIT effect on Overhead Costs
Overhead Costs are greatly reduced with JIT operation. This is because of the following
reasons:
Elimination of non value-added activities and improvement in value-added activities.
Reduction of time
Reduction in Inventory levels and associated costs
Reduction / Elimination of unnecessary cost drivers
Introduction of Machine Cells to identify direct costs than overhead expenses.
Using JIT, a company can also reduce its investment in capital assets.
A few large machines can be replaced with a larger number of much smaller, more easily
configured machines.
Equipment setup times become shorter, which in turn makes it profitable to have shorter
production runs thereby eliminating an excessive investment in inventory that would have
been created by excessive long production runs. This releases cash for other uses while
also reducing the amount of depreciation charged to overhead.
Question X:
Explain the Impact of JIT on Product Prices.
Impact of JIT on Product Prices:
When a company achieves a higher level of product quality, along with ability to deliver
products on the dates required, customers may be willing to pay a premium. If customers
are highly sensitive to quality or delivery reliability (which are the benefits of JIT), it may
be possible to increase price substantially.
If customers place a higher degree of importance on other factors, then there will be no
opportunity for a price increase.
In case all firm in an industry adopt JIT, they offer the same level of quality and service. JIT
philosophy, in such cases, just keeps a company from losing sales to its competitors.
The impact of a JIT system on product pricing is primarily driven by customers perceived
need for higher product quality and reliable delivery times, as well as the presence of
competitors with JIT system, the same installation, and operational base.
c. Material handling: In a JIT system, most material handling cost are limited since machine
operators move parts around within their machine cells. Only costs for materials handling
between cells and charged to an overhead cost pool for allocation.
d. Operating Suppliers: Supplies are used mostly with the machine cells to the majority of
item sin this expense category can be separately tracked by individual cell and charged to
products directly.
e. Repairs and maintenance: All maintenance costs incurred for machinery can be grouped
into machine cells. By having the maintenance staff, charge their time and materials to
these cells, these costs can be charged straight to products. Maintenance work on the
facility will be charged to an Overhead cost pool.
f. Supervision: If supervision is by machine cell, the cost of the supervisor can be split
among the cells supervised. However the cost of general facility management as well as
of any support staff, must still be charged to an overhead cost pool.
With such a higher proportion of direct costs associated with each product managers have
much more relevant information about the true cost of each product manufactured.
Question XI:
Traditional performance measurement criteria fails in a JIT system Explain.
Some traditionally used performance measurement criteria are:
Machine Utilisation or Machine Capacity
Labour cost per unit of output or Output per employee
Direct labour Time Keeping and Time booking
These are not useful in a JIT environment due to the following reasons.
Nature of Performance Measurement Why not applicable in JIT?
measure
Machine Utilisation:
It forces production managers to produce
To ensure that every asset a company
as much output as possible, resulting in
purchases is being thoroughly utilized.
large amount of inventory piling up in
To confirm that substantial investment in
the warehouse.
machinery should be used to the In JIT systems producing only what is
utmost.
actually needed is the underlying rule.
Machine cells in a JIT system are smaller
and less costly. Hence justification of
investment is not compulsory.
Labour Cost per Unit output:
JIT system focuses on producing
To optimize labour cost per unit by
only what is needed, so an
increasing output per employee.
employee who has incentives to
create vast piles of parts is
producing contrary to the rules of the
system.
JIT focuses not on output quantity,
but on the quality of output or the
number of employee suggestions for
improving the system.
Direct Labour Efficiency
Question XII:
What are the performance measures in JIT?
Use of Specific performance measures instead of traditional measures in JIT.
The following performance measurement criteria are relevant to JIT.
Inventory turnover: One of the primary objectives of JIT systems is the reduction of
unnecessary inventory. Hence inventory turnover is a suitable performance measure in
JIT. This measure can be subdivided into separate ratios for raw materials, work in
process, and finished goods.
Set up time reduction: The average setup time per machine can be measured periodically
and plotted on a trend I Inc. The shortest possible set intervals are crucial for the success
of short production runs, so this is a major JIT measurement. It is best to measure it by
machine, rather than in the aggregate for all machines.
Customer complaints: JIT presumes optimum product quality. Hence customer complaints
on product problems should be investigated immediately. The accumulation of customer
complaints and their dissemination to management should be considered a major JIT
measure.
Scrap: JIT aims to drive materials scrap rates down to exceedingly low level. The cost of
scrap (especially when supported by a detailed list of items that were scrapped) is of
particular concern as a JIT system is being implemented, since it helps to identify problem
areas requiring further management attention.
Cost of quality: One focus of JIT is on creating high-quality products, so it is reasonable to
keep track of the full cost of quality (which comprises defect control costs, failure costs,
and the cost of lost sales) on a trend line. Managers want to see the details behind this
measure so that they know where the largest quality cots still reside in the company and
can then work to reduce them.
Customer service: This measure really has several components like delivering products on
the dates required by customers shipping full orders to customers, and not having
products returned because of poor quality. This measure can be summarized in a variety
of ways or reported at the component level, but the main issue is to measure and post the
information for all to see, so that the company focuses strongly on providing the highest
possible degree of customer service.
Ideas generated: JIT system works best when employees provide suggestions for
improvements that, when taken in total result in a vastly improved efficient operation. The
amount of idea generation going on can be measured by the number of ideas per worker,
the number of ideas suggested in total, the number of ideas implemented, or the
proportion of ideas suggested that are implemented.
Question XIII:
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.
BACKFLUSH COSTING
Traditional, normal and standard costing systems use the sequential tracking method for
accounting costs. This involves recording journal entries in the same order as transactions
occur, i.e. purchase, issue of materials, production, overheads absorption etc. Such systems
are required in those manufacturing environment where inventory / WIP values are large.
An alternative approach to sequential tracking is Backflush Costing. It is a costing system that
omits recording some or all of the journal entries relating to the cycle from purchase of direct
materials to the sale of finished goods. The journal entries for the subsequent stages use
normal or standard costs to work backward to flush out the cost in the cycle for which the
journal entries were omitted earlier.
Since JIT systems operate in modern manufacturing environment characterised by low
inventory and WIP values, usually also associated with low cost variances, the use of
backflush costing is ideal when compared to sequential Tracking method.
However the following issues must be corrected before effective implementation of Backflush
Cosing:
1. Accurate Production reporting: The total production figure entered into the stem must
be absolutely correct, or else the wrong component types and quantities will be subtracted
from stock. This is a particular problem when there is high turnover or a low level of
training to the production staff that records this information.
2. Proper Scrap reporting: All abnormal scrap must be diligently tracked and recorded.
Otherwise, these materials will fall outside the backflushing system and will not be
charged to inventory. Since scrap can occur anywhere in a production process, lack of
attention by any of the production staff can result in an inaccurate inventory.
3. Lot tracing: Lot tracing is impossible under backflushing system. It is required when a
manufacturer need to keep records of which production lots were used to create a product
in case all the items in a lot must be recalled. Only a picking system can adequately
record this information. Some computer systems allow picking and backflushing system to
coexist.
4. Inventory accuracy: The inventory balance may be too high at all times because the
backflushing transaction that relieves inventory usually does so only once a day, during
which time other inventory is sent to the production process. This makes it difficult to
maintain an accurate set of inventory records in the warehouse. The success of
backflushing system is directly related to a companys willingness to invest in a well-paid,
experienced well-educated production staff that undergoes little turnover.
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. (November 2004) (4 Marks)
items. MRP pre-supposes the use of computers and hence the above information will be
required as system data files.
Question III:
What are the pre-requisites for the successful operation of MRP?
Pre-requisites for successful operation of MRP system
(a) Production Schedule: The latest production and purchasing schedules prepared should
be strictly adhered to Day-to-day change from predetermined schedules will cause
chaos.
(b) Standard Materials Input: The raw materials, sub-assemblies and components required
for production should be pre-determined in quantifiable terms. Standards should be set
for the consumption quantity, quality mix and yield of raw materials, for every unit of the
finished output.
(c) Workers co-operation: Work force must be appraised of the system and the need for
absolute adherence to the schedules prepared. Also necessary internal control system
should be developed to ensure the total adherence to the schedule.
(d) Accuracy of data: Accuracy of the data supplied is vital to the MRP system. Adherence
to the purchase and production schedule becomes difficult in the absence of accurate
data.
Question IV:
Explain briefly the method of operation of MRP system.
MRP is a computer based inventory information system, which is used to plan and control raw
materials and component parts inventories.
Operation of a MRP system
STAGE 1: Pre-requisite information and system input:
All the required data are made available into the system.
The Master Production Schedule (MPS), which states the production goal in terms of
finished goods quantity for a production period, is then taken as the base for processing
purposes.
The Bill of Materials (BOM) file contains information about how the production of the
finished goods is undertaken and is structured to :
(a)
Assess all of the raw materials and component parts required to complete a
product; and
(b)
The inventory records file of the MRP system determines the current levels of finished
goods, raw materials and component parts inventory at the beginning of a planning
period. Receipts of raw materials, component parts etc. and delivery lead times during
the planning period are included in the inventory records file to appropriately consider
them at the time of their arrival.
Question III:
Explain briefly the main features of ERP.
Features of ERP:
1. Integrated: ERP facilitates company-wide information integration covering all functional
areas like manufacturing, selling and distribution, payables, receivables, inventory,
accounts, human resources, etc. ERP provides complete integration of systems not only
across departments but also across companies under the same management.
2. Information Sharing: ERP bridges the information gap across organizations.
3. Project Management: ERP is the solution for better project management
4. E-Com Facilities: ERP allows automatic introduction of technologies like Electronic Fund
Transfer (EFT), Electronic Data Interchange (EDI), Internet, Intranet, Video Conferencing,
E-Commerce etc.
5. Business Decision Making Solution: ERP provides business intelligence tools like
Decision Support systems (DSS), Executive Information System (EIS), Reporting, Data
Mining and Early warning systems (Robots) for enabling people to make better decisions.
It eliminates most business problems like material shortage, productivity enhancements,
customer service, cash management, inventory problems, quality problems, prompt
delivery etc.
6. Futuristic: ERP not only addresses the current requirements of the company but also
provides the opportunity of continually improving and refining business processes.
Question IV:
State the benefits of ERP.
Benefits of ERP:
1. Product Costing: ERP system supports advanced costing methods like Standard
Costing, Actual Costing, Activity based costing, thereby helping in determination of cost
products accurately.
2. Cost Monitoring and Control: ERP can integrate all costing methods and information
with finance. This provides the company with essential financial information or monitoring
and controlling costs.
3. Planning and Managing: The ERP system simplifies complicated logistics and helps in
planning for and managing different divisions in different locations as a single unit.
4. Information Flow: The advanced utility of the ERP system helps in processing the flow of
product and financial information in several different ways.
5. Efficient Database Management: The ERP system aids in the efficient managing of data
on warehouse, suppliers customers etc. required to run an organization effectively and
profitably.
6. Inventory Management: Inventory reporting supports all reporting of specific and general
types of stock transactions like stock transfers, reclassifications, ID changes and physical
inventory results. Also ERP can manage stock and purchase requisitions selections of
appropriate locations for receipts, inventory valuation, warehouse management and cost
accounting.
7. Customer Satisfaction: ERP system defines the logistics processes flexibly and
efficiently to deliver the right product from the right warehouse to the right customer at the
right time every time, thereby satisfying the customers. It also supports planning
transportation, confirmation, dispatch and proof of delivery processing. Additionally, it
ensures better after sales service.
8. Competitive Edge: ERP system helps a company to gain the Competitive Edge by (a)
enabling the company to respond quickly and accurately to change in market conditions;
(b) improving business process (c) ensuring quality control; (d) improved and objective
production planning; intranet and Extranet Solutions.
Q. 2
State the benefits accruing from ERP. (May 2004) (4 marks)
Answer:
Refer Question IV above
Customer Service
Cost Drivers
Number of research projects
Personnel hours on a project
Technical complexities of projects
Number of service calls
Number of products serviced
Hours spent on servicing products
Question II:
What are the steps involved in Activity Based Costing?
Steps involved in Activity Based Costing:
Step 1: Identify the various Activities within the organization.
Only significant activities shall be considered for decision-making purposes.
Step 2: Relate the Overheads to the Activities using Resources Cost Drivers
1. Overheads will be related to Support and Primary Activities
2. Resources Cost Drivers, i.e. the quantity of resources used by an activity is used for this
purpose.
3. All costs will be identified under the activities, thus creating Activity Cost Pools/Cost
Buckets.
Step 3: Apportion the costs of Support Activities over the Primary Activities
1. This is very much like reapportionment of service department expenses to production
departments.
2. Cost of support activities are spread over to primary activities to collect costs only under
primary activities.
3. The base is the cost driver that is measure of how the support activities are used.
Step 4: Determine the Activity Cost Drivers for each Activity Cost Pool
1. Activity cost drivers used to relate the overheads collected in the cost pools to cost objects
(products) should be determined.
2. This is based on the factor that drives the consumption of the activity, i.e. the answer to
the question: what causes the activity to incur costs?
3. For example in production scheduling, the driver will be number of batches ordered.
Step 5: Calculate Activity Cost Driver Rate = Cost of Activity (Cost Pool) / Activity Cost Driver
1. Activity Cost Driver Rates are computed for each activity, just like overhead absorption
rates.
2. The rates will be multiplied by the different amounts of each activity that each
product/other cost object consumes, so as to ascertain its cost.
3. This rate can be used for the following:
i)
To ascertain cost of products, (as traditional absorption costing)
ii)
To ascertain cost of other objects such as customers/customer segments and
distribution channels.
Question III:
What are different types of activities?
Identification of activities for ABC
Meaning of Activities: Activities comprise of units of work or tasks. For example, purchase
of materials is an activity consisting a series of tasks like purchase requisition,
advertisement inviting quotations, identification of suppliers, placement of purchase order,
follow-up etc.
Types of Activities: Activities basically fall into four different categories, known as the
manufacturing cost hierarchy. These categories were first identified by Cooper in 1990
and help to determine the type of activity cost driver required. The categories are:
Type of Activity
Unit level activities:
These are activities for which the
consumption of resources can be
identified with the number of units
produced. The costs of some activities
(mainly primary activities) are strongly
correlated to the number of units
produced.
Batch level activities:
The costs of some activities (mainly
manufacturing support activities) are
driven by the number of batches of units
produced. These are activities related to
setting up of a batch or a production run.
The costs of such activities vary with the
number of batches made, but is fixed for
all units within that batch.
Product level activities:
Examples
Use of indirect materials / consumables.
Inspection or Testing
Producing parts
specifications and keeping technical
drawings of products up-to-date.
Advertising of individual
products rather than companys
name.
Ground Maintenance
Plant Security
Production Managers Salary
Question V:
State the need, purpose and benefits of ABC.
Need for ABC:
Manufacturing organizations need ABC for product costing where:
(a) Production overheads are high in relation to direct costs.
(b) There is great diversity in the product range.
(c) Products use very different amounts of the overhead resource
To link the cost to its causal factor i.e. the Cost Driver
To identify costs of activities rather than cost centres
To ascertain product costs with greater accuracy by relating overheads to activities
To overcome the inherent limitations of traditional absorption costing and use of blanket
overhead rates.
Question VI:
What are the steps involved in the installation of an Activity Based Costing System.
Steps involved in the installation of an Activity Based Costing System:
1. Specification of Objectives: The motives for pursuing an ABC system must be
established at the outset, Generally, the objectives are:
a. To improve product costing where a belief exists that existing methods undercost
some products and overcost others; or
b. To identify non-value adding activities in the production process which might be a
suitable focus for attention or elimination.
2. Identification of Costs for ABC: Direct costs, like materials and direct labour, are easily
assigned directly to products. Some indirect costs that are product specific (e.g. specific
advertising, dealers commission) may be directly assigned to the product. Hence the
remaining indirect costs form the focus of ABC. Such costs are indirectly assigned to the
cost object (i.e. product) via Cost Pools and Activity Drivers.
3. Process Specification: This involves identification of different stages of the production
process, the commitment of resources to each processing times and bottlenecks. This will
provide a list of transactions which may or may not be defined as activities at a
subsequent stage.
4. Activity definition: The list of transactions as identified in the previous stage is analysed.
This ensures aggregation or grouping of common activities and elimination of immaterial
activities. Activities are categorized into Primary Activities and Support Activities. The
resultant costs pools will likely-have-a number of different events or drives, associated
with their incurrence.
5. Activity driver selection: Activity cost drivers used to relate the overheads collected in
the cost pools to cost objects (products) should be determined. This is based on the factor
that drives the consumption of the activity, i.e. the answer to the question; What causes
the activity to incur costs? Generally a single Driver is selected for every activity even
though multiple and inter related activity drivers exist.
6. Costing: A single representative activity driver can be used to assign costs from the
activity pools to the cost objects. Such linking of total Costs to Cost objects is generally
based on the activity cost driver rate.
7. Staff Training: The co-operation of the work force is critical to the successful
implementation of ABC. Staff training should be oriented to create an awareness of the
purpose of ABC. The need for staff co-operation in the concerted team effort for mutual
benefit must be emphasized throughout the training activity.
8. Review and Follow-up: The actual operation of the ABC system should be closely
monitored. Periodic Review and Follow-up action is necessary for successful
implementation of the system.
Question VII:
Define Activity Based Cost Management (ABM).
Activity Based Cost Management (ABM)
The use of ABC as a costing tool to manage costs at activity level is known as Activity Based
Cost Management (ABM).
Through various analyses, ABM manages activities rather than resources. It determines what
drives the activities of the organization and how these activities can be improved to
increase the profitability.
ABM utilizes cost information gathered through ABC.
ABM is a discipline that focuses on the management of activities as the route to improving the
value received by the customer and the profit achieved by providing this value. This
discipline includes (a) Cost Driver analysis; (b) Activity analysis; and (c) Performance
measurement.
Question VIII:
What are the stages in Activity Based Cost Management (ABM).
Stages in Activity Based Cost Management:
Stages
Activity
1.Identification of the activities that have taken place in the
2.organization. Assigning costs to cost pool for each activity.
3.Spreading of support activities across the primary
4.activities. Determining cost driver for each activity.
5. Managing the costs of activities.
Various analyses under ABM
Cost Driver analysis identifies the factors that cause activities to be performed in order to
manage activity costs.
An activity may be performed inefficiently due to a particular reason. Managers have to
address this cost driver to correct the root cause of the problem.
Activity Analysis:
It involves identification of the activities of an organization and the activity centres (or activity
cost pools that should be used in an ABC system).
Activity analysis also identifies Value Added (VA) and Non Value Added (NVA) activities.
The number of activity centres is likely to change over time as organizational needs for
activity information evolve.
Performance Analysis:
(a) Performance analysis involves the identification of appropriate measures to report the
performance of activity centres or other organizational units, consistent with each units
goals and objectives.
(b) Performance analysis aims to identify the best ways to measure the performance of
factors that are important to organizations in order to stimulate continuous improvement.
Question IX:
Differentiate between Value Added and Non-value Added activities.
Value Added and Non-value Added activities
Value-added activities (VA)
These are activities necessary for the
performance of the process.
Question X:
State Business applications of ABM.
Business applications of ABM:
Cost reduction: ABM helps the organization to identify costs activities and to find
opportunities to streamline or reduce the costs or eliminate the entire activity. It is useful in
identifying and quantifying process waste and providing vehicle for continuous process
improvement through continuous cost reduction.
Activity Based Budgeting: Activity based budgeting analyses the resource input or cost for
each activity. It provides a framework for estimating the amount of resources required in
accordance with the budgeted level of activity. Actual results can be compared with
budgeted results to (both in financial and non-financial terms) those activities with major
discrepancies for potential reduction in supply or resources. It is a planning control
system, which seeks to support the objectives of continuous improvement.
Business process re-engineering: Business process re-engineering involves examining
business processes, current operations of organization and making substantial changes to
current organizational operations. A business process consist of linked set of activities.
For example purchase of materials is a business process consisting of activities such as
Measures
Zero defects
Percentage yield
No. of orders; No. of complaints
Question XI:
State the benefits of ABM.
Benefits of ABM:
Cost Reduction: Provision of excellent basis and focus for cost reduction
Budget implementation: Provides operational management with a clear view of how to
implement an Activity Based budget.
Cost Definition: Provision of clear understanding of the underlying causes of business
processing costs.
Decision Making: Provision of excellent basis for effectiveness of management decisionmaking.
Resource utilization: Identification of key process waste elements permit management
prioritization and leverage of key resource.
Question XI:
Differentiate between ABC & ABM.
Difference between ABC and ABM:
ABC
ABC refers to the technique of determining
the costs of activities and the cost of output
that those activities produce.
The aim of ABC is to generate improved
cost data for use in managing a companys
activities.
ABM
It refers to the management philosophy that
focuses on the planning, execution and
measurement of activities as the key to
competitive advantage.
The ABM is a much broader concept. Its aim
is to use information generated by ABC, for
effective business processes and profitability.
Question XII:
ABC is used as decision making tool- Discuss.
Use of ABC as decision making tool:
TQM: ABC is a complement to total quality management (TQM). It provides quantitative data
that can track the financial impact of improvements implemented as part of the TQM
initiative. It is suggested that ABC is the most important concept introduced since TQM.
Product Profitability Decisions: The expansion of product lines will mean overhead
allocation to all products. Using traditional financial data, overhead burden is distributed
equally across the products. ABC traces the costs back to the activity. The overhead cost
of the new product is correctly reflected. This allows the existing merits while leaving the
new line to justify itself.
Facility and Resource Expansion: Often the basis for relocation or opening of a new
distribution centre is based on cost associations. Reduction in freight or other logistics
costs of the new facility, staff or equipment. When the number used are enterprise based,
the return might not be as expected. The ABC model can identify the specific cost
elements being targeted, providing a much clearer picture from which management can
act.
HR Decision: ABC can augment decision support for human resources. Where activity and
therefore cost, can be associated to an individual, new levels of financial performance can
be determined. Adding or deleting resources slots can be determined based on costs of
activities as well. The added data provided through ABC can present a number of options
including outsourcing, productivity improvements through automation and determination of
employee/revenue ratios.
Q. 2
Explain briefly four different categories of activities that drive the expenses at the
product level. (November 2002) (3 marks)
Answer:
Refer question III
Q. 3
What are the areas in which activity based information is used for decision making?
(November 2000) (4 marks)
Answer:
The areas in which activity based information is used for decision making are as under:
Pricing
Market segmentation and distribution channels
Make or Buy decisions and outsourcing
Transfer Pricing
Plant closed down decisions
Evaluation of offshore production
Capital Investment decisions
Product line profitability
Question II: What are the steps to be taken in the implementation of TQM?
Various stages / steps to be taken in the implementation of TQM:
Stage 1: Identification of customers / customer groups: through a team approach (a
technique called Multi-voting), the firm should identify major customer groups. This helps to
priortise the list of customers and provides a focus of services.
Stage 2: Identifying customer expectations: Once the major customer groups are identified,
their expectations are listed. The question to be answered is what does the customer expect
from the firm?
Stage 3: Identifying customer decision-making requirements and product utilities: Where
the focus is on quality improvement, the overriding need is to stay close to the customers and
follow their suggestions. In this way, a decision-support system can be developed,
incorporating both financial and non-financial information, which seeks to satisfy user
requirements. Hence, the firm finds outs the answer to what are customers decision
making requirements and product utilities? The answer is sought by listing out managerial
perceptions and not by actual interaction with the customers.
Stage 4: Identifying perceived problems in decision-making process and product
utilities: Using participative processes such as brainstorming and multi-voting, the firm seeks
to list out its perception of problem areas and shortcomings in meeting customer requirements.
This will list out areas of weakness where the greatest impact could be achieved through the
implementation of improvements. The firm identifies the answer to the question what problem
areas do we perceive in the decision-making process?
Stage 5: Comparison with other organizations and bench marking: Detailed and
systematic internal deliberations allow the firm to develop a clear idea of their own strengths
and weaknesses and of the areas of most significant deficiency. The benchmarking exercise
allows the firm to see how other companies are coping with similar problems and opportunities.
Stage 6: Customer feedback: Stages 1 to 5 provide information base, developed without
reference to the customer. This is rectified at stage 6 with a survey of representative
customers, which embraces their views on perceived problem areas. Interaction with the
customers and obtaining their views, helps the firm in correcting its own perceptions and
refining its processes.
Stage 7 & 8: The identification of improvement opportunities and Quality Improvement
Process: The outcomes of the customer survey, benchmarking and internal analysis provides
the inputs for stages 7 and 8, i.e. the identification of improvement opportunities and the
implementation of a formal improvement process. This is done through a six-step process
called PRAISE, for short.
Question III: What is PRAISE analysis? Briefly explain the difficulties experienced at
each stage of PRAISE analysis and suggest remedial action.
PRAISE Analysis
The identification of improvement opportunities and implementation of quality improvement
process (Stages 7 and 8) of the TQM Process is through a six-step activity sequence, identified
by the acronym PRAISE.
Step
1
Activity
Problem
identification
Ranking
Analysis
Innovation
Solution
Evaluation
Elements
Areas of customer dissatisfaction
Absence of competitive advantage
Complacency regarding present arrangements
Priorities problems and opportunities by
1. Perceived importance, and
2. Ease of measurement and solution
Ask Why? to identify possible causes. Keep asking
Why? to move beyond the symptoms and to avoid
jumping to premature conclusions.
Ask What? To consider potential implications
Ask How much? to quantify cause and effect
Use creative thinking to generate potential solution
Operationalise these solutions by identifying
Barriers to implementation,
Available enablers, and
People whose co-operation must be sought
Implement the preferred solution
Take appropriate action to bring about the required
changes
Reinforce with training and documentation back-up
Monitor the effectiveness of actions
Ranking
Difficulties
Effects of a problem are apparent but
problem themselves are difficult to
identify.
Problem may be identifiable, but it is
difficult to identify a measurable
improvement opportunity
Some problems are too vague to define
e.g. morale, communication, productivity
etc.
Difference in perception of individuals in
ranking
Difference in preferences based on
functions e.g. production, finance,
marketing etc.
Lack of consensus between individuals
Analysis
Innovation
Solution
Evaluation
Problems in implementation
Lack of measurable data for comparison of
expectations with actual
Remedies
Participative
approaches like
brainstorming,
multi-voting,
panel discussion
Quantification
and precise
definition of
problem
Participative
approach
Subordination of
individual to
group interest
Lateral Thinking
Brainstorming
Systematic
evaluation of all
aspects of each
strategy
Effective internal
communication
Training of
personnel and
managers
Participative
approach
Effective control
system to track
actuals
Feedback system
Central to the PRAISE system are (a) quality control the search for continuous improvements
in quality and (b) total employee involvement the co-operation and commitment of
employees. This dual approach provides a single focus the customer whose increased
satisfaction remains the primary goal of the procedure.
Question IV: Explain in brief the fundamental requirements for the implementation of
quality improvement process.
OR
What are the six Cs for successful implementation of TQM?
This training must quickly be extended beyond the immediate accounting circle to include
employees at supervisory levels and also who are involved at the data input stage.
Question VI: Explain three-point action plan for Smooth implementation of PRAISE
process.
A three-point action plan for implementation of the process is:
1. Bite-sized chunks: Big improvement opportunities are generally complex and require
extensive inter departmental co-operation. The choice of a relatively small problem in the
first instance provides a greater chance of success. Therefore, the TQM team has to
proceed from small to big issues gradually.
2. Solvable problem: The problem selected should not be trivial, but it should be one with
a potential impact and a clear improvement opportunity. Measurable progress towards
implementation should be accomplished within a reasonable time in order to maintain the
motivations of participants and advertise the success of the improvement itself.
3. Recognition of participants: The successful projects and team members should
receive appropriate recognition throughout the enterprise. Prominent individuals should
be rewarded for their efforts as a measure of personal recognition and as
encouragement to others. The reward may be recognition itself, and sometimes
monetary / non-monetary prizes may also be given.
(e) Control and continuous improvement: TQM facilitates not only control, but also
continuous improvement. The monitoring of the data around a process will allow
modifications which makes it in-control and capable. As changes or improvements are
made they are documented and the system updated so that everyone uses the current
best method.
(f) Use of Control reports: Diagrams, Statistical quality control charts and cost of quality
reports are prepared for periodic review of the TQM system in operation. The deviation
from expected costs are analysed for suitable corrective action. The various types of
costs to be reported are (i) Prevention Costs; (ii) Appraisal Costs; (iii) Internal failure
costs; and (iv) External Failure Costs.
Components of cost to be reported in a Cost of Quality Report
1. Prevention Costs: These are incurred in preventing the production of products that do
not conform to specification. They include the costs of preventive maintenance, quality
planning and training and the extra costs of acquiring higher quality.
2. Appraisal Costs: These are incurred to ensure that materials and product meet quality
performance standards. They include the costs of inspecting purchased parts, work in
process and finished goods, quality audits and field test.
3. Internal Failure Costs: These are associated materials and products that fail to meet
quality standards. They include costs incurred before the product is dispatched to the
customer, such as the costs of scrap, repair, downtime and work stoppages caused by
defects.
4. External failure Costs: These are incurred when inferior products are delivered to
customers. They include the cost of handling customer complaints, warranty
replacement, repairs of returned products and the costs arising from a damaged
company reputation.
Note: Prevention and appraisal cost are called Costs of Quality Compliance while Internal and
costs are called Costs of Non-compliance.
Principles of TQM
Clear exposition of the benefits of a project
Total Employee Involvement (TEI)
Process measurement
Involvement of all customers and contributors
Elimination of irrelevant data
Understanding the needs of the whole process
Use of graphical and pictorial techniques to achieve understanding
Establishment of performance specifications and targets
Use of errors to prompt continuous improvement
Use of statistics to tell people how well they are doing.
Remedies to correct misdirection in TQM
TQM may become misdirected on the following grounds:
(a) Focus on documentation process and ill-measurable outcomes
(b) Emphasis on quality assurance rather than improvement; and
(c) Internal-focus, which is at odds with the alleged customer orientation.
This can be correction by reviving the customer focus with total employee involvement
(TEI), oriented towards organizational goals. This will involve the following areas of
thrust:
1. Loyalty to the vision of the company through the pursuit of tough, visible goals.
2. Recognition of satisfied customers and motivated employees as the true assets of a
company.
3. Delegation of decision-making to the point of responsibility by eliminating hierarchical
ties of authority to allow direct and speedy response to customer needs.
4. Decentralisation of management to make best use of the creative energy of the
workforce.
Industry Value Chain refers to the series of activities, which add value to the product
supplied to the industry.
It starts with the value-creating processes of suppliers, who provide the basic raw
materials and components.
It continues with the value creating processes of different classes of buyers or end-use
consumers and culminates in the disposal and recycling of materials.
Question III:
Firms competitive advantage
a. To survive and prosper in an industry, a firm must meet two criteria (1) Supply what
customers want to buy, and (2) Survive competition
b. A firms overall Competitive Advantage is derived from the difference between Value
Offered to Customers and Cost of creating that customer value.
c. This Competitive advantage takes two possible forms (1) Differentiation Advantage and
(2) Low-Cost Advantage. A comparative analysis of these forms is given below:
Differentiation Advantage
It occurs when customers perceive that a
firms product offering is of higher quality,
involves less risk and/or outperforms
competing products offered by competitors.
Customers are thus willing to pay a
premium price for this product.
Gained by:
Ability to deliver goods & services in timely
manner
Producing better quality
Provision of after-sales support services
Offering a wider range of goods and
services etc.
Advantage can be exploited by:
Increasing prices to offsets the
improvement in customer benefits thus
maintaining current market share; or
Pricing below the full-premium level in
order to build market share.
Gained by:
Access to low cost raw material
Innovative process technology
Access to distribution channels
Economies of scale
Superior operating management etc.
Can be exploited by:
(1) Pricing the products lower than its
competitors so as to gain market
share
and
maintain
current
profitability or,
(2) Matching with the price of competing
products and increase its profitability.
The following actions and steps are involved in the above analyses:
Stage
1.
2.
3.
Description
Internal Cost Analysis:
Identify the firms value creating processes
Determine the portion of the total cost of the product or services
attributable to each value-creating process.
Identify the cost drivers for each process.
Identify the links between processes
Evaluate the opportunities for achieving relative cost advantage.
Internal Differentiation Analysis:
Identify the industrys value creating processes
Evaluate differentiation strategies for enhancing customer value
Determine the best sustainable differentiation strategies
Vertical Linkage Analysis
Identify the industrys value chain and assign costs, revenues and assets
to value-creating processes.
Diagnose the cost drivers for each value-creating process; and
Evaluate the opportunities for sustainable competitive advantage
Not mutually exclusive Firms begin by focusing on their internal operations and
gradually widening their focus to consider their competitive position within their industry.
Continuous VCA is a continuous process of gaining competitive advantage not a onetime affair.
2.
Determine the portion of total cost of the product/service attributable to each value
creating process:
A full-cost approach provides the best estimate of life-cycle costs for evaluating the
strategic cost advantage of a firms value-creating process.
For estimating the full cost of each value-creating activity, full utilization of the capacity of
the activity or its practical capacity is normally used. Facility managers and equipment
vendors are useful sources of capacity estimates. When cost vary dramatically,
companies should seek more information for a more realistic long-term estimate of
capacity.
3.
4.
Example:
Large
pharmaceutical companies
economies of scale that
lower their unit enjoy costs
for expensive R&D
and
flattened
continuous
organization help many firms in their
improvement efforts.
5.
Activities within a value chain are interdependent and hence firms must identify value
chain linkages among interdependent activities that may impact their total cost.
Cost improvement programs in one value chain process may lower or increase costs
and/or revenues in other processes. Transfer of goods and services from one value
chain process to another increases cost. Eliminating these transfer or costs has an
impact on overall costs in the subsequent chain.
Such linkage offer sustainable competitive advantage, because of their subtle, complex
and inimitable nature.
Evaluate the opportunities for achieving relative cost advantage
Using the value chain approach, a company goes beyond simple across-the-board cuts
and attempts to lower cost and improve efficiency within each value-creating process.
For instance a company might negotiate lower costs of process inputs such as wages or
purchases, or evaluate make-or-buy options.
Reducing process input costs may consist of measures such as negotiating lower wages,
moving production to countries with cheaper labour costs, entering into long term
contracts with suppliers at reduced prices, etc. Companies also use buyer-seller
partnerships to gain advantages in cost quality, flexibility, delivery and, technology.
Using Pareto Analysis company should prioritize its value-creating processes since 20%
of value creating processes often account for 80% of total costs.
(d) Brand / lineage Positioning that lends greater appeal to the companys products on
critical selection criteria.
(e) Price: including both net purchase price and cost savings available to the customer
through the financial services market.
iii) Determine the best sustainable differentiation strategies:
In order to prioritize its processes as sources of differentiation, a company must determine
what attributes of each process enhance customer value.
The more unique a firms resources and skills, the more sustainable is its differentiation
advantage over competitors.
2.
The firm should identify the vertical linkages in the industry value chain, for example, the
petroleum industry consist of numerous value creating processes or activities, including
exploration, production, refining, marketing and distribution, which define the value chain
for this industry.
One firm may participate in all parts of this value chain; another firm may participate in
only a few.
The information systems to identify and analyse these subtle relationship should be
developed
Costs, Revenues and Assets of each value-creating process may be determined based
on relevant cost approach, use of market prices, transfer prices, current replacement
cost of assets, etc.
Diagnose the cost drivers for each value-creating process:
3.
To evaluate the opportunities for competitive advantage in the global marketplace, firms
need to consider such things as a countrys values, political climate, environmental
concerns, trade relations, tax laws, inflation rates and currency fluctuations.
Question V:
Explain briefly the strategic framework required for value chain analysis.
Strategic frameworks required for value chain analysis
Value chain analysis requires a strategic framework of focus for organizing internal and
external information, for analyzing information, and for summarizing findings and
recommendations.
Recent concepts from strategists and organization experts lead to three strategic frameworks
for VCA.
1. Industry structure analysis:
2. Core competencies analysis and
3. Segmentation analysis
1. Industry Structure Analysis of Michael Porter
It is a five-factor model to organise information about an industry structure to evaluate its
potential attractiveness. Under this model, the profitability of an industry or market is
measured by the long term return on investment of the average firm depends largely on the
following five factors that influence profitability.
a) Bargaining power of buyers:
The degree of buyer power generally depends on:
Customer concentration (higher concentration of customers means greater negotiation
leverage).
Propensity for customers to integrate backward (higher propensity for backward integration
means greater bargaining leverage);
Costs of switching suppliers (lower switching costs means greater leverage for the buyer) and
Number of alternative suppliers (higher alternatives indicate greater customer leverage.)
b) Bargaining power of suppliers:
Just as powerful buyers can squeeze profits by putting downward pressure on prices,
suppliers squeeze profits by increasing input costs.
The same factors that determine the power of buyers also determine the power of suppliers.
The bargaining power of suppliers and buyers relative to the firm depends on the relationships
between their value chains.
Identifying the specific activities involved and the nature of their strengths and relationships
can give important insights into the power balance between the buyer and seller, and how
it may be altered for, the firms benefit.
Products with few substitutes command higher prices than products with many close
substitutes since customer will prefer switching in the latter case.
A thorough understanding of the value chains of buyers as they relate to the firms product can
help in assessing (and combating) the threat of substitution.
d) Threat of new entrants:
When an industry is earning a return on invested capital above the cost of capital, that
industry will act as a magnet to firms outside the industry.
Unless the entry of new firms is barred, the rate of profit must fall to the competitive level.
Even the mere threat of entry may be sufficient to ensure that established firms constrain
their prices to the competitive level.
e) Intensity of competition:
Markets experiencing rapid growth typically see less intense competition
Rival companies can usually satisfy profitability and growth without having to take market
shares from their competitiors.
2. Core Competencies Analysis
Core competencies are created by superior integration of technological, physical and human
resources,. They represent distinctive skills as well as intangible, invisible, intellectual assets
and cultural capabilities. Cultural capabilities refer to the ability to manage change, the ability to
learn and team working. Organisations should be viewed as a bundle of a few core
competencies, each supported by several individual skills.
Core competence based diversification reduces risk and investment and increases the
opportunities for transferring learning and best practice across business units.
A core competence is identified by the following tests:
Leverage test - Does it provide potential access to a wide variety of markets?
Value enhancement test Does it make a significant contribution to the customers
perception regarding benefits of the end product?
Imitability test Can it be imitated? Does it reduce the threat of imitation by competitors?
Applying the VCA approach to core competencies for competitive advantage includes the
following steps:
Validate core competencies in current businesses: Core competencies should tie
together the portfolio of end products and help the firm excel in dominating its industry.
Core competencies need to be continually validated, due to continuous technological
development over time.
Export or leverage core competencies to the value chains of other existing
businesses: The same set of core competencies can be exploited in multiple
businesses by exporting core competencies to the value chains of other existing
businesses.
Use core competencies to reconfigure the value chains of existing businesses: While
firms may manage their existing value chains better than their competitors, sophisticated
firms work harder on using their core competencies to reconfigure the value chain to
improve payoffs. Otherwise competitors may, exploit opportunities.
Use core competencies to create new value chains: With strong core competencies in its
existing businesses, an organization can seek new customers by developing new value
chains.
3. Segmentation Analysis (Stage 3)
Industries are sometimes collections of different market segments. Vertically integrated
industries are examples of a string of natural businesses from the source of raw material to end
use by the final consumer. Not all firms ill an industry participate in all segments.
Segmentation analysis will reveal competitive advantages and disadvantages of different
segments. A firm may use this information to decide whether to exit the segment, to enter a
segment, reconfigure one or more segments, or embark on cost reduction/differentiation
programs.
Using the value chain approach for segmentation analysis, Grant recommended five steps:
1. Identify segmentation variables and categories:
The market may be divided into a number of segments using appropriate bases. Some
approaches to define market segments are:
Based on customer characteristics
Geographic
Type of organization
Size of firm
Life-style customers
Age
Occupation
Based on Product
Use-type
Usage
Benefits sought
Prices sensitivity
Competition
Brand Loyalty
Use of Cost
Driver
Cost
Containment
Philosophy
Cost
preferences
Nature of data
Benchmarking
Insights
for
Spend to save
Focus
on
control
of Focus on gaining advantage and not
manufacturing costs
only on cost control and reduction.
Internal Information
External and internal information
Partially
present
Inter- Focus on full-fledged benchmarking
finance comparison, if any, learning from competitors but exploiting
is generally restricted to ones own strengths gain advantage.
financial and operational
information.
Limited to some extent
Identify cost drivers at the individual
Strategic
Decisions
activity
level
and
develop
cost/differentiation advantage either by
controlling those drivers better than
competating by reconfiguring the value
chain, Quantify and assess supplier
power and buyer power a exploit
linkages with suppliers and buyers.
Question II:
Discuss the objectives of introducing a budgetary control system in an organization.
The objective of budgeting are:
a) To encourage self-study in all aspects of a companys operations.
b) To get all members of management to put their heads to the basic question of how the
business should be run to make them a co-ordinated team operating in unison towards
clearly defined objectives.
c) To force a definition and crystallization of company policies and aims.
d) To increase the effectiveness with which people and capital are employed.
e) To disclose areas of potential improvement in the companys operations.
f) To stimulate study of relationship of the company to its external economic environment
for improving the effectiveness of its direction.
Question III:
Define the term budgetary control.
Budgetary Control:
Definition: Budgetary Control is defined as the establishment of budgets, relating the
responsibilities of executives to the requirement of a policy, and the continuous comparison of
actual with budgeted results either to secure by individual action the objective of that policy or
to provide a base for its revision.
Salient features:
(a)
Objectives: Determining the objectives to be achieved, over the budget period, and the
policy or policies that might be adopted for the achievement of these ends.
(b)
Activities: Determining the variety of activities that should be undertaken for the
achievement of the objectives.
(c)
(d)
(e)
Control Action: Ensuring that corrective action will be taken where the plan is not being
achieved and, if that be not possible, for the revision of the plan.
Question IV:
Define the objectives of budgetary control.
Objectives of budgetary control system
The objectives of a budgetary control system are:
(a)
Definition of Goals: Portraying with precision, the overall aims of the business and
determining targets of performance for each section or department of the business.
(b)
(c)
Basis for performance evaluation: Providing basis for the comparison of actual
performance with the predetermined targets and investigation of deviation, if any, of
actual performance and expenses from the budgeted figures. It helps to take timely
corrective measures.
(d)
Optimum use of resources: Ensuring the best use of all available resources to
maximize profit or production, subject to the limiting factors.
Coordination: Co-ordinating the various activities of the business and centralizing control, but
also facility for management to decentralise responsibility arid delegate authority.
Planned action: Engendering a spirit of careful forethought, assessment of what is possible
and an attempt at it. It leads to dynamism without recklessness. It also helps to draw up
long range plans with a fair measure of accuracy.
Basis for policy: Providing a basis for revision of current and future policies.
Providing a yardstick against which actual results can be compared.
Question V:
Briefly describe the Role of a Budget Officer.
Role of a Budget Officer:
The Budget Committee would be composed of all functional heads and a member from
the Board to preside over and guide the deliberations.
The Budget Committee acts through the Budget Officer whose responsibilities include:
(a) Functional Budget preparation: To assist in the preparation of the various budgets by
coordinating the work of the accounts department which normally compiles the budgets,
with the relevant functional departments like Sales, Production, Plant maintenance etc.
(b) Communication to Responsible Centres: To forward the budget to the individuals who
are responsible to adhere to them and to guide them in overcoming any practical
difficulties in its working.
(c) Coordination: To prepare the periodical budget reports for circulation to the individuals
concerned, coordinating with them in the formulation of budgets for subsequent periods.
(d) Follow-up: To determine the follow-up action to be taken on the budget reports.
(e) Budget Committee Review: To prepare an overall budget working report for discussion
at the Budget Committee meetings and to ensure follow-up on the lines of action
suggested by the Committee.
(f) Board Review: To prepare periodical reports for the Board meeting, comparing the
budgeted Profit and Loss Account and the Balance Sheet will the actual results.
Question VI:
What are the advantages and limitations of Budgetary Control System?
Advantages of Budgetary Control System
Efficiency: It enables the management to conduct its business activities in an efficient
manner. Effective utilization of scarce resources, i.e. men, material, machinery, methods
and money is made possible.
Cost Control: It is powerful instrument used by business houses for the control of their
expenditure. It inculcates the feeling of cost consciousness among workers.
Performance evaluation: It provides a yardstick for measuring and
performance of individuals and their departments.
evaluating the
Standard Costing and Variance analysis: It creates suitable conditions for the
implementation of standard costing system in a business organization. It reveals the
deviations to management from the budgeted figures after making a comparison with
actual figures.
Policy formulation: It helps in the review of current trends and framing of future policies.
False Sense of Security: Mere budgeting cannot lead to profitability. Budgets cannot be
executed automatically. It may create a false sense of security that everything has been
taken care of in the budgets.
Lack of coordination: Staff co-operation is usually not available during budgetary control
exercise.
Time and Cost: The introduction and implementation of the system may be expensive.
Question VII:
Define Flexible Budget. What is the need for Flexible Budget? Explain the situations in
which Flexible Budget may be used.
Flexible Budget:
Meaning: It is a budget, which is designed to change in relation to level of activity by
recognizing the difference between fixed, semi-variable and variable costs.
Need: The need for preparation of flexible budgets arises in the following circumstances
Seasonal fluctuations in sales and/or production, for example in soft drinks industry.
Introduction of new products, product design and versions on a frequent basis.
Industries engaged in make-to-order business like shipbuilding;
An industry which is influenced by changes in fashion; and
General change in sales
Flexible budgeting may be resorted to in the following situations:
New Business: In the case of new business venture due to its typical nature it may be
difficult to forecast the demand of a product accurately.
Uncertain Environment: Where the business is dependent upon the mercy of nature
e.g. a person dealing in wool trade may have enough market if temperature goes below
the freezing point.
Factor market conditions: In the case of labour intensive industry where the
production of the concern is dependent upon the availability of labour.
Question VIII:
What are the steps involved in the preparation of budgets?
Steps involved in the preparation of budgets?
Definition of Objectives: Objectives should be defined precisely. They should be written out;
areas of control de-marketed and items of revenue and expenditure to be covered by the
budget stated. This will give a clear understanding of the plan and its scope to all those
who must cooperate to make it a success.
Identification of key (or budget) factor: A key factor represents source whose availability is
less than its requirement. Such resource constraints put a limit on the organization
objective of maximum profitability. Some examples are lack of sales demand, rationing of
raw material, labour shortage, plant capacity etc. For proper budgeting, the key factor
must be located and estimated properly.
Budget Committee and Controller: Formulation of a budget usually requires whole time
services of a senior executive; he must be assisted in this work by a Budget Committee,
consisting of all the heads of department along with the Managing Director as the
Chairman. The Controller is responsible for coordination and development of budget
programmes and preparing the Budget Manual .
Budget Manual: The Budget manual is a schedule, document or booklet, which shows in a
written form, the budgeting organization and procedure. The manual should be well
written and indexed so that a copy thereof may be given to each department head for
guidance.
Budget period: The period covered by a budget is known as budget period. Normally a
calendar year or a period coterminous with the financial year is adopted as the Budget
Period. It is then sub-divided into shorter periods it may be months or quarters or such
period as coincide with period of trading activity.
Standard of activity or output: The standards of activity levels for future period should be
laid down. These are generally based on past statistics, known market changes and
current conditions and forecast of future situations. In a progressive business, the
achievement of a year must exceed those of earlier years. In budgeting, fixing the budget
of sales and capital expenditure are most important since these budgets determine the
extent of development activity.
Question IX:
What is Zero Base Budgeting?
Zero Base Budgeting (ZBB):
Meaning: It is an expenditure control device where each divisional head has to justify the
requirement of funds for each head of expenditure and prepare the budget accordingly, without
reference to the past budget or achievements.
It is an operating planning and budgeting process, which requires each manager to justify his
entire budget requests in detail from scratch (hence zero-base).
Features:
Wholistic: The technique deals practically with all the elements of budget proposals.
Analytical: A critical evaluation of all the ongoing activities is also done afresh together with
new proposals. Each manager has to justify whey he should spend any money at all.
Priority Based: This approach requires that all activities be identified as decision on
packages, which would be evaluated by systematic analysis and ranked in order of
importance.
Review Based: an organisation should not only make decisions about the proposed newprogrammes but it should also from time to time, review the utility and appropriateness
of the existing programmes.
Rational: It allows for budget reductions and expansions in a rational manner and allows reallocation of resources from low to high priority programme.
Question X:
Explain the Steps in Zero Base Budgeting.
Old is Gold Attitude: Generally managers are reluctant to start afresh. They tend to plan for
future just by reference to past actions and budgets.
Time Consuming: It is time consuming as well as costly.
Lack of trained staff: It needs properly trained managerial personnel to do the required job.
Question XII:
Explain Performance Budgeting. What are its features and advantages? OR What are its
requisites?
Performance Budgeting:
Meaning:
It is the process of analysing, identifying, simplifying and crystallizing specific performance
objectives, of a job to be achieved over a period, within the framework of organizational
objectives, the purposes and objectives of the job.
The technique is characterised by its specific direction towards the business objectives of the
organization.
Features and Advantages:
Performance budgeting lays immediate stress on the achievement of specific goals over a
period of time.
It aims at a continuous growth of the organisation so that it continues to meet the dynamic
needs of its growing clientle.
It enables the organization to be sensitive and adaptive, preventing it from developing
rigidities, which may retard the process of growth.
It requires the preparation of periodic performance reports, which compare budget and actual
performance to find out existing variances.
Important considerations in Performance Reporting:
The important considerations in drawing up of reports and determining their scope are the
following:
Significance
Timeliness
Accuracy
Appropriateness
Discrimination
Presentation
Performance Reports:
A. Top Management: (including Board of Directors and financial mangers)
Balance Sheet
Profit & Loss Statement
Position of Stock;
Disposition of funds or working capital
Capital expenditure and forward commitments together with progress of projects in hand.
Cash flow statements;
Sales, production, and other appropriate statistics
B. Sales Management
Actual sales compared with budgeted sales to measure performance by (a) products; (b)
territories; (c) individual salesmen; and (d) customers.
Standard profit and loss, product-wise (a) for fixing selling prices and (b) to concentrate on
sales of most profitable products.
Selling expenses in relation to budget and sales value analysed by (a) products; (b)
territories; (c) individual salesmen; and (d) customers
Bad debts and accounts, which are slow and difficult in collection.
Status reports on new or doubtful customers.
C. Production management
To Buyer: Price variations on purchases analysed by commodities.
To Foreman
Customer perspective i.e how customers see us? In order to translate effective internal
processes into organization success, customers/clients must be happy with the service
they receive. The Customer perspective considers the business through the eyes of the
customers, measuring and reflecting upon customer satisfaction.
Internal perspective i.e. in what must the organization excel? The internal perspective
focuses attention on the performance of the key internal processes, which drive the
business. The nature of the processes is dependent on the nature of the organization.
Innovation and learning perspective, i.e Can we continue to improve and create value?
The value & Growth perspective is a measure of potential future performance it direct
attention to the basis of all future success the organization people and infrastructure.
Adequate investment in these areas is critical to all long-term success.
Financial, perspective i. e. How we look to our shareholders? The financial perspective
measures the results that the organisation delivers to it shareholders.
Thus, the scoreboard provides a view of an organizations overall performance by integrating
financial measures with other key performance indicators. All these four perspective provide a
balanced view of the present and future performance of the business.
Question XV:
What are the stages involved in the creation of a balanced score card. Explain them
briefly.
Process of creating a Balanced Score Card:
Step
Description
1
Identify the vision i.e. where an organization is going. For example, the vision of a
company may be to dominate the market.
2.
Identify the organisations strategies i.e. how an organization is planning to go
there. For example, strategy may be to focus on cost efficiency, high quality and
fresh investment in new technology.
3.
Define critical success factors and perspective i.e. what we have to do well in
each perspective (see Note Below for illustration of perspectives and performance
measures)
4.
Identify measures, which will ensure that every thing is going in the expected way.
5.
Evaluation of Balanced score card i.e. ensuring what we are measuring is right.
6.
Create action plans and plan reporting of the Balanced Score Card.
7.
Followup and manage i.e. which person should have reports and how reports
should look like
A. Customer Perspective
Goals
Performance
Price
Competitive price
Delivery Number of on time delivery, lead time from receipt of order to delivery to
customers.
Quality Own quality relative to industry standards, number of defects or defect
level
Performance
Manufacturing cycle time
Annual sales vs. Plan sales, increase in number of
customers in a unit of time.
Rate of new product introduction/quarter
Performance
Product performance compared to competitors,
number of new products with patented technology.
Manufacturing overheads per quarter as a
percentage of sales rate of decrease in cost of
quality per quarter
Market share in all major markets
Number of new products, numbers of patents
Cost leadership
Market leadership
Research and development
D. Financial Perspective
Goals
Sales
Cost of sales
Profitability
Prosperity
Performance
Revenue and profit growth
Extent to which it remained fixed or decreased each year
Return on capital employed
Cash flow
Question XVI:
What do you understand by benchmarking?
Bench Marking:
Benchmarking is the process of identifying and learning from the best practices anywhere
in the world.
It is powerful tool for continuous improvement in performance.
It involves comparing firms products, services or activities against other best performing
organization, either internal or external to the firm. The objective is to find out how the
product, service or activity can be improved and ensure that the improvements are
implemented.
It attempts to identify an activity that needs to be improved and finding a non-rival
organization that is considered to represent world-class best practice and studying how it
performs the activity.
Question XVII:
Explain briefly the Different types of Bench marking.
Different types of Bench marking:
(1) Competitive Bench marking: It involves the comparison of ones own products,
processes and business results with that of competitors. Bench marking partners are
drawn from the same industry. To protect confidentiality it is common for the companies
to undertake this type of benchmarking through associations of third parties.
(2) Strategic Benchmarking: It involves a systematic process by which a company seeks to
improve its overall performance by examining the long-term strategies. It involves
comparing high-level aspects such as developing new products and services, core
competencies etc. It is similar to process benchmarking in nature but differs in its scope
and depth.
(3) Global benchmarking: It is a benchmarking through which distinction in international
culture, business processes and trade practices across companies are bridged and their
ramification for business process improvement are understood and utilized. Globalisation
and advances in information technology leads to use of this type of benchmarking.
(4) Process benchmarking: It involves the comparison of an organisations critical business
processes and operations against best practice organization that performs similar work or
deliver similar services.
(5) Functional benchmarking: This is used when organizations look to benchmark with
partners drawn from different business sectors or areas of activity to find ways of
improving similar functions or work processes. This sort of benchmarking can lead to
innovation and dramatic improvements.
(6) Internal Benchmarking: It involves seeking partners from with the same organization,
for example from business units located in different areas. The main advantages are (a)
Easy access to sensitive data and information (b) Availability of standardized data; and
(c) Lesser requirement of time and resources. However, real innovation may be lacking.
(7) External Benchmarking: It involves seeking help of outside organization that are know
to be best in class. It provides opportunities of learning from those who are at leading
edge. However, this type of benchmarking may take up more time and resource to ensure
the comparability of data and information. The credibility of the findings and the
development of sound recommendation.
a.
Intra-Group Benchmarking: Here the groups of companies in the same industry agree
that similar units within the cooperating companies will pool data on their process. The
processes are benchmarked against each other at or near operation level. Improvement
Task forces are established to identify and transfer best practice to all members of the
group.
b.
Question XVIII:
Explain the Stages involved in the process of Benchmarking.
Stages in the process of Benchmarking
Stage 1: Planning
(a) Determination of benchmarking goal statement: This requires identification of areas to be
benchmarked, which uses the following criteria:
Delivery performance
Responsiveness to customer
requirements
Inventory levels
Work-in-Progress
Cost of sales
(b) Identification of best performance: The next step is seeking the best. To arrive at the
best is both expensive and time consuming , so it is better to identify a company, which
has recorded performance success in a similar area.
(c) Establishment of the benchmarking or process Improvement team: This should
include persons who are most knowledgeable about the internal operations and will be
directly affected by changes due to benchmarking.
(d) Defining the relevant benchmarking measures: Relevant measures will not include the
measures used by the organization today but they will be refined into measures that
comprehend the true performance differences. Developing good measurement is key to
successful benchmarking.
Stage 2: Collection of data and information: This involves the following steps
Compile information and data on performance. They may include mapping processes.
Select and contact partners
Develop a mutual understanding about the procedures to be followed and, if necessary,
Benchmarking Protocol with partners.
Prepare questions
Distribute schedule of questions to each partner
Undertake information avid data collection by chose method for example, interview, sitevisits, telephone, fax and e-mail.
Collect the findings to enable analysis.
Stage 3: Analysis of findings:
Review the findings and produce tables, Charts and graphs to support the analysis
Identify gaps in performance between our organization and better performers.
Seek explanations for the gaps in performance. The performance gaps can be positive
negative or zero.
Ensure that comparisons are meaningful and credible.
Communicate the findings to those who are affected.
Identify realistic opportunities for improvements. The negative performance gap indicates an
undesirable competitive position and provides a basis for performance improvement. If
there is no gap it may indicate a natural position relative to the performance being
benchmarked. The zero position should be analysed for identifying means to transform its
performance to a level of superiority or positive gap.
Stage 4: Recommendations:
1. Making recommendations:
Deciding the feasibility of making the improvements in the light of the conditions that apply
within own organization.
Agreement on the improvements that are likely to be feasible
Producing a report on the Benchmarking in which the recommendations are included.
Obtaining the support of key stakeholder groups for making the changes needed.
Developing action plans for implementation.
2. Implementing recommendations:
(a) Implement the action plans
(b) Monitor performance
(c) Reward and communicate successes
(d) Keep key stakeholders informed of progress.
Stage 5: Monitoring and reviewing: This involves:
(a) Evaluating the benchmarking process undertaken and the results of the improvement
against objectives and success criteria plus overall efficiency and effectiveness.
(b) Documenting the lessons learnt and make them available to others
(c) Periodically re-considering the benchmarks for continuous improvement.
Question XIX:
What are the Pre-requisites for successful benchmarking?
Pre-requisites for successful benchmarking
1. Commitment: Senior managers should support benchmarking and must be committed to
continuous improvements.
2. Clarity of Objectives: The objectives should be clearly defined at the preliminary stage.
Benchmarking teams have a clear picture of their organisations performance before
approaching others for comparisons.
3. Appropriate Scope: The scope of the work should be appropriate in the light of the
objectives resources, time available and the experience level of those involved.
4. Resources: Sufficient resources must be available to complete projects within the
required time scale.
5. Skills: Benchmarking teams should have the right skills and competencies.
6. Communication: Stakeholder, particularly staff and their representatives are to be kept
informed of the reasons for benchmarking.
Question XX:
Discuss briefly the difficulties in the implementation of Benchmarking.
Difficulties in implementation of Benchmarking
1. Time consuming: Benchmarking is time consuming and at times difficult. It has
significant requirement of staff time and company resources. Companies often waste time
in benchmarking non-critical functions.
2. Lack of Management Support: Benchmarking implementation require the direct
involvement of the senior manager etc. The drive to be best in the industry or world
cannot be delegated.
3. Resistance from employees: It is likely that there may be resistance from employees.
4. Paper Goals: Companies can become preoccupied with the measure. The goal becomes
not to improve process but to match the best practices at any cost.
5. Copy-paste attitude: The key element in benchmarking is the adaptation of a best
practice to tailor it to a companys needs and culture. Without that step, a company
merely adopts another companys process. This approach condemns benchmarking to
fail.
Question XXI:
What are benchmarking code of conduct?
Benchmarking Code of Conduct:
To contribute to efficient, effective, and ethical benchmarking, individuals agree for themselves
and their organization to abide by the following principles for benchmarking with other
organizations.
(a) Principle of Legality: Avoid discussion or actions that might lead to or imply an interest
in restraint of trade; market or customer allocation schemes, price fixing dealing
arrangements bid rigging, bribery or misappropriation. Do not discuss costs with
competitors if costs are an element of pricing.
(b) Principles of Exchange: Be willing to provide the same level of information that you
request in any benchmarking exchange.
(c) Principle of Confidentiality: Treat benchmarking interchange as something confidential
to the individuals and organizations involved. Information
obtained must not be
communicated outside the partnering organization without prior consent of participating
benchmarking partners. An organizations participation in a study should not be
communicated externally without their permission.
(d) Principle of Use: Use information obtained through benchmarking partnering only for the
purpose of improvement of operations with the partnering companies themselves.
External use or communications of a benchmarking partners name with their data of
observed practices requires permission of that partner. Do not, as a consultant of client,
extend one companys benchmarking study findings to another without the first
companys permission.
(e) Principle of first part Contact: Initiate contacts, whenever possible, though a
benchmarking contact designated by the partner company. Obtain mutual agreement with
the contact on any hand off of communication or responsibility to other parties.
(f) Principle of Third Party Contact: Obtain an individuals permission before providing
their name in response to a contact request.
(g) Principle of Preparation: Demonstrate commitment to the efficiency and effectiveness
benchmarking process with adequate preparation at each process particularly, at initial
partnering contact.
Question XXII:
Explain Optimised Production Technology (OPT) and Throughout Accounting (TA).
Optimised Production Technology (OPT) and Throughout Accounting (TA)
Goldratt and Core advocated a new approach to production management called Optimised
Production Technology (OPT)
OPT is based on the principle that profits are expanded by increasing the throughout of the
plant i.e. rate at which raw materials are turned into sales.
The OPT approach determines whatever prevents throughout being higher by distinguishing
between bottleneck and non-bottleneck resources.
This approach advocates that bottleneck resources/activities should be fully utilized while nonbottleneck resources/activities should not be utilized to 100% of their capacity since it would
result in increase in inventory.
The most widely recognized management accounting system developed for this purpose is
known as Throughout Accounting (TA).
Question XXIII:
Explain the concept and aim of Theory of Constraints.
Theory of Constraints (TOC):
TOC focuses its attention on constraints and bottlenecks within the organization that hinder
speedy production. The main concept is to maximize the rate of manufacturing output i.e. the
throughput (Sales + Closing WIP - Opening WIP) of the organization.
This requires examination of the bottlenecks and constraints, which are defined as under:
Bottleneck: It is an activity within the organization where the demand for that resource is
more than its capacity to supply.
Constraint: It is a situational factor, which makes the achievement of objectives/throughput
more difficult than it would otherwise be, e.g. lack of skilled employees, lack of customer
orders or the need to achieve a high level of quality in product output.
Relationship between Constraint and Bottleneck: A bottleneck is always a constraint but a
constraint need not be a bottleneck. For example, let the major constraint be meeting the
delivery schedule for customers orders. The bottleneck in such a case may be certain machine
in the factory.
Throughput is thus related directly to the ability to cope with the constraint and to manage the
bottleneck. This focus on throughput forced management to examine both the constraints and
the bottleneck in order to increase throughput.
Operation of TOC:
The main aim of TOC is to increase throughput contribution. This can be done by techniques
such as
1. Linear programming for allocating the optimum use of bottleneck resources.
2. Use of shadow prices for decision making and
3. Variance analysis using Activity Based Costing Techniques.
Thus, theory of constraint attempts to do the following:
Objective: Maximise Throughput Contribution (i.e. Sales revenue Loss Direct materials)
Constraints: subject to
Q. 2
What are benchmarking code of conduct? (November 2004 (3 marks)
Answer:
(As the question was for only 3 marks only following needs to be written.)
Bench Marking:
Benchmarking is the process of identifying and learning from the best practices anywhere
in the world.
It is powerful tool for continuous improvement in performance.
It involves comparing firms products, services or activities against other best performing
organization, either internal or external to the firm. The objective is to find out how the
product, service or activity can be improved and ensure that the improvements are
implemented.
It attempts to identify an activity that needs to be improved and finding a non-rival
organization that is considered to represent world-class best practice and studying how it
performs the activity.
Suggested Benchmarking Code of Conduct:
1. Principle of Legality
2. Principles of Exchange
3. Principle of Confidentiality
4. Principle of Use
5. Principle of first part Contact
6. Principle of Third Party Contact
7. Principle of Preparation
Q. 3
Explain the theory of constraints. (November 2003) (4 marks)
Q. 4
What do you mean by benchmarking? What are the pre-requisites for benchmarking?
(November 2003) (5 marks)
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. (May 2003) (4 marks)
Q. 6
State, how is zero base budgeting superior to traditional budgeting? (November 2002) (4
marks)
Answer:
Write Advantages of ZBB.