Short notes version- from the examination point of view -regular notes are attached

The notes for MACS is in line with the 3

rd
semester requirement of VTU MBA syllabus. This are
grouped into two setions. Setion A omprises of theory .Suggested answers for Theoritial
!uestions are related to past " years. Setion B omprises of numerials. All the numerials are
sol#ed from the past question papers.$ontat M.%.Saibaba at saibaba&&'()*gmail.om for
feedba+ and larifiations and impro#ements.
Setion A ,
Module 1
Goals: Goals are broad overall aims of the organization. Goals are statements of what
a company intends to achieve over the period of the strategic plan (e.g. over the next
year, five years, ten years). A goal also means a desired result a person or an
organization, plans and commits to achieve.
Q-What are the strategic key variables in management control systems
A key variable is a significant indicator of business activity. According to Samuel Paul there is
positive relationship between key variables and the organizational performance.xamples of key
variables
Production key variables! "apacity utilization, losses, #uality control, maintenance.
Marketing key variables: $arket share, %ew product development
Asset management key variables! Asset turnover, &'(
HM: mployee training, attrition.
Management by ob!ectives "M#$% is a process of defining ob)ectives within an organization so that
management and employees agree to the ob)ectives and understand what they need to do in the
organization. *he essence of $+' is participative goal setting, choosing course of actions and
decision making.$+'! *he term ,management by ob)ectives, was first popularized by -eter .rucker
in his book /*he -ractice of $anagement/.
Some o& the im'ortant &eatures and advantages o& M#$ are!
0. (acilitates Motivation of employees1
2. )nsures better communication and *oordination +ithin the organi,ation.
3. *larity in setting o& goals:
4. )nsures Goal congruence !
-imitations
*here are several limitations !5ome of them are
1
0. .t over-em'hasi,es the setting o& goals
/0Sel&-centered em'loyees might be 'rone to distort results0
Q-What do you understand by Management controls 0What are the basic elements o& the
control
According to Anthony and Govindara)an , $anagement "ontrol is 6the process by which managers
ensure that resources are used effectively and efficiently in the accomplishment of the organization/s
ob)ectives7.
A management control system is the means by which senior managers ensure that subordinate
managers, efficiently and effectively, strive to attain the company/s ob)ectives.
According to 8orngren et al. management control system is an integrated techni9ue for collecting and
using information to motivate employee behavior and to evaluate performance.
Q-What are the elements o& a control system0"e& to (ig%
Any control system has &our im'ortant elements0 1hey are
0) 2etector or sensor: .etector analyzes the situation
2) Assesor: Assesor helps in comparing the actual results with the standard or expected results.
3) )&&ector: ffector reduces the gap between the actual and the standard result.
4) *ommunication net+ork: *he communication network transmits information between the
dectector, the assesor and the effector.
2
ELEMENTS OF THE CONTROL PROCESS


Source Robert N Anthony,Govindr!n, Mn"e#ent contro$ %y%te#%
Contro$ device
2. Assessor!
"omparison with
standard
1& 'etector(
)n*or#tion bout
+ht i%
h,,enin"
-& E.ector(
/ehvior
$tertion, i*
needed
Entity bein"
contro$$ed
Q-)3'lain the various ste's in control 'rocess
*he process of control usually involves four important steps. *hey are
(dentifying the goals or ob)ectives
(mplementing the programs or policies
$easuring and comparing outcomes against targets
Analyzing whether the achieved targets are in accordance with the goals or ob)ectives.
Q-2e&ine management control and task control4 2istinguish bet+een task control and
management control0"re&-&ig%
Management *ontrol. $anagement control is concerned with implementation of strategies,
effective resource utilization, competitiveness of the unit, and the translation of corporate goals into
business unit ob)ectives. $anagement control is oriented towards behavior of personnel to implement
strategies effectively. $anagement control lies at the intermediate level between the levels of strategy
formulation and task control.
1ask control: *ask control means the control of individual tasks. *hese tasks are carried out
according to the, policies, rules and regulations laid down by the management control process. *ask
control is 9uantitative in nature. e.g. the number of items ordered by the customers, the components
used in manufacturing the products, the number of man:hours used in a particular process, etc.
-
GENERAL RELAT)ONSH)PS AMONG PLANN)NG AN' CONTROL
F0NCT)ONS

Go$%, %trte"ie% nd
,o$icie%


Source Robert N Anthony,Govindr!n, Mn"e#ent contro$
%y%te#%
$'erational control is primarily concerned with efficiency issues of various of the organization. *he
time horizon of control is very short, the benchmarks are known and well defined, and the outcomes
are tangible and easily measurable.
.nternal controls within business entities are also referred to as o'erational controls. (nternal
control is a process effected by an organization/s structure, work and authority flows, people and
management information systems. (t helps the organization accomplish specific goals. (t is a means
by which an organization/s resources are directed, monitored, and measured.
Q-1ask control vs0 management control
*ask control is the process of assuring that specified tasks are carried out effectively and
efficiently.*ask control activities are scientific eg.,('#). *ask control involves the control of
individual tasks. *hese tasks are carried out according to the rules and regulations laid down by the
management control process. *ask control is 9uantitative in nature whereas management control is
oriented towards behavior. (n task control, in some cases, such as automated processes, employees
may not be involved; in other cases, there may be interaction between a manager and a worker.
1
Strte"y
*or#u$tion
Mn"e#ent
contro$
T%2 contro$
)#,$e#enttion o*
%trte"ie%
E3cient nd e.ective ,er*or#nce o*
individu$ t%2%
$anagement control involves interaction between two managers or between a superior and
subordinate.
(Note add points from the above paras:do not write this line in the exam)
Q-#ring out the di&&erences bet+een o'erational control5 task control and management control0
&efer to the above paras for answer.
Q-6Management control systems are tools to im'lement strategies 6)3'lain the 'rocedure o&
strategy &ormulation at both cor'orate level and business level0
$anagement control systems help managers move an organization toward its strategic ob)ectives and
strategy execution. $anagement controls are effected efficient organization structure, 8&$ and
culture. (t is an important aspect of strategy implementation. *he following figure shows the
framework for strategy implementation.

Source Robert N Anthony,Govindr!n, Mn"e#ent contro$ %y%te#%
Strategy &ormulation:
5trategy formulation is the process of determining appropriate courses of action for achieving
organizational ob)ectives and thereby accomplishing organizational goals. (t is the development of
long range plans for the effective management of 5<'* aspects of business. *he purpose is to
utilize the strength and to overcome the threat.
4
)MPLEMENTAT)ON MECHAN)SMS
Mn"e#en
t conro$%
Or"ni5tio
n %tructure
Hu#n
re%ource
#n"e#ent
Cu$ture
Strte"
y
Per*or#n
ce
5trategies are considered at two levels in an organization! cor'orate strategy and business unit
strategy0 "orporate resources are allocated based on these the strategies. +usiness unit=s strategy
formulation is based on the corporate mission. 8owever in both cases the approach for strategy
formulation is by and large the same.(&ef fig

67What are the in&ormal &actors in&luencing goal congruence
Goal congruence means agreement of actions of individuals and groups in achieving the
organization=s goals. >or congruence "orporate goals are communicated by budgets, organization
charts, and )ob descriptions. *he following are the
.n&ormal &actors o& goal congruence: 'rganizational culture; ?eadership! (ndividual aspirations!
.ecentralization:
8
)ntern$ n$y%i%
Techno$o"y 2no+ho+
M*"& 2no+ ho+
M2"& 2no+ho+
'i%tn& 2no+ho+
Lo"i%tic% 2no+ho+
Environ#ent$
n$y%i%
Co#,etitor
Cu%to#er
Su,,$ier
Re"u$tory
Soci$9,o$itic$
O,,ortunitie% nd
thret%
)denti*y o,,ortunitie%
Stren"th nd
+e2ne%%e%
)denti*y core
co#,etencie%
Fi: intern$
co#,etencie%
+ith e:tern$
o,,ortunitie%
Fir#;%
%trte"ie%
(ormal &actors are organization structure:performance evaluation and compensation systems:
*ransfer pricing
Q-What do you mean by res'onsibility accounting:4What is res'onsibility accounting
&esponsibility accounting means evaluation and )udging of each manager/s performance of the
responsibility center, under his or her control. (t is based on the assumption that every cost incurred
must be the responsibility of one person somewhere in the company. &esponsibility accounting also
means collection, summarization, and reporting of financial information about various decision
centers (responsibility centers) throughout an organization.
Q-)SP$7S.#.-.18 *)71)S
&esponsibility center is a unit or function of an organization headed by a manager who is directly
responsible for its performance. $anager of a responsibility operates the center as a separate business
entity, responsible for its operations and profitability.
*$S1 *)71). A cost center is a production or service function, activity or item of e9uipment, the
costs of which may be attributed to cost units. xamples of cost center are &@., -roduction,
$arketing, assembly department:personnel, accounting etc. A cost center forms the basis for building
up cost records for cost measurements, budgeting and control.
Pro&it centers
A profit center is a section of a company treated as a separate business. A profit center manager is
held accountable for both revenues, and costs (expenses), and therefore, profits. *he profit center
helps the organization to make the best use of specialized market knowledge of the divisional
managers.
.nvestment centers: An investment center operates like a separate entity within the organization. *he
essential element of an investment center is that it is treated as a unit which is measured against its
use of capital, as opposed to a cost or profit center, which are measured against costs or profits. An
investment center has control over sales revenues and operating costs, and the assets used to generate
profit.
*$S1 97.1 is a &unctional cost unit +hich establishes standard cost 'er +orkload element o&
activity0
Module /
What are the elements o& cost:"re& &ig%
lements of cost : (0) material, (2) labour and (3) expenses.
<
$aterials can be direct and indirect.
2irect Material! All materials which become an integral part of the finished product,
.ndirect Material!. xamples are "onsumable stores, lubrication oil, stationery and spare parts etc.
-abour
8uman efforts used for conversion of materials into finished products is called labour .-ayment made
towards the labour cost. (t can also be direct and indirect.
)3'enses
All expenditures other than material and labour incurred for manufacturing a product or rendering
service are termed as /expenses/. xpenses may be direct or indirect.

Q-2istinguish bet+een 'roduct cost and 'eriod cost0 Why is it considered im'ortant0"re&-&ig%
1he 2i&&erence #et+een Product *ost and Period *ost0
Product costs refers to that cost which varies in direct proportion to the volume of output. *he cost
per unit of product cost remains unchanged as production increases or decreases but total cost
increases. xamples ; cost of direct material, direct labor and direct expenses.
{For financial accounting purposes ,product costs include all the costs that are involved in acquiring
or making. In the case of manufactured goods these costs consist of direct materials, direct labour
and manufacturing overhead}
Period cost is the &i3ed cost. (t refers to that cost which remains unchanged by change in volume of
output. *hese costs are called period costs because it is dependant on the time rather than the volume
of output. xamples are rent of the factory building, 5alary of managers, (nsurance of building etc.
{In financial accounting period costs are all the costs that are not included in product costs. These
costs are expensed on the income statement in the period in hich they are incurred}.
Why is the distinction bet+een 'roduct cost and 'eriod costs im'ortant:
*he distinction between product costs and period costs is important for 0) properly measuring net
income during a period of time and 2) reporting the proper cost of inventory on the balance sheet.
=
-roduct costs will be reported on the income statement as the cost of goods sold expense in the period
that the units of product are sold. -eriod costs are treated as expenses on accrual basis.
Q-2e&ine im'uted cost: 2i&&erential cost: $''ortunity cost:4)3'lain im'uted cost54out o& 'ocket
cost5 relevant cost5 sunk cost0
1he &ollo+ing are the *ost conce'ts in decision making
Marginal cost! $arginal cost is the total of variable costs, i.e., prime cost Avariable overheads. (t is
based on the distinction between fixed and variable costs. >ixed costs are ignored and only variable
costs are taken into consideration for determining the cost of products, <ork in progress and finished
goods.
2i&&erential cost! Any cost that differs between alternatives in a decision:making situation is called
differential cost. (t is the change in costs due to changes in the level of activity or method of
production, technology or process. (f the change increases the cost, it will be called incremental cost.
.ifferential cost is also known as avoidable, relevant cost and (ncremental cost .
.m'uted cost! A cost that is incurred by virtue of using an asset instead of investing it or undertaking
an alternative course of action. An imputed cost is an invisible cost that is not incurred directly, as
opposed to an explicit cost, which is incurred directly. (mputed cost is also known as 6implied cost7
or 6opportunity cost.
$''ortunity cost! 'pportunity cost is the cost of any activity measured in terms of the value of the
next best alternative forgone (that is not chosen). (t is the sacrifice related to the second best choice
available to someone, or a firm, who has picked among several mutually exclusive choices
Q-)3'lain di&&erent ty'es o& 6cost classi&ications;
"ost classification is the process of grouping costs according to their common characteristics.
"lassification is made with the purpose of achieving the re9uirements of a particular concern.
*lassi&ication o& costs
#y nature o& elements !$aterials, labour #y &unctions (-roduction:selling and
>
expenses distribution)
#y degree o& traceability to the 'roduct
(direct and indirect)
#y change in activity or volume (>ixed,
variable and semi:variable)
#y controllability #y normality (%ormal cost, abnormal cost)
#y relationshi' +ith accounting 'eriod
("apital and &evenue)
#y time (8istorical cost:predetermined
costs)
#y association +ith the 'roduct (product
cost:period costs)
According to 'lanning and control
(+udgeted costs and standard costs)
*ost analysis &or managerial decision
making
$arginal cost, out of pocket cost,
differential cost, sunk cost, imputed or
notional cost, opportunity cost, replacement
cost, avoidable cost and unavoidable cost,
explicit cost:implicit costs.
Q-Sources o& in&ormation on cost! -ayroll, $aterial re9uisition slips, )ob cards, >inancial
accounting records for depreciation and other overheads.
Q-What is !ob costing
Bob costing is that form of specific order costing which applies where the work is undertaken as an
identifiable unit such as!
i) $anufacture of product to customers= specific re9uirements.
ii) >abrication of certain materials where raw materials are supplied by the customers
iii) (nternal capital expenditure )obs etc.
)lelments o& cost
Prime costC.irect materialsA .irect labourA .irect expenses
Works cost or (actory costC-rime costA <orks or >actory overhead
*ost o& 'roductionC<orks costA Adminstration overheads
1otal cost or cost o& salesC "ost of production A5elling and distribution overheads
Selling 'rice-cost o& salesCprofitDloss
8int0!*he following are not to be considered in cost sheet! *ransfer to reserves; .iscount on shares
1?
written off; .ividend; (ncome tax; +ad debts, +ad .ebt &eserves; transfer fees, -reliminary
expenses written off, .onations made
8int2!5ome times selling price is to be determined on the basis of cost of production but profit
percentage is generally given on sales. >or calculation of profit the following formula should be used
-rofit C&ate percentage on sales x *otal costsD(0EE:rate percentage on sales)
&ate F on salesC2G;total costC&s 33,EEE
-rofitC 2G x 33EEE D(0EE:2G)C&s00EEE
Q-2e&inition o& overhead: "ost pertaining to a cost center or cost unit may be divided into two
portions direct and indirect. "($A defines indirect cost as 6expenditure on labour, materials or
services which cannot be conveniently identified with a specific saleable cost per unit7.
Q-)3'lain the ste's in 6overhead accounting;
*o ascertain the total cost, overhead is added to the prime cost. *he overheads which cannot be
specifically related to cost units are apportioned to various departments and then to cost centers or
production units. *he following steps are involved in this procedure
0) "ollection of overhead ( indirect labour , indirect materials, (ndirect expenses)
2) "lassification and codification of overhead (5elling overhead, distribution overhead, &@.
overhead, $anufacturing overhead etc:fixed overhead! variable overhead)
3) Allocation and apportionment of overhead
4) &eapportionment of service department costs to production departments
G) Absorption of overhead by production units.
11
@ refer to numerical problems for detailed explanation of the aboveA
Q-2istinguish bet+een 6cost centre and cost unit;
*ost centre has been defined as 6a location, person or item of e9uipment for which costs may be
ascertained and used for the purpose of cost control7.
<hereas a cost unit is a 6unit of 9uantity of product service or time in relation to which costs may
be ascertained and or expressed7.
.m'ortance o& overhead allocation
*otal cost of product constitutes .irect $aterial, .irect ?abor @ 'verheads. Accuracy of product
cost computation depends on accurate distribution of overheads to products. (naccuracies would lead
to incorrect decisions 1 especially the pricing decisions.
Q- Allocation and a''ortionment "'rimary distribution%
<Allocation= means the process of identifying the whole items of cost to the cost centers or cost units
or departments. (t is to be noted that these expenses could be directly identified with the cost centers
and not common to several cost centers.x:::salary of foreman, wages of a $Dc operator
<A''ortionment= is defined as the allotment to two or more cost centers , proportions of the common
items of cost on the estimated basis of benefits received.
g:::rent of factory building is not allocated but apportioned to various departments on some suitable
basis, similarly, salary of general manager cannot be allocated wholly to one department as he attends
in general to all departments. (t should be therefore apportioned on some e9uitable basis.
Q-)3'lain the di&&erences bet+een allocation o& overhead 5a''ortionment o& overhead4 State the
di&&erence bet+een allocation and a''ortionment o& overheads
2i&&erences bet+een allocation and a''ortionment
0. Hnder allocation of overheads, the entire amount is charged to a department. Hnder apportionment of
overheads, only a proportionate amount is charged to the department.
12
2. Allocation is the first step in the departmentalization of overheads, whereas, apportionment comes
next.
3. Allocation is a simple process, whereas apportionment is a cumbersome process.
4. (n case of allocation, overheads can be conveniently identified with a department, whereas it is not
possible to identify overheads to a department under apportionment process.
#asis o& a''ortionment o& overheads
+ase (tems of cost
0. >loor area or volume of dept. &ent and rates; taxes; heating and lighting; repairs
@ maintenance of building; accident prevention cost,
fire precaution service; air conditioning
2. number of employees ?abor welfare expenses, canteen expenses, indirect
labor cost, supervision, time keeping, fringe benefits,
medical expenses and pensions
3. "apital value of asset .epreciation, repairs and maintenance, insurance
4. 8orse power or kilowatt power
G. .irect material cost (ndirect material, material handling, wastage
I. .irect labor cost (ndirect labor, sundry expenses, compensation of
workers, 5(, administrative expenses
J. %o. of light points ?ighting expenses
K. ?abor hrsDmDc hrs (ndirect materials, labor(indirect), miscellaneous
expenses
L. *otal sales Dtotal cost $arketing expenses
0E. %o. of material re9uisition 5tore keeping expenses
ea''ortionment $& Service 2e'artment *osts (secondary distribution)
'nce the overheads have been allotted and apportioned to production and service departments and
totaled, the next step is to reapportion the service department costs to production departments. *his is
necessary because our ultimate ob)ect is to charge overheads to cost units, and no cost unit should
pass through service departments. *herefore the cost of service departments must be charged to
production departments.
1-
A''ortionment o& service de'artment overhead
Apportionment to production apportionment to production as well
.epartment only as other service depts.

%on reciprocal basis &eciprocal basis
5imultaneous e9uation method repeated distribution method
A''ortionment to 'roduction de'artment only: 8ere the total amount of each service department
is distributed to only production department.
Some o& the im'ortant basis o& a''ortionment o& service de'artment overheads are:
5ervice departments +asis of apportionment
0. -urchase departments a. Malue of material purchased b. %o. of orders placed
2. *ime office, personnel dept. & %o of employees b. <ages paid c. ?abor hours
-& "anteen, labour welfare & %o of employees b. <ages paid
4. Accounts office a. %o of employees:%o of time cards handled
G. ?aboratory & *esting laboratory hours b. Hnits of oDp
I. I. $aintenance %o of hours worked in each department
*ost absor'tion:*he process of ascertaining the charge of indirect cost per unit of production or
service is called Nabsorption=
(n other words, the overhead is absorbed by the physical units manufactured or units or services
rendered during a period or for specific )obs. *his helps to determine indirect cost of manufacturing a
product or provision of service.Absorption of overheads can be made based on some suitable basis.
*he following are some of widely used methods of absorption!
a) 'n the basis of N-roduction units= b) As a F of N.irect ?abour "ost=
c) As a F of N.irect $aterial "ost= d) As a F of N-rime "ost=
e) 'n the basis of N.irect ?abour 8ours= i.e. ?abour 8our &ate
11
f) 'n the basis of N$achine 8ours= i.e. $achine 8our &ate
What is activity based costing:
Activity #ased *osting! Activity:based costing (A+") is a special costing system that identifies
activities in an organization and assigns the cost of each activity with resources to all products and
services according to the actual consumption by each activity. (n A+" system, costs are assigned
according to the >cause and e&&ect> relationship between activities and cost ob)ects, which is captured
using cost drivers.
(n the traditional costing systems overheads are added as a percentage of expenses into the direct
costs. *his method is 9uite satisfactory when the overhead costs are a small percentage of the direct
costs. 8owever as the percentages of overhead costs rises, this techni9ue becomes increasingly
inaccurate because the indirect costs are not caused e9ually by all the products.*herefore, using an
arbitrary percentage leads to distortion of costs resulting in the following problems!
a) >ixation of wrong selling prices (+y pricing low, profitable opportunities may be missed or by
pricing high, customers may be lost.
b) *aking wrong decisions (product :sales mix decisions of discontinuing or development etc)
.
$verhead Allocation ? 1raditional vs Activity #ased *osting

14
Steps involved in ABC model
Q-)3'lain the stages involved in Activity based costing system4)3'lain the di&&erent stages
involved in Activity based costing
*he ob)ective of an A+" implementation is to relate all of the costs of doing business to products,
services, or customers. *he process involves assigning and attaching the costs of the activity to cost
ob)ects.
Si3 ste'sin Activity based costing system:
a) (dentify the esources (expenditures) of an organization. -ick resource wise cost data from
financial accounting records.
b) (dentify activitiesD.etermine Activities (work performed).
c) .efine *ost $b!ects (products, services, customers).
d) $ap resource costs to activities by developing esource drivers to link &esources to Activities
e) (dentify activity cost drivers by .eveloping *ost 2rivers to link Activities to "ost 'b)ects.
f) "ompute overhead costs of the products D services
<hile traditional costing arbitrarily allocates overhead costs, A+" traces overhead costs by looking at
the activities that each product and service calls upon. <ith A+" the products consume the activities.
(t is the activities that cost money.
Q-What is cost 'ool and cost driver:
*ost drivers ! cost drivers are the underlying causes of costs of activities. "ost drivers form the
basis of cost allocation and are used to measure the use of activities by different products Dservices.
>or example the cost of the activity Npurchasing= is measured by the number of purchase orders
placed! >or internal transportation the number of parts moved.
Module @
"ost +ehavior
18
*he way a specific cost reacts to changes in activity levels is called cost behavior. "osts may stay the
same or may change proportionately in response to a change in activity.
(i3ed costs
>ixed costs are those that stay the same in total regardless of the number of units produced or sold.
Although total fixed costs are the same, fixed costs per unit changes. 5traight:line depreciation is an
example of a fixed cost. (t does not matter whether the machine is used to produce 0,EEE units or
0E,EEE,EEE units in a month, the depreciation expense is the same because it is based on the number
of years the machine will be in service.
Aariable costs
Mariable costs are the costs that change in total each time an additional unit is produced or sold.
.irect materials is a variable cost.
Graphically, the total fixed cost looks like a straight horizontal line while the total variable cost line
slopes upward.
*he graphs for the fixed cost per unit and variable cost per unit look exactly opposite the total fixed
costs and total variable costs graphs. Although total fixed costs are constant, the fixed cost per unit
changes with the number of units. *he variable cost per unit is constant.
1<
Semi variable costs
5emi variable costs have characteristics of both fixed and variable costs. >or example, a company
pays a fee of O0,EEE for the first KEE local phone calls in a month and OE.0E per local call made above
KEE. .uring $arch, a company made 2,EEE local calls. (ts phone bill will be O0,02E (O0,EEE A(0,2EE
P OE.0E)).
Margin o& Sa&ety
*he margin o& sa&ety is a tool to help management understand how far sales could change before the
company would have a net loss. (t is computed by subtracting break:even sales from budgeted or
forecasted sales. (refer to numerical problems)
Sensitivity Analysis
A business environment can change 9uickly, so a business should understand how sensitive its sales,
costs, and income are to changes. "M- analysis using the break:even formula is often used for this
analysis. +y varying one of the variables, impact on the other variables is estimated.
1=
Module B
Mariable "osting!(t is a method in which the costs to be inventoried include only the variable
manufacturing costs. >ixed factory overhead is treated as a period cost:it is deducted along with
the selling and administrative expenses in the period incurred. *hat is,
>ixed factory overhead is treated as a period expense.
Mariable costing is used for internal management only. (ts uses include! (0) inventory valuation
and income determination; (2) relevant cost analysis; (3) break : even and cost : volume : profit
("M-) analyses ; and (4) short:term decision:making. Mariable costing is, however, not
acceptable for external reporting or income tax reporting.
9nder absor'tion costing, the cost to be inventoried includes all manufacturing costs, both
variable and fixed. %onmanufacturing (operating) expenses, i.e., selling and administrative
expenses, are treated as period expenses and thus are charged against the current revenue.
Q-What are the assum'tions o& marginal costing
Marginal costing: $arginal cost is the ascertainment of marginal cost and the effect on profit of
changes in volume or type of output by differentiating between fixed and variable costs. $arginal
costing distinguishes between fixed costs and variable costs as convention ally classified.
$arginal "ost C Mariable "ost C.irect ?abourA.irect $aterialA.irect xpenseAMariable 'verheads
*he term Ncontribution= means the difference between 5ales and $arginal cost.
"ontribution C5ales : $arginal "ost.
"ontribution is e9ual to fixed cost plus profit (" C > A -).
.n case a &irm neither makes 'ro&it nor su&&ers loss5 contribution +ill be !ust eCual to &i3ed cost
"* D (% 0 1his is kno+n as break even 'oint0
*he concept of contribution is very useful in marginal costing. (t has a relationship with sales. *he
proportion of contribution to sales is known as -DM ratio which remains the same under given
conditions of production and sales.
1>
Q Advantages and 2isadvantages o& Marginal *osting 1echniCue :
Advantages
0. $arginal costing is simple to understand.
2. (t helps in short:term profit planning by breakeven and profitability analysis,
3. (t can be shown both in terms of 9uantity and graphs.
4. "omparative profitability and performance between two or more products and divisions can
easily be assessed and brought to the notice of management for decision making.
G. *he effects of alternative sales or production policies can be more readily available and
assessed, and decisions taken would yield the maximum return to business.
I. (t eliminates large balances left in overhead control accounts
J. -ractical cost control is greatly facilitated. +y avoiding arbitrary allocation of fixed overhead,
efforts can be concentrated on maintaining a uniform and consistent marginal cost
2isadvantages
0. *he separation of costs into fixed and variable is difficult
2. %ormal costing systems also apply overhead under normal operating volume and this shows
that no advantage is gained by marginal costing.
3. Application of fixed overhead can lead to under or over absorption of the same.
4. >ixed cost is not taken care of under marginal costing.
G. (n practice, sales price, fixed cost and variable cost per unit may vary. *hus, the assumptions
underlying the theory of marginal costing sometimes becomes unrealistic.
Marginal costing is not a method o& costing but a techniCue o& 'resentation o& sales and cost
data +ith a vie+ to guide management in decision-making0
>ollowing presentation of two -roforma shows the difference between the presentation of information
according to absorption and marginal costing techni9ues!
MAG.7A- *$S1.7G P$-($MA
Q Q
5ales &evenue xxxxx
?ess $arginal "ost of 5ales
'pening 5tock (Malued R marginal cost) xxxx
Add -roduction "ost (Malued R marginal cost) xxxx
*otal -roduction "ost xxxx
?ess "losing 5tock (Malued R marginal cost) (xxx)
$arginal "ost of -roduction xxxx
Add 5elling, Admin @ .istribution "ost xxxx
2?
$arginal "ost of 5ales (xxxx)
"ontribution xxxxx
?ess >ixed "ost (xxxx)
$arginal "osting -rofit xxxxx
Marginal *osting versus Absor'tion *osting
*he net profits are not the same in both methods because of the following reasons!
10 $ver and 9nder Absorbed $verheads
.n absor'tion costing, fixed overheads can never be absorbed exactly because of difficulty in
forecasting costs and volume of output. (n marginal costing, however, the actual fixed overhead
incurred is wholly charged against contribution and hence, there will be some difference in net profits
between the two methods.
/0 2i&&erence in Stock Aaluation
(n marginal costing, work in progress and finished stocks are valued at marginal cost, but in
absorption costing, they are valued at total production cost. 8ence, profit will differ as different
amounts of fixed overheads are considered in two accounts.*he value of closing stock will be higher
in absorption costing than in marginal costing
@02i&&erences in 'ro&its4'er unit: -rofit per unit in any period can be affected by the actual volume
of production in absorption costing; this is not the case in marginal costing.
(n marginal costing, the identification of variable costs and of contribution enables management to
use cost information more easily for decision:making purposes
-imitations o& Absor'tion *osting
*he following are the criticisms against absorption costing!
Absorption costing is dependent on the levels of output which may vary from period to period, and
conse9uently cost per unit changes due to the existence of fixed overhead. Hnless fixed overhead rate
is based on normal capacity, such changed costs are not helpful for the purposes of comparison and
control.
>or the decision:making purpose of management, better information about expected profit is obtained
from the use of variable costs and contribution approach in the accounting system which is not so in
abosorption costing.
(mportant formulae
0. *ontribution " Per unit% D Sale 'er unit - Aariable *ost 'er unit
2. Contribution B Fi:ed Co%t C ProDt
21
3. ProDt B Contribution 7 Fi:ed Co%t
4. Total proft or loss = Total Contribution - Total Fixed Costs
4& ProDt Eo$u#e Rtio B Contribution9 S$e F 1?? @ )t #en% i* +e %e$$ R%& 1??
,roduct, +ht +i$$ be 7 7 our contribution #r"in, #ore contribution
#r"in #en% #ore ,roDt
8 /re2 Even Point i% ,oint +here Tot$ %$e% revenue B Tot$ Co%t
<& /re2 Even Point @ )n unit A B Tot$ Fi:ed e:,en%e% 9 Contribution ,er unit
=& /re2 Even Point @ )n S$e% E$ue A B /re2 even ,oint @in unit%A F Se$$in" ,rice ,er
unitA
L.+reak ven -oint to achieve target profit marginC *otal "ontribution D "ontribution per unit
: or C fixed cost A profit D selling price : variable cost per unit
A''lication o& Marginal *osting in Managerial 2ecisions ".t is also a''lication o& *AP analysis%
+y effective use of marginal costing techni9ues and formulae, one can apply marginal costing for
managerial decisions with following ways !
10 2ecision regarding to sell goods at di&&erent 'rices to di&&erent customers !5ometimes,
company has to give special discount to special customers. At that time manager has to take decision
at what limit, one can give discount to special customers. $arginal costing may help in this decisions.
/0 *hoose o& Good Product Mi3! <hen companies are producing multiple products company
managers will give preference to that product whose contribution will high. &anking based on
contribution helps in choosing optimum product mix. (refer to numerical problems to understand)
@0*alculation o& Margin o& Sa&ety! $arginal costing can be utilized for calculating margin of safety.
$argin of safety is difference between actual sale and sale at breakeven point.
(or long term 'ro&it 'lanning5 absor'tion costing is the better techniCue0
Q- What are the assum'tions o& marginal costing:-1he assum'tions are
0) Mariable costs vary in proportions to the volume:
2) ?inear behavior of costs
3) >ixed costs are fixed independent of the volume
4) (rrelevance of economies of scale and scope
G) MolumesDprices are the only factors which affects businesses
I) 5ales mix is constant
Presentation o& *ost 2ata under Marginal *osting and Absor'tion *osting"re&er to the
numerical 'roblem%
22
)3'lain 6#reak even analysis; and
6cost volume ?'ro&it analysis;0 *AP analysis is a systematic method of examining the relationships
between selling prices, total sales revenue, volume of production, expenses and profit. (t simplifies
the application of practical aspects of business.
)3'lain the three +ays in +hich P4A ratio can be im'roved
*he three ways in which +- can be improved are
0% eduction in the variable cost:by applying techni9ues, of cost reduction and cost control,
exploiting conomies of scale, better production techni9ues, #uality control.
2) .ncrease in the sale 'rice; +y providing better product features, additional product features,
(mproved #uality and reliability, better service features etc.
3) "ombination of both:cost reduction and increase in sale price by Malue analysis and Malue
engineering.
)#,ortnt *or#u$e in /EP
Per unit GPE Rtio
H
GPE Rtio7*rction
SALES S 1? 1?? 1
EAR)A/LE COST E 8 8? ?&8
CONTR)/0T)ON S7E 1 1? ?&1
F)FE' COST FC
Note PE Rtio i% $%o c$$ed % contribution to %$e%IC9S J rtio or contribution #r"in
rtio
)* PE Rtio or C9S rtio i% ?&1 #en% the vrib$e co%t9%$e% rtio i% ?&8 becu%e
C9SCE9SB1??H OR 1
Three #ethod% o* c$cu$tin" PE rtio
METHO' 1 METHO' 2 METHO' -
PE Rtio B C9S or
FC7 LOSS 9
SALES
S7EC 9S
FCCPROF)T9S
ALES
Chn"e )n ProDt9Chn"e )n S$e%
Chn"e in contribution9chn"e in
%$e%
2-
/EP 0nit%B FC9Cont9unit /EP R% BFC9PE Rtio
$eve$ o* S$e% reKuired to chieve tr"et ,roDt@unit%A B @FCCTPA9Cont9unit
$eve$ o* S$e% reKuired to chieve tr"et ,roDt@Ru,ee%A B @FCCTPA9PE Rtio
SALESBTot$ Co%t CProDt (( Tot$ Co%tBFCCTEC or (( FCCEC90nit
: 6TL
SALES BFCCTECC ProDt (( SALESBFCCEC9 0N)T : 6TLC ProDt
At /EP %$e% BPROF)T )S M?; SALES BTOTAL COST
Mr"in o* %*ety i% the e:ce%% o* ctu$ or bud"eted %$e% over the bre2 even %$e%& )t
re,re%ent% the #ount by +hich %$e% revenue cn *$$ be*ore $o%% i% incurred& Mr"in
o* %*ety re,re%ent% %$e% beyond the bre2 even ,oint&
MARG)N OF SAFETL BActu$ S$e%7/e, S$e% @)t cn be in 0nit% 9 Ru,ee%A
MARG)N OF SAFETL @H OR FRACT)ONA B N IACT0AL SALES7/EP SALESJ9ACT0AL SALES O
F1??
The %i5e o* #r"in o* %*ety re,re%ent% the %tren"th o* the bu%ine%%& /etter MOS
re,re%ent% ,roDtbi$ity nd robu%tne%% in "ro+th&
For calculating point of indiference Total cost of ABC =Total cost of XYZ (refer
to nuerical proble
!"en suc" data is gi#en
2??87
$%
2??<7$& First step PE rtio Bchn"e in ,roDt%9Chn"e in
%$e%
E C rtioB8?H
T"e second step i% S1B?&8? S1CFCCP1 @,roDt nd
%$e% o* 2??8A
S2B?&8? S1CFCCP2 @ProDt nd
%$e% o* 2??<A
So$ve ny one o* the eKution% to "et Fi:ed co%t
T"ird step is to fnd B'( using FC)(* ratio
S$e%7
S19S2
-?,??
?
1?,???
ProDt
P19P2

2,???
8,???
Erib$e
co%t
8?H o*
%$e%
Fi:ed co%t
B
S7E7ProDt
1=,???
1?,???
21???
1?,???
21
E0 M$29-) E
What is &ull cost 'ricing:
Pricing 'olicies
$b!ectives o& the Price Policy !*he following ob)ectives are to be considered while fixing the prices
of the product.
10 Pro&it ma3imi,ation in the short term *he primary ob)ective of the firm is to maximize its
profits. (n the short run, a firm not only should be able to recover its total costs, but also should get
excess revenue over costs. (t may follow policies such as 5kimming price policy, -enetration pricing
policy, competitive pricing policy etc.
/0 Pro&it o'timi,ation in the long run! $'timum 'ro&it re&ers to the most ideal or desirable level
o& 'ro&it08ence, earning the most reasonable or optimum profit has become a part and parcel of a
sound pricing policy of a firm in recent years.
@0 Price Stabili,ation! -rice stabilization over a period of time is another ob)ective. -rice stability is
one of the pre re9uisite conditions for steady and persistent growth of a firm. A stable price policy
only can win the confidence of customers and may add to the goodwill of the concern. (t builds up the
reputation and image of the firm.
B0 (acing com'etitive situation! 'ne of the ob)ectives of the pricing policy is to face the competitive
situations in the market or to prevent competition to dominate.
E0 Maintenance o& market share!*he economic strength and success of a firm is measured in terms
of its market share; the pricing policy is formulated to maintain its market share at any cost.
F0 *a'turing the Market! capture the market, dominate the market, command and control the
market in the long run.
G0 )ntry into ne+ markets! Apart from growth, market share expansion, diversification in its
activities, a firm makes a special attempt to enter into new markets. *he price set by a firm has to be
so attractive that the buyers in other markets have to switch on to the products of the firm.
H0 2ee'er 'enetration o& the market! *he pricing policy has to be designed in such a manner that a
firm can make inroads into the market with minimum difficulties. .eeper penetration is the first step
in the direction of capturing and dominating the market in the latter stages.
I0 Achieving a target return! prices of the products are so calculated as to earn the target return on
investment.
1J0 1arget 'ro&it on the entire 'roduct line irres'ective o& 'ro&it level o& individual 'roducts0
24
*he price set by a firm should increase the sale of all the products rather than yield a profit on one
product only. A rational pricing policy should always keep in view the entire product line and
maximum total sales revenue from the sale of all products.
110 -ong run +el&are o& the &irm! A firm has multiple ob)ectives. 'b)ective of the pricing policy has
to be designed in such a way as to fulfill the long run interests of the firm keeping internal conditions
and external environment in mind.
02. Ability to 'ay! -ricing decisions are sometimes taken on the basis of the ability to pay by the
customers, i.e., higher price can be charged to those who can afford to pay. 5uch a policy is generally
followed by those people who supply different types of services to their customers.
1@0 )thical Pricing! +asically, pricing policy should be based on certain ethical principles. *he
pricing policy has to secure reasonable amount of profits to a firm to preserve the interests of the
community and promote its welfare.
1y'es4Methods o& 'ricing
Marginal cost 'ricing! $arginal cost:plus pricing is a method of pricing a unit of a product at its
marginal cost plus some profit. $arginal cost is the total cost of producing an extra unit of a product
at a certain level of production. *he ob)ective is to achieve a desired 6"ontribution7 towards fixed
costs and overheads. *he resulting profit in a business is therefore! *otal contribution:*otal fixed
costs.
(ull cost 'ricing! (6full cost plus) >ull cost pricing is a practice where the price of a product is
calculated by a firm on the basis of its direct costs per unit of output plus a markup to cover overhead
costs and profits. *he overhead costs are generally calculated assuming less than full capacity
operation of a plant in order to allow for fluctuating levels of production and costs. *he profit margin
is computed as a fixed percentage of the average total cost of the product.
$. P.*.7G: *he 6return on investment7 pricing method determines the price of a product based
on the target return on the amount invested in a product.
Hnit price CS*otal cost(fixed Avariable)A(F return x investment)TD+udgeted sales volume.
*his method ensures that the target return is earned, however this is sub)ect to limitations imposed by
competition and regulations.
*ontribution A''roach 1o Pricing ! "ontribution approach pricing maximizes the profit derived
from an individual product, based on the difference between the product/s price and variable costs
(the product/s contribution margin per unit).*his method is adopted in situations where a company
often receives a non:routine, special order for its products at lower prices than usual. (n normal times,
the company may refuse such an order since it will not yield a satisfactory profit. (f times are bad or
there is idle capacity, an order should be accepted if the incremental revenue exceeds the incremental
costs involved. 5uch a price, is called a contribution price and is lower than the regular price.
28
(ull cost 'ricing and marginal cost 'ricing
A2AA71AG)S $( (9-- *$S1 P.*.7G

0. Guaranteed *ontribution: <hen full costs plus basis is used for pricing, the firm earns a
guaranteed contribution e9uivalent to fixed costs plus profit margin. ven, if profit margin is taken as
nil, fixed costs included in prices will guarantee minimum contribution.
2. Assured Pro&it! "ost plus is a fair method of price fixation. *he business executives are
convinced that the price fixed will cover the cost.
3. educed risks and uncertainties: (f price is greater than cost, the risk is covered. *his is true
when normal expected capacity basis of cost estimation is used. *he decision:maker may accept a
pricing formula that seems reasonable for reducing uncertainty.
4. Most suitable in -ong run: "ost plus pricing is ideal in the long run since there is no
permanent opportunity cost. *he effect of seasonal fluctuation is ironed out and prices are established
based on normal long run costs.
G. *onsiders market &actors! "ost plus pricing does not mean that market forces are ignored.
*he mark up added to the cost to make a price reflects the well:established customs of trade, which
guide the price fixer towards a competitive price.
I. (ull ecovery o& all costs o& the 'roducts! >or long:run pricing decisions, full cost of the
product inform managers of the minimum costs to be recovered so as to continue in business
rather than shut down.
J. Price stability: -rice fixation based on full costs of the product promotes price stability,
because it limits the ability of sales persons to cut prices. -rice stability facilities planning.
K. Sim'licity: A full:cost formula for pricing does not re9uire a detailed analysis of cost:
behavior patterns to separate costs into fixed:variable components for each product. (t is simple to
operate.

A''lication o& &ull cost 'lus 'ricing
>ull cost plus pricing is particularly useful for businesses that carry out a large amount of contract
work or )obbing work for which individual )ob or contract prices must be 9uoted regularly to
prospective customers. 8owever the percentage profit mark up does not have to be rigid and fixed,
but can be varied to suit the circumstances. (n particular the percentage mark up can be varied to suit
demand conditions in the market.
A2AA71AG)S $( MAG.7A- *$S1 P-9S APP$A*H 1$ P.*.7G!
*he advantages of a marginal cost:plus approach to pricing are as follows.
(t is a simple and easy method to use.
2<
*he mark:up percentage can be varied, and so mark: up pricing can be ad)usted to reflect
demand conditions.
(t draws management attention to contribution, and the effects of higher or lower sales
volumes on profit. (n this way, it helps to create better awareness of the concepts and
implications of marginal costing and cost :volume:profit analysis. >or example, if a product
costs &s 0E per unit and a mark :up of 0GE F is added to reach a price of &s.2G per unit,
management should be clearly aware that every additional &s.0EE of sales revenue would add
&sIE to contribution and profit.
(n practice, mark:up pricing is used in businesses where there is a readily identifiable basic
variable cost. &etail industries are the most obvious example, and it is 9uite common for the
prices of goods in shops to be fixed by adding a mark: up (2EF or 33.3F,say ) to the purchase
cost.
2ra+backs to marginal cost- 'lus 'ricing
Although the size of the mark:up can be varied in accordance with demand conditions, it
does not ensure that sufficient attention is paid to demand conditions, competitors/ prices
and profit maximization.
(t ignores fixed overheads in the pricing decision, but the sales price must be sufficiently
high to ensure that a profit is made after covering fixed costs.
APP-.*A1.$7 $( MAG.7A- *$S1 P.*.7G
Approach to pricing might be taken when a business is working at full capacity, and is restricted by a
shortage of resources from expanding its output further. +y deciding what target profit it would like
to earn, it could establish a mark:up per unit of limiting factor0 (n the short term, when the production
is covering whole of the expenses (>ixed and variable), then to enhance the profit, some orders may
be accepted at below the regular price, which must be more than the marginal cost of producing those
extra units. *his is the situation where marginal cost:plus pricing helps. >or example! <hen a factory
is covering all of its variable and >ixed costs, and a lucrative export opportunity comes, then that
extra production can be sold at a price which may be less than regular price but more than the
marginal cost of production. <hereas a full cost: plus approach to pricing draws attention to net profit
and the net profit margin, a variable cost:plus approach to pricing draws attention to gross profit and
the gross profit margin, or contribution.
What is trans&er 'ricing
2=
1rans&er 'ricing! 1rans&er 'ricing is the value placed on goods and services exchanged between
affiliates or divisions within a company.*ransfer pricing is a system of pricing adopted by a company
for providing goods and services by one segment of the company to other segments of the same
company.
A 6trans&er 'rice; is the price at which one company buys and sells goods or services or shares
resources with a related affiliate in its supply chain. *ransfer pricing policy system of a company
forms the basis for evaluation of departmental performance and its managers.
>or example, most companies in the oil industry have a petroleum refining and retail sales divisions
that are usually evaluated on the basis of return on investment (&'() or residual income method. *he
petroleum refining division processes crude oil into gasoline, kerosene, and other end products. *he
retail sales division takes gasoline and other products from the refining division and sells them
through the company/s chain of service stations. ach product has a price for transfers within the
company.
'i%cu%% the ob!ective% o* trn%*er ,ricin" #echni%# nd it% re$evnce to
#n"e#ent contro$ ,roce%%
Pur'oses o& 1rans&er Pricing
*he basic purpose of transfer pricing is to induce optimal decision making in a decentralized
organization (i.e., in most cases, to maximize the profit of the organization as a whole). *he other
ob)ectives are to
)valuate the 'er&ormance o& each division se'arately by generating separate profit
figures for each division.
Hel' coordinate 'roduction5 sales and 'ricing decisions o& the di&&erent divisions.
1o allo+ the com'any to generate 'ro&it "or cost% &igures &or each division
se'arately0
1o o'timi,e the allocation o& an organi,ation=s resources0
Hel' the divisions to achieve goal congruence
)3'lain the various ty'es4methods o& trans&er 'ricing4-ist out the di&&erent ty'es o& trans&er
'rices 0State any three broad bases available &or determining trans&er 'rices +ith di&&erent
o'tions available +ithin each base0)3'lain the mechanics5merits and dra+backs o& <Market
based= trans&er 'ricing +ith suitable illustration0 What is market based 1rans&er 'ricing and
+hat are the di&&iculties in using this a''roach
*ransfer pricing serves the following purposes.
2>
0. <hen product is transferred between profit centers or investment centers within a
decentralized firm, transfer prices are necessary to calculate divisional profits, which then
affect divisional performance evaluation.
2& <hen divisional managers have the authority to decide whether to buy or sell internally or on
the external market, the transfer price can determine whether managers= incentives align with
the incentives of the overall company and its owners. *he ob)ective is to achieve goal
congruence5 in which divisional managers will want to transfer product when doing so
maximizes the consolidated corporate profits.
3. <hen multinational firms transfer product across international borders, transfer prices are
relevant in the calculation of income taxes, and are sometimes relevant in connection with
other international trade and regulatory issues.
Methods o& trans&er 'ricing: *he most common transfer pricing methods are
Market-based 1rans&er Pricing. <hen the outside market for the good is well:defined, competitive,
and stable, firms often use the market price as an upper bound for the transfer price.
+y using market:based transfer prices in a perfectly competitive market, a company can achieve the
following!
Goal congruence
$anagement effort
Good subunit performance evaluation
5ubunit autonomy
A market:based transfer price aligns their incentives with owners= incentives of maximizing overall
corporate profits. 5ometimes, there are cost savings on internal transfers compared with external sales
for which appropriate ad)ustments are made to the transfer price.
-imitations o& market based trans&er 'rices
8owever, many intermediate products do not have readily:available market prices. xamples are! a
pharmaceutical company with a drug under patent protection (an effective monopoly); and an
appliance company that makes component parts in the -arts .ivision and transfers those parts to its
assembly divisions for which there is no market price and market:based transfer price cannot be
used in such cases. Another disadvantage of a market:based transfer price is that the prices for some
commodities can fluctuate widely and 9uickly, markets could be different, varying levels of 9uality
and services and product features, which affect the system.
7egotiated 1rans&er Pricing! .ivisional managers are encouraged to negotiate a mutually agreeable
transfer price. %egotiated transfer pricing is typically combined with free external sourcing.
*ost-based 1rans&er Pricing:
"ost:based transfer prices are helpful when market prices are unavailable, inappropriate, or
too costly to obtain.
$any companies use transfer prices based on full costs.
-?
*o approximate market prices, cost:based transfer prices are sometimes set at full cost plus a
margin.
(n the absence of an established market price many companies base the transfer price on the
production cost of the supplying division.
*he most common methods are!
U >ull "ost
U "ost:plus
U Mariable "ost plus ?ump 5um charge
U Mariable "ost plus 'pportunity cost
U .ual *ransfer -rices
ach of these methods is outlined below.
(ull *ost! (n this method the full cost (5tandard cost) of the product is charged. *his method is
popular because of its clarity and convenience and because it is often viewed as a satisfactory
approximation of outside market prices.
*ost-'lus: <hen transfers are made at full cost, the buying division takes all the gains from trade
while the supplying division receives none. *o overcome this problem the supplying division is
fre9uently allowed to add a mark:up in order to make a 6reasonable7 profit.
Aariable *ost 'lus a -um' Sum *harge: (n order to motivate the buying division to make
appropriate purchasing decisions, the transfer price could be set e9ual to (standard) variable cost plus
a lump:sum periodical charge covering the supplying division=s related fixed costs.
Aariable *ost 'lus $''ortunity *ost: Also know as the $inimum *ransfer -rice! $inimum
*ransfer -rice C (ncremental "ost A 'pportunity "ost.
2ual 1rans&er Prices! *o avoid some of the problems associated with the above schemes, some
companies adopt a dual transfer pricing system. >or example!
"harge the buyer for the variable cost. *he ob)ective is to motivate the manager of the buying
division to make optimal (short:term) decisions.
"redit the seller at a price that allows for a normal profit margin. *his facilitates a 6fair7 evaluation of
the selling division=s performance.
Q-What are the 'roblems associated +ith trans&er 'ricing in a multinational enter'rise as +ell
as trans&er 'ricing bet+een di&&erent units o& M7*=S situated in di&&erent countries0
A large proportion of world trade is accounted for by cross:border trade taking place within
multinational enterprises, where branches or subsidiaries of the same multinational enterprise
exchange goods or services. *hese transactions within the group are not exposed to the same market
forces as transactions between independent enterprises. *hey are referred to as 6controlled
transactions7. (f the prices of these transactions are artificially lowered or increased they may lead to
-1
taxable profits being shifted from one country to another. *ax avoidance also happens.
*ake a beverage company located, say, in $exico, which has a subsidiary in >rance. ?et=s assume
that the >rench subsidiary pays royalties to the $exican head9uarters for the rights to sell its drinks.
*axes are owed in >rance based on the >rench subsidiary=s results. *he higher the royalties paid by
the >rench subsidiary, the lower the taxable profits in >rance. *he >rench tax authorities will be
satisfied if they see that the royalties paid by the >rench company to its head9uarters in $exico are
not higher than those that would be paid to an independent enterprise for a similar transaction. +ut if
the royalties are too high, there is a possibility that profits are being shifted out of >rance to reduce
tax liabilities there. *he 6arm=s length principle7 is used to address such issues.
*he arm=s length principle has become the international norm for allocating the tax bases of
multinational enterprises among the countries where they operate. *he '". lists as many as five
methods for approximating arm=s length outcomes to determine an arm=s length price for cross:border
transactions within $%s.
Q $utline the o''ortunity cost a''roach to trans&er 'ricing
According to 8orngren 6opportunity cost based transfer pricing is the minimum transfer price should
be (0) the additional outlay costs per unit incurred to the point of transfer(approximated by variable
costs),plus (2) the opportunity costs per unit to the firm as a whole7
-ut differently the transfer price (*-) should be e9ual the standard variable cost (5M") plus the
contribution margin per unit given up on the outside sale by the company, when a segment sell
internally. *he contribution margin given up is referred to as the lost contribution margin
1PDSA*K?"$
M$29-) F: #92G)1.7G
Q-#udgeting and budgetary control: #udgeting as a tool o& management control: What are the
essential &eatures o& an e&&icient system o& budgetary controlL +hat are the di&&erent ty'es o&
&unctional budgets: Which are 're'ared by a large scale manu&acturing concern: )3'lain and
illustrate0 What is a budget manual and +hat are its contents
(%*&'.H"*('%!
'ne of the essential features of modern business management is planning and control. +udgetary
control is the most common, useful and widely used standard device of planning and control. (t is
very helpful for the business organization to conduct a business in the competitive market.
+H.G*(%G @+H.G*A&V "'%*&'?!
#udget! A budget is a detailed plan of operations for some specific future period.
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#udgeting! $eans the processes and activities adopted in the preparation of budgets, monitoring and
evaluation of the same.
$b!ectives and &unctions o& budgetingL
An effective budgeting system is vital to the success of a business firm. +udgeting is need in
organization to perform the following systems
i) planning ii) coordination iii) communication iv) monitoring and control v) performance evaluation
#udgetary controlM management control! *his refers to a system of management and accounting
control by which all operations and outputs are forecast as far as ahead as possible and the actual
results, when known are compared with the budget estimates. *hus the term budgetary control is
designed to evaluate the performance in terms of goals budgeted. $anagement control system and
+udgeting are two interlinked factors in strategy implementation of an organization. +udgeting forms
the basis of $anagement control. +udgeting facilitates proper definition of ob)ectives and
corresponding allocation of resources. $anagement control facilitates the monitoring and
implementation of the same.
18P)S $( (97*1.$7A- #92G)1S:
(0) Sales #udget! *he sales forecast or sales budget is the basic core budget on which other
budgets depend. *his is analyzed between products, periods and areas.
Pre'aration $& Sales #udget! 5ales budget is prepared by the sales manager. >ollowing matters
are considered at the time of its preparation!
(i) Analysis of 8istorical 5ales
(ii) &eports +y 5alesman
(iii) +usiness "onditions
(iv) $arket Analysis
(v) 5pecial "ondition
"/% Production #udget!-roduction budget is prepared after the preparation of sales budget, to
determine 9uantity of goods which should be produced to meet the budget of sales .(t is expressed in
physical terms, such as Hnit of output, ?abor re9uirement,$aterial re9uirement. etc
(@% 2irect -abour #udget! *he direct labour budget tells about the estimates of direct labour
re9uirements essential for carrying out the budgeted output.
"@% a+ Material #udget: $aterials budget is based on the inventory policy and production
re9uirements
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(4% Manu&acturing $verhead #udget! $anufacturing overhead is classified into three categories,
(0)>ixed (2)Mariable (3)5emi:variable
(I) Selling and 2istribution $verhead #udget! *he selling expenses include all items of
expenditure on the promotion, maintenance and distribution of finished goods.
(J) *ash #udget! *he cash budget is a summary of the firm=s expected cash inflows and outflows
over a particular period of time .
"H% 1he Master budget! *he ("$A,ngland, defines it as the 5ummary +udget ,incorporating its
component functional budgets, which is finally approved, adopted and employed.
(L) (i3ed #udgets! (t is a budget in which targets are rigidly fixed. According to (.".$.A. ?ondon.
>ixed budget is a budget which remains unchanged irrespective of the level of activity actually
attained. 5uch budgets are usually prepared from one to three months in advance of the fiscal year to
which they are applicable.
(0E) (le3ible #udget! A flexible budget is , designed to provide information as to sales, expenses and
profits for different levels of activity which may be obtained.
(00) Per&ormance #udget: Among the methods which relate costs to outputs, performance budgeting
stands out the most prominent. (t has emerged as a whole new way of considering fiscal
responsibility.
(02) Nero-#ase #udgeting "N##)! *he ob)ective of W++ is to formulate the budget by estimating
the amounts of expenditure likely to be incurred from the base level, a fresh. *his method is called
Wero +ase budgeting since the existing system is discontinued and a fresh budget is prepared or the
existing system is reviewed on the assumption of Wero:+ase.
A2AA71AG)S $( #92G)1A8 *$71$-: "Mention the advantages o& budgeting%
+udgetary control has become an essential tool of management for controlling costs and maximizing
profits. (ts advantages to management are as follows!
(0) )conomy in +orking! (t brings efficiency and economy in the working of the
business enterprises . All activities are guided by the goals set in the budgets.
(2) #uck- 'assing is avoided! (t establishes divisional and departmental responsibility. (t thus
prevents alibis and buck:passing when the budget figures are not met.
(3) )stablishes coordination! (t helps in coordination of the various divisions of a business; the
production, marketing, financial and administration divisions.
(4) Acts as a sa&ety signal! (t acts as a safety signal for the management. (t shows when to proceed
cautiously and when manufacturing expansion can be safetly undertaken
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(G) Ado'tion o& uni&orm 'olicy! Hniform policy can be pursued by all division of business.
(I) 2ecrease in 'roduction costs ! 5easonal variation in production can be reduced by developing
new 6fill in products7.
(J) Ado'tion o& standard costing 'rinci'les! *he use of budget figures as measures of operating
performance and financial position makes possible the adoption of the standard costing principle in
divisions other than the production division.
(K) $'timum mi3! (t helps management in obtaining the most profitable combination of different
factors of production.
(L% (avour +ith credit agencies! management who have developed a well ordered budget plan and
who operate it accordingly, receive greater favour from credit agencies
-.M.1A1.$7S $( #92G)1A8 *$71$-:
#ased on estimates! *he strength or weakness of the budgetary programme depends to a degree on
the accuracy with which the basic estimates are made. *he estimate must be based on all available
facts and good )udgments.
7eed &or continuous ada'tation! A budgetary programmed can not be installed and perfected in a
short time. +udget techni9ues must be continuously adapted not only for each particular concern but
for changing conditions within the concern.
7o automatic e3ecution o& the budget! 'nce the budget is complete, it will be effective only if all
responsible executives get behind it and exert continuous and aggressive efforts towards its
achievement.
$nly a tool o& the management! *he budget should be regarded not as a master but as a servant .(t is
one of the best tools yet devised for advancing the affairs of accompany and the individuals in their
various areas of management activity
Module G: Standard costing and variance analysis:
State the signi&icance o& com'uting materials cost variance and materials usage variance0
According to "($A, ?ondon, 5tandard costing is defined as 6A predetermined calculation of how
much costs should be under specific working conditions. (t is built up from an assessment of the
value of cost elements and correlates technical specifications and 9uantification of materials, labour
and other costs to the prices and Dor wages rates expected to apply during the period in the which the
standard cost is intended to be used. (ts main purposes are to provide bases for control through
variance accounting, for the valuation of stock. 5tandard costs are the predetermined costs of
manufacturing products during a specific period under current or anticipated operating conditions,
<ork in -rogress and in some cases for fixing selling prices7
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What are the advantages o& standard costing:
(t provides a yardstick against which actual are measured
(t helps in introducing incentives to employees and provides a basis for motivating
(t helps in adopting management by exception techni9ues
(nvestigation of variances helps in identifying the real causes of inefficiency and persons responsible
for the same
(t helps in valuing the closing stock
7eed &or setting standard: Standards are needed +hen management aims in achieving
economic e&&iciency0 .t is e3tensively utili,ed in the &ollo+ing activities o& an organi,ation0
(a) stablishing budgets.
(b) "ontrolling costs , measuring efficiencies and motivating personnel.
(c) -romoting cost reduction.
(d) 5implifying cost procedures and expediting cost reports.
(e) Assigning costs to inventories.
(f) 5etting sales prices.
(g) (n planning and controlling operations
(h) +etter decision making by adopting 6$anagement by exception7
2evelo'ment o& standards:
1he success o& standard costing de'ends u'on the establishment o& correct standards0*he
following preliminaries should be gone through before standards are planned to be evolved
2) stablishment of cost centers
3) *ypes of standards
4) 5etting the standards
2evelo'ing or setting the standards or establishing the standard costs0
0) A standard committee should be formed comprising of the operating personnel, cost accountant
and other related personnel.
2) 5tandards should be preferably for each element of the costs.
2irect material cost! 5tandard material cost for each product should be predetermined .*his will
include
i) .etermination of the standard 9uantity of materials needed for the production
ii) .etermination of the standard price per unit of material
2irect labour cost! .etermination of standard direct labour cost will include the determination of
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i) 5tandard time
ii) 5tandard rate
$verhead costs: )3'lain the classi&ication o& overhead variance0
$verheads! 'verheads are segregated into fixed and variable and standard overhead rate should be
determined for fixed as well as variable overhead. *hese rates should also be determined according
to the function:wise classification of overheads:manufacturing, administrative and selling and
distribution, so that exact place of overhead variance may be located and corrective action may be
taken. 5tandard overhead rate is determined keeping in view past experience, present conditions and
future trends. >ixation of standard overhead rate may involve determination of standard overhead
costs, estimation of standard level of production reduced to a common base such units of production,
direct labour hours ,machine hours, etc.
5tandard Mariable overhead rate C 5tandard M'8 for the budget period D+udgeted production in
unitsDhours for the budgeted period.
5tandard >ixed overhead rate C 5tandard >'8 for the budget period D+udgeted production in
unitsDhours for the budgeted period.
-imitations o& standard costing
.ifficult to establish
%ot suitable and expensive for small concerns
(naccurate standards can cause frustration
Module H: *ost control and cost reduction
Q-)3'lain the &unctions o& cost Auditor0 What is cost Audit: )3'lain the sco'e o& *ost Audit0
What is the di&&erence bet+een cost control and cost reduction:
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*ost *ontrol: (n business practices, cost control is a plan of action wherein the expenses are not
allowed to grow past a reasonable level than what are budgeted. According to "($A ,?ondon,
"ost control is defined as 6*he regulation by executive action of the cost of operating an
undertaking particularly where such action is guided by cost accounting7. "ost control aims at
reducing inefficiencies and wastages and setting up predetermined costs and plans to achieving
them. "ost control is exercised through setting standards or norms or targets and comparing
actual performance. *his is with a view to ascertain deviations from set targets or norms or
standards and taking corrective action to ensure that the future performance confirms to the set
standards. "ontrolling costs is the best way to maintain or control the increase in cash flows.
*ost eduction: "ost reduction is a planned positive approach to reduce expenditure. According to
"($A ?ondon Cost reduction is to be understood as the achievement of real and permanent
reduction in the unit cost of goods manufactured or services rendered without impairing their
suitability for the use intended or diminution on the quality of the product7. (t is a corrective
function, by analyzing costs and by making continuous improvement of business processes,
functions, activities etc.
"ost reduction is achieved by two ways!+y reducing the consumption!+y increasing productivity
(ields covered by cost reduction "sco'e o& cost reduction4areas o& cost reduction%
10Product design! .esign constitutes one of the most important field where cost reduction is
attempted. fficient designing for a new product and improving the design for an existing product can
the reduce the costs of material, ?abour , and other manufacturing expenses.MADM techni9ues can be
applied effectively
2.(actory layout and )Cui'ment! 5cientifically planned layout and +etter utilization of the
machines and e9uipment will ensure cost reduction by improving the effectiveness and efficiency.
30Marketing: Activities of marketing such as market research, packing, warehousing, distribution,
after:sales service can be brought under the cost reduction programme and thereby cost reduction can
be achieved.
4. Personnel Management! +y focusing on better manpower planning, *raining in 9uality and
productivity, Bob evaluation, $erit rating and better 8&$, the employee cost and efficiency can be
improved leading to cost reduction.
G. Manu&acturing !+y elimination of wasteD efficiency in operations D better maintenance of
machines and e9uipment .-roduction planning and control D AutomationD'perations research D
I. $aterials management !+etter materials management (standardizationDprocurementDefficient
supply chain Dusage D B(*DXanban).Application of Malue analysis to $$ can lead to eliminate of an
item or alternative materials
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J.Quality management; Adoption of *#$
K. 1echnology !Adoption of better technology leads to cost reduction
L.$arketing management! better product mix through $arket research
0E.Management control and (inancial management! +etter financial management +udgetary
control and $anagement control systems leads to cost reduction and control..
1ools and techniCues &or cost reduction: >ollowing tools are used in cost reduction
D D-lanning and control of finance D"ost benefit analysisD"ontribution analysis D-&*D
Advantages o& *ost eduction!Advantages o& *ost eduction to a &irm !
(mproves profits.
(mproves financial position.
(mproves competitive capabilities.
5erves as an index of economic efficiency.(productive and allocative)
>acilitates better allocation of resources
Advantages o& *ost eduction to the .ndustry! 'ne company serves as a trend setter for the other
companies,developing healthy competition.
*ost Audit: "ost Audit has been defined by "($A,?ondon as the 6verification of cost accounts and a
check on the adherence to the cost accounting plan7. "ost audit is basically an internal audit used for
enterprise governance to assess operational efficiencies and resource management.
5pecial attention is given to verification of cost records and adherence to acceptable cost accounting
procedures and policies of the firm as a whole. :
2e&ine the sco'e o& cost audit! scope of cost audit, as defined by ("<A(, covers the evaluation of
the efficiency of operations and the propriety of management actions. (n this sense, cost audit is
synonymous with efficiency audit mainly as a guide for management policy and decision making
besides being a barometer of actual:performance performance.
A.materials
1y'es o& cost audit:
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*ost audit to assist the Management! *he ob)ective is to make available accurate, relevant
and prompt information to the management and to facilitate the management in taking
important decisions.
*ost audit under Statute0 *he "entral Government may, under section 233:+ of the
companies Act 0LGI order that certain classes of companies which are re9uired to maintain
proper records regarding materials consumed, labour and other expenses under section 2EL,
are re9uired to get their cost accounts audited. *he aim of such type of audit is that the
Government wants to ascertain the relationship of costs and prices
*ost audit on behal& o& the customer! "ost plus contracts are generally awarded sub)ect to
provisions of cost audit.
*ost audit on behal& o& 1rade association! 5ometimes a *rade association may appoint a
cost adutor to conduct cost audit
o *o ascertain comparative profitability of its member.
o *o determine minimum price to avoid cut throat competition among its members.
o *o maintain prices at a certain level so as to prevent undue profiteering.
*ost audit on behal& o& 1ribunals! *ribunals re9uest for cost audit for taking important
decision
Advantages o& *ost audit: ffective cost audits provide a complete breakdown of expenses that give
a company financial clarity about accounts.*he other advantages are
stablishes the accuracy of cost accounts
8elps management in taking important decisions
&educing the cost of production
+rings more reliability in costing data
$anagement by exception is possible
Analysis of variances is facilitated
Assist the financial auditing
nables the government to plan and estimate subsidies and protection to industries
8elps management in inter:unit comparison.
-imitations o& cost audit
)3'ensive: 'ne primary disadvantage associated with cost audits is the excessive fees.
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-engthy 'rocess: "ost audits are also lengthy processes that re9uire employee devotion.
-ost 1ime: Although thorough, an auditor/s report is usually given three to five weeks after
the balance sheet is released., time lost between the balance sheet release and auditor/s report
may cost the company money
9ncertainty: .ue to estimation uncertainty is associated with it
2istinguish bet+een cost audit and &inancial audit: .ifference between "ost Audit and >inancial
Audit
*he basic nature of audit is checking and it holds good for both the cost audit as well as the financial
audit. 8owever following are the points of difference between these two audits!
0. *om'ulsory nature 6 >inancial audit is compulsory for all the companies registered under
companies act, 0LGI.
"ost audit is not compulsory for all the companies. 'nly in the case of manufacturing or mining
companies have to maintain cost accounts under section 2EL and get those accounts audited under
section 233b.
20 Pur'ose 6 *he purpose of the financial audit is to report on the profit and loss account and balance
sheet as to whether they show true and fair view of the business or not.
*he purpose of the cost audit is to certify that whether the expenditure incurred on the production of
items has been incurred prudently or not.
40 .nstance 6 >inancial audit is conducted at the instance of the shareholders. "ost audit is done at the
re9uirement of third parties like government, industrial organizations etc.
G. Appointment 6 >inancial audit is appointed normally by the shareholders in the general meeting
whereas the board of directors with the previous approval of the central government appoints a cost
auditor.
I. ecurrence! >inancial audit is conducted every year whereas a cost audit may be done in the year
in which it is re9uired by the government or any other agency.(xcept $fg and $ining cos)
J. Stock 6 (n financial audit auditor has to check the exact value of closing stock for the purpose of
balance sheet, whereas in the cost audit the auditor has to check the ade9uacy of the stock keeping in
view of the needs of the concern.
K. e'ort 6 (n the financial audit the report is submitted to the management to be laid in the general
meeting of the shareholders, the report of the cost auditor is submitted to the company and also to the
central government within 0KE days from the end of the company=s financial year to which the cost
audit
3. )3'ression o& o'inion 6 *he financial auditor has to comment upon the accuracy of the
transactions recorded and the cost auditor has to comment upon the correctness and wiseness of the
decisions taken in production of items
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